The right trading system

I have been tracking the Dow for signs of a top since my last post on 11 February: We’re not far from a market turn. On Wednesday, I spotted the confirmation that the turn was in. I’ll get to that later.

With the Dow down 200 pips from Wednesday’s top at 14,060 I have to ask a tricky question. If the market has turned from up to down, what were the factors that changed the situation?

Every trader will answer that according to the theory he/she holds about what really drives the markets.

I’m sure you have seen a market that, for no apparent reason, makes a major top or bottom and you have been left scratching your head wondering what changed? I know I have – before I started studying Elliott waves, that is.

Of course, the pundits are full of logical explanations after the event. Sadly, I have yet to discover a way to make any money on that move after it has occurred.

Naturally, we all have our theories on what drives the stock market. Some say it is earnings. Others say it is the force of excess buying over selling (in a bull run) – the popular ‘wall of money’ theory. Yet others believe the media drives the markets. That’s the story the mainstream media like to tell about themselves, and I have no time for it.

In the 1970s, the popular theory was that stock movements are random – the ‘random walk’ theory. This was during a time when stocks were range-bound.

And among economists, there is no general consensus on what drives the stock market. Best not to follow them, then.

Scaling the wall of money

Let’s examine briefly the ‘wall of money’ theory. On the surface, it makes sense (as all theories do if they support your investments!). The money sitting on the sidelines has to go somewhere, surely?

Interest rates are zilch, gold is collapsing, bonds are too expensive, and commodities are also expensive. So, what is left?

OK, so what is the mechanism that determines the price?

The last trade is always between a willing buyer and a willing seller. They each had their different motives for this trade, of course. The buyer might be a short covering their position or a genuine buyer who believes the stock is a good investment from a value or dividend perspective.

The seller may have a good profit already and has located a better place for the funds. They believe there is not much left to go for, and are willing to take the profit. Or it may be a new short who believes the stock will decline.

The price they agree is the latest price. The seller would prefer a higher price and the buyer a lower one. But they compromise and settle.

Now another seller comes along and makes an offer, or a buyer makes a bid. The potential buyers see that offer and if one of them likes it, they will trade at that price, which may be higher or lower than the previous one. Then the potential sellers see that price, and if they like it, they will make their offers. And if the sellers are more persistent than the buyers, the trade prices will fall.

Be aware that all traders follow historical price movements and most base their decisions on what the price has done already. A high price will bring out many sellers, while a low price will attract many buyers. That is why markets move in waves.

All trades are made at the margin between a very small number of traders who hold positions or who want positions. The bulk of positions, long or short, are not trading.

Be aware that this wall of money is not forced to move! If enough traders who control this money believe they had better sit tight in cash – since they are wary of making a wrong move – they will not invest. That is a function of their sentiment, and as we know, sentiment can be monitored.

And even if some of this wall of money does filter into stocks, will it overpower any selling? The theory takes no account of the other side of the trades!

The forecasting system that works

The only theory that makes any sense to me is Elliott wave theory, which is an empirical observational system for forecasting market moves and turns based on many decades of experience.

And below is a chart showing the short-term waves that conform precisely to the Elliott wave principles.

I recommend all traders become familiar with at least the main principles – it could change the way you view markets.

And the one piece of evidence I was looking for yesterday was a small-scale five-wave move to the downside off a new Dow high.

This is the chart I took off my screen early yesterday:

Dow Jones spread betting chart

(Click on the chart for a larger version)

This little pattern tells me all I want to know – that we have a clear five-wave move – with a long and strong third wave – off a new high for the bull run off the 2009 low. This indicates the trend is now down.

Now, why was I looking for a Dow top around this date?

A mirror image pattern in Europe

Simply because I found an identical pattern in a major European stock index last month – in the Euro STOXX 50! This index comprises the 50 largest-cap stocks in Europe. It is known as the ‘European Dow’.

Here is the pattern I found:

Euro STOXX 50 spread betting chart

(Click on the chart for a larger version)

This market topped on 28 January, almost a month ago! There is a clear five-wave move down off the all-time high and a textbook A-B-C counter-trend rally.

Yesterday, the market broke below the wave 1 low to confirm this interpretation – and we are currently in large wave 3 down.

Because the economic downturn originated in Europe, it is only fitting that this market should have turned first.

To confirm this Elliott wave interpretation, I will need to see a rapid move down.

And so since early February, I have been – not very patiently – waiting for this move to be replicated in the Dow.

And this morning, it appears I have my confirmation – and here is the 15-minute chart:

Dow Jones spread betting chart

(Click on the chart for a larger version)

I have my five waves down and we are currently in a textbook A-B-C up to the Fibonacci 50% retrace and on a large negative-momentum divergence.

Compare this chart with the above Euro STOXX chart – they are almost identical in their Elliott waves.

There are no guarantees in the markets, but this is about as good as it gets for a trade set-up.

What would be your trade here? And where would you place your protective stop?

• 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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