What are the main trading theories?

What are the main trading theories?

Trading theories
Photo by @ako

The main trading theories include Dow Theory, Elliott Wave Theory, Gann Theory, Auction Market Theory, Efficient Market Hypothesis and Market Anomalies. In this lesson, we’ll look at what these theories are, why they’re important, and how you can use them in your trading.

Trading Theories Explained

Building on what you’ve learned in our trading indicators lesson, trading theories are ways for you, for analysts, and for traders to try to make sense of what’s happening in the markets. 

  • Why do the markets move as they do?
  • Where will the potential price movements be in the future?
  • Will you see the movements shift up or down, and to what extent could markets move in either direction?

By using trading theories, you can attempt to answer these questions. You should then be able to explain the value of assets and why they should be priced at any particular level.

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Why are trading theories important?

Trading theories are important because they allow you to create a defined structure to trade. Using the various trading theories, it’s possible for you to create a strategy and a way to decide on market direction, trade entry, and exit levels.

What are the main types of trading theories?

The main types of trading theories are:

  • Dow Theory
  • Elliott Wave Theory
  • Gann Theory
  • Auction Market Theory
  • Efficient Market Hypothesis
  • Market Anomalies

Let’s look at these in further depth.

Dow theory

Dow theory was created in the late 19th century by combining a series of articles written by Charles Dow for the Wall Street Journal. This theory’s considered as the birth of technical analysis in the western world. Dow — who was also the founder of the Wall Street Journal — was seen as the forefather of this type of analysis.

Dow theory has the following core principles or tenets.

  • Markets discount everything

Anything that could, or has moved the price in the financial markets, is already discounted into the price. This includes the behaviours and positioning of investors and traders.

  • There are three market trends

The primary trend (or major trend). This is long term, ranging from less than a year, to several years.

The secondary trend (or medium trend). Ranging from two weeks to multiple months, which would be counter to the primary trend.

Minor trends. These last for days or a few weeks and are viewed as market ‘noise’.

  • Primary trends have three phases

The ‘accumulation phase’. Where smart investors buy in a bull market.

The ‘participation’ or ‘mark-up phase’. Broad-based buying of stocks

The ‘distribution phase’. When the smart money starts to liquidate long exposure.

  • The averages must confirm each other 

To be sustainable, Dow highlighted that the Industrial and Transportation averages must be moving in the same direction. Today, though, you might look at different averages in a country (the S&P500 and the Nasdaq, for example) or across international indices for confirmation. 

 

  • Volume must confirm the trend 

When markets move, they must see significant volume, or the price moves aren’t likely to be sustainable.

  • Trends persist until reversed 

It’s only when the secondary trend significantly reverses the primary trend that a new primary trend in the opposite direction can be seen to have begun.

Primary trend - Dow theory
Screenshot from TradingView

 

Elliott wave theory

Ralph Nelson Elliott published his Elliott Wave theory in a book, ‘The Wave Principle’. He developed the theory between the 1920s–30s, building on Dow Theory. 

After analysing decades of data, Elliott realised that stock markets moved in cycles and waves that repeated. He saw that these cycles and waves were driven by investor and trader emotions — influenced by external forces and the mass psychology of the moment. 

Elliott noticed that the waves and cycles had patterns that repeated, which could be used to predict future prices. He identified impulsive waves in the direction of the trend and then corrective waves, which were counter to the trend. 

For every impulsive move, there’d be a corrective one. Elliott broke these waves into what he described as ‘fractals’.

Elliott highlighted that a trending market moves in a 5-3 wave pattern, as you’ll see below. 

He termed the first five waves, which you’ll see labelled, as ‘impulsive waves’ and the last three waves as ‘corrective waves’. 

He also described waves 1, 3 and 5 as ‘motive’ — that is, in the direction of the overall trend. Waves 2 and 4 are ‘corrective’.

Elliott saw that the five-wave trend is then corrected by a three-wave countertrend, or ‘ABC’.

Elliot wave - ABC
Screenshot from TradingView

Many traders and technical analysts still use Elliott Wave theory as the basis for their own online trading, forex trading and market strategies.

Gann theory

W.D. Gann was an analyst and trader from the early 20th century. He developed a technical analysis theory based on what he called ‘Gann angles’, as part of Gann Theory

Although it’s based on geometry, Gann Theory also has elements drawn from astronomy and astrology, with timing focused on planetary configurations and eclipses. So, it comes as no surprise to learn that his theory’s often questioned.

Gann’s probably best known for his work on Gann angles. He believed that the ideal price and time balance was when the two moved at the same pace. So, when price moves identical to time, the Gann angle is at 45 degrees. 

Using Gann theory, one unit of price equals one unit of time, which is 1×1 or 45 degrees. The other Gann angles are 2×1, 3×1, 4x, 8×1 and 16×1. 

Put simply, if the market is moving higher above the 1×1, or a 45-degree line, it’s a bull market. Anything below this is a bear market.

Gann fan theory
Screenshot from TradingView

 

Auction market theory

Auction Market Theory was made popular by J. Peter Steidlmayer in the 1980s through his technical analysis approach, ‘Market Profile’. 

Financial markets broadly work by using Auction Market Theory. Part of this is the ‘price discovery’ process, which determines where the market is currently trading. This is achieved by the constant interaction between buyers and sellers in the marketplace. 

The ‘fair value’ or ‘fair price’ of the market is made possible by this constant interaction, as supply and demand constantly look for balance.

Auction market theorists look for ‘fair value’ by observing where price is posted in the most volume and traded the most often. They also observe where price has shown the least ‘conflict’ between buyers and sellers. By identifying ‘fair value’, it’s possible to create a trading plan, where you can look for the market to move towards these levels or areas of ‘fair value’.

 

Efficient market hypothesis

Efficient Market Hypothesis or EMH is also known as ‘Efficient Market theory’. 

EMH states that the market price reflects all the possible information available. What you can gather from this is that it’s impossible to consistently achieve what’s known as ‘alpha’. Basically, this means you can’t beat the market. 

For example, stocks are always trading at their ‘fair value’, so they’re never under or overvalued. You can’t buy a ‘cheap’ stock or go short on an overvalued ‘expensive’ one. In this case, the best strategy is to be passive, to just buy and hold. 

But EMH is quite controversial, with many critics pointing to the fact that investors can and do consistently beat the market. US investor, Warren Buffet, is often highlighted as an example of this. 

Also, stock market bubbles and crashes are instances when stock prices stray from their fair values. Market anomalies, as we discuss below, reflect the fact that markets aren’t efficient. 

Finally, there’s behavioural economics, and the psychological nature of trading and investing. These point to the fact that market participants — the traders and investors — don’t always behave rationally. This highlights, again, that markets really aren’t as efficient as they’d seem.

Market anomalies

Market anomalies are a way of explaining the difference between an actual price of an asset class — a stock, for example. This is in relation to what would be the expected price according to Efficient Market Hypothesis (EMH, as we’ve discussed above). Market anomalies highlight that EMH doesn’t always work. 

Here we’ll look at some of the more common market anomalies.

Of these common market anomalies are calendar effects, which include:

  • The Monday effect — Stock prices tend to close lower on a Monday in comparison to the prior Friday
  • The turn of month effect — Where a market would rise at the end of a trading month and early into the next month
  • The January effect — Where markets, particularly stock markets, experience an increase in volume and higher stock prices at the end of the year, and for the beginning of a new year
  • The holiday effect – Where markets (again, typically share markets) rise the day before a market holiday

Other market anomalies include: 

  • The stock split effect — Here, markets rise in anticipation of a stock split announcement or when a stock split’s announced
  • The announcement drift effect – Where markets continue to move after a significant announcement — even immediately — to a new efficient price level

There are other market anomalies for you to consider, including the ‘value effect’, the ‘momentum effect’ and ‘superstitious effects’.

Trading theories summary

By this stage, you should be familiar with the main trading theories, what they are and why they’re an important part of your trading routine. You’ll find trading theories particularly helpful when it comes to determining the potential movement and shifting of markets, and forming suitable strategies.

This technical analysis lesson has delved into Dow Theory, Elliott Wave Theory, Gann Theory, Auction Market Theory, Efficient Market Hypothesis, and Market Anomalies. It’s touched upon the histories and the principles and trends of each. With your knowledge of these, you’ll be able to create a rounded picture of the value of assets. 

In our next lesson, we’ll shift the focus and look at trading psychology.

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