Is the Dow set for a big fall?

In recent weeks we’ve looked at how to trade Elliott waves. We know that a typical Elliott wave follows a five-wave pattern – consisting of three up waves and two corrective waves. And I’ve been looking for such a pattern in the Dow.

Well since my article on 3 August, the Dow has rallied off my lower tramline. Am I now close to a great short trade on the Dow? Let’s look at the chart (below).

The Dow has edged up towards my upper tramline just above the 13,200 area. We are in a critical region, as the 1 May 13,340 high lies only 160 pips above the current market.

I have labelled the May high as the large-scale fifth (final) wave up from the October 10,400 low. And this could herald a major fall in the Dow as it bounces off our upper tramline.

Dow Jones spread betting chart

(Click on the chart for a larger version)

What if the Dow continues to rally?

Of course the market could rally above this May high. And if we do get a new high, then the situation does get a little more complicated. The question then would be: do I have a possible new labelling?

I don’t think I have to worry about this for now. Take a look at the chart below:

Dow Jones spread betting chart

(Click on the chart for a larger version)

As you’ll see, the wave 4 overlaps with wave 1. And this breaks one of the key rules for an Elliott wave: wave 4 must not overlap wave 1. So I’m comfortable with my labelling for now.

Why I’m staying on the sidelines for now

What should I do from here?

Well, to be honest I am not at all certain how this will play out. Looking back over charts, we can all have a decent stab at identifying the correct wave labels. But the market does not pay out on this ability.

So on that basis I am standing aside for now. I am simply too confused to trade.

Thankfully, the other indexes – S&P and Nasdaq – are trading well below their recent highs, and my Elliott wave labels are in much less danger of being overturned. So I’ll return to these in forthcoming issues of MoneyWeek Trader.

But before I go, I just wanted to address a very interesting question from a reader about my article on Friday.

As you’ll remember, we were looking at the Elliott labelling on the US T-bond.

Let’s remind ourselves of the chart:

US Treasury Bonds spread betting chart

(Click on the chart for a larger version)

On Friday I stated that I had to abandon my wave 4 label because I could see no 5 wave. The problem was that no new lows were put in below the 3 wave low.

But a reader asked: why not call the rally to the 1.52 level as my new wave 4, and then the Friday low could be the fifth wave I am looking for?

Yes, that is possible, but I do not believe it a likely interpretation simply because of the different scales of the waves. In particular, wave 2 up is short in time and the new wave 4 up would be much longer in time. Basically, they are out of scale – and that illustrates one of the guidelines in using Elliott waves. The relative size and time duration of the waves must be in proportion.

The other problem is if I label Friday’s low as my fifth wave, it would be very complex and the longest of the five waves in time, and that is uncharacteristic of true fifth Elliott waves.

So I will stay with my A-B-C formation down for now. We could see another challenge of the lower tramline, but I would expect that to hold, at least for now.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading

Advanced tramline trading

An introduction to Elliott wave theory

Advanced trading with Elliott waves

Trading with Fibonacci levels

Trading with ‘momentum’

Putting it all together

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