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Which Stock Trading Theory Works?
By Price Headley
Published on 02/14/2006
Price Headley takes a look at three common stock market trading theories.

Which Stock Trading Theory Works?

“Too many cooks spoil the broth.” “Two heads are better than one”.
 “Clothes make the man.” “Don’t judge a book by its cover.”
“The more the merrier.” “Two’s company, three’s a crowd.”

In today’s information age, there seems to be too much information out there and many opportunities to get overloaded or just plain confused. The key is to decide when certain ideas are valid in which context and also to decide on what you believe. The same goes when it comes to investing. There are 3 popular technical theories or techniques that we would like to discuss today: Elliot Wave Theory, Fibonacci numbers, and the Dow Theory. They are somewhat different in their approaches, and we will tell you how to deal with them. Explanations of each theory are brief so as the keep the length of this article reasonably short.

The Dow Theory

Dow Theory comes from Charles Dow, who was a journalist and co-founder of Dow Jones and Company. He had several major beliefs in his Dow theory

  1. Markets have 3 trends: Most of the time, the market would moves sharply in one direction, recedes briefly in another, and then resumes the original direction. This is the basis of most all technical analysis.
  2. Markets have 3 phases: accumulation by astute investors, then trend followers jump on board, and finally the same astute investors begin unloading their shares.
  3. The stock market is relatively efficient: Stock prices react quickly to news.
  4. Stock market averages should confirm each other: When market indices begin to diverge, it typically signifies a change in direction is occurring
  5. Trades are confirmed with volume.
  6. Trends exist, until real signals indicate otherwise.

Elliot Wave Theory

Developed by Ralph Elliot in the 1920’s, Elliot Wave Theory suggests that the market moves in repetitive patterns called waves. The theory consists of the following:

Every market action is followed by a reaction

  • There are 5 waves in the direction of the main trend followed by 3 corrective waves
  • The cycle is over after the waves of 5 and 3,
  • The 5-3 move becomes 2 subdivisions of the next higher 5-3 wave

Fibonacci Numbers

Fibonacci ratios and sequences originate from a 12 century mathematician who found that the ratio 1.618 recurred an unusually high amount of times in nature. It exists from the ratio of females to males in any given beehive, to the length of the average human’s  forearm compared to the distance between his shoulders and fingertips. Because of the extraordinary recurrence of this number in math and nature, some individuals use the Fibonaccci ratio in technical analysis, rationalizing that this natural number exists in financial markets and thus can be used to predict price behavior.

So Many Theories So Little Time

I’ve experienced the same thing that every analytical person experiences- information overload. We can test all theories if we have all the time in the world, but we don’t’ have all the time in the world. So, the first thing that I do is to evaluate a theory based on logic. If the logic is bad, I just simply dismiss the theory and move on. For example, there was an article on a popular website that said if you buy the lowest dividend paying stock and the highest dividend paying stock in the Dow, this would have earned you 50% from 2001-2005 (some of these numbers are inaccurate, I can’t remember the numbers from the article). Well, there was no real logic behind the technique, and the technique was not very popular (so I couldn’t use the greater fool philosophy) so I dismissed that technique quickly.

As far as the three theories discussed in this article, the Dow Theory tends to be most useful and effective by far. Elliot Wave theory has some validity, but is extremely subjective. For instance, it’s hard to tell when a stock is beginning a 5-3 phase. Because Fibonacci Theory is popular, it can be effective to use this technique and the greater fool method. In other words, you can get certain techniques to work because you know that Fibonacci followers are about to buy a particular stock for example. However, Fibonacci sequences are not as important or relevant as powerful trends and thus the theory is much less useful than the Dow Theory.

Here is the most important idea of the day though, and it is truly actionable. Systems should not be high complicated. If systems are too complicated to be implemented effectively, they should be discarded. Also, sophisticated does not necessarily mean profitable when it comes to systems. The best way to evaluate plausible theories is to test them. For example, do you believe that a move below the 63-day moving average is bearish? Then you should test it on 90 different stocks (30 at a time) across 3 different time periods. If you find that a move below the 63-day moving average is not bearish, then you can quit thinking that and totally discard the 63-day moving average. It’s that simple. When you have theories and when you use certain indicators to get a feel for bullish versus bearish, test all of your indicators and rest easy afterwards. Be disciplined, and trade well!

Price Headley is the founder and chief analyst of BigTrends.com.