This Dow ‘wedge’ is making me nervous

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On Friday, markets retreated in powerful selling waves. This afternoon, I want to show how this has affected the Dow. This picture is mixed, to say the least.

In my article on 15 October, I pointed out that the textbook Elliott wave patterns to the move off the 5 October 13,360 high was a clear indication that the trend had changed to down.

In that article (see: The Dow follows the script beautifully), I noted the likelihood of a rally starting that morning.

The chart is reproduced below.

I had my first level of resistance at the pink bar.

 
(Click on the chart for a larger version)

So how did the rally progress?

Well, it sliced right up through my pink zone and headed for the upper reaches of the Fibonacci scale!

In fact, we had a lovely A-B-C with negative momentum divergence at the C wave high. And the C wave reached the Fibonacci 76% level.

 
(Click on the chart for a larger version)

Time to look for a short trade!

Now, remember I have been regularly making the observation that the Dow has a reputation for making very deep upper retracements of its down-moves. And this is its latest manifestation.

A high probability, low risk trade

So how did I locate a sensible entry point?  Here is a close-up of Friday’s action:

 

(Click on the chart for a larger version)

I have drawn my short-term tramline pair using the excellent prior pivot points as anchor points for both lines.

Note that where my upper line intersects the Fibonacci 76% (horizontal) line, that was where I had a slight overshoot and then a pull-back into the trading channel. That was a clue that I had reached the rally top. The market was not comfortable above this area.

Then, setting a sell-stop order just below the lower tramline – and also below the minor lows in the A-B-C sequence – would be a high-probability, low-risk trade, and would catch the down-move if it was to occur.

So if the market had touched off my sell orders and then reversed upwards in a ‘head fake’, a protective stop inside the channel was a sensible strategy.

On Friday, the downward break was genuine and by the close, the market had fallen 180 pips or so beneath my entry. Nice trade!

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Could we be in wave 3?

I like to keep an eye on the larger picture, so here is the updated daily chart I showed last time:

 
(Click on the chart for a larger version)

The market is rolling over away from my centre tramline and towards the lower line. My first major target remains the 13,000 area.

Let’s have a look at the possible Elliott waves:

 
(Click on the chart for a larger version)

If the first wave down off the 5 October high is wave 1, and last week’s deep upward retracement is wave 2, then we could well be in wave 3 down.

Confirmation would come if the 13,300 lows can be taken out and then rapid progress towards the next major low at 13,000 (my first major target, remember?).

Third waves are ‘long and strong’, so if we do have a third wave on our hands, rallies should be brief and declines large. That is what I will be looking for.

But what is the alternative scenario?  After all, markets are probabilistic,  anything is possible, but not everything is probable!

Here is one possibility:

 
(Click on the chart for a larger version)

On this hourly chart, I can draw a rare example of an expanding wedge, where the lower line represents support. A rally back to the upper line can occur at any time.

So what could bring this about?

One possibility is that the Chinese and Japanese stock markets are now in rally mode!  Check out the Nikkei and Shanghai or Hong Kong markets and you will see what I mean.

Also, the latest AAII report shows a growing bearish-leaning US public. This is potentially supportive to US stocks.

The question I have is this: has Friday’s wash-out set the stage for another assault on the highs? It has taken out many weak longs – are there many more left to shake out of the tree?

All of which means that I am a nervous Dow bear today!

• 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

• Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here . If you have any queries regarding MoneyWeek Trader, please contact us here.

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Published in Spread betting blog More articles by John C Burford