Action and reaction in the Markets

“The principle of action and reaction applies in the market almost as certainly as it does in mechanics. The secondary movement as a rule bears some relation to the primary movement. The larger the original advance, the larger the reaction. This is qualified however, by the fact that when an advance represents an adjustment of prices to new conditions, a relatively large part of that advance is retained.

The ordinary rule of reaction in a rising market is that it will be from 3/8th to 5/8ths of the amount of the advance.  In large movements, for well-defined causes, this rule does not hold. It is rare, however, that reaction, even against large movements, does not amount to one-quarter of the primary move.”

Charles H Dow, Wall Street Journal, Nov 24, 1900, Review & Outlook. Reproduced in Dow Theory Unplugged W&A Publishing 2009.

This particular editorial, noted to be incomplete, amplifies Dow’s view of the second of the three movements he observed in the markets.  These observations comprise the most important tenet of Dow Theory, the second.

The quote above points out that the second of the three movements is in fact a reaction to the first, which he likens to the incoming or outgoing tide.

His view that the reactive movement will be from 3/8th to 5/8ths of the advance is based on what he saw to be the statistically significant range before a change in the secondary trend or reaction, restored the direction of the primary trend. It is an observation with which WD Gann came to agree in his view of the importance of eighths fractions.

Subsequently RN Elliott, saw the turning points as being distributed around the Fibonacci ratios of 38.2% and 61.8% of the primary move. Others have loosely referred to the range as being between 1/3rd and 2/3rds.

It is certainly true that there is a distribution of trend change around the half-way mark. When the retracement is less than half, some traders who believe the primary trend is strong, or who have missed their chance to get on board at a favourable price in the initial move, will not be able to resist buying in at this point. When the primary trend is less compelling prospective new investors may only buy at lower prices, the point of trend change then being also lower.

Should the retracement exceed the initial move, it would flag a change of sentiment on the part of investors, and augur the onset of a downtrend.

This concept of action and reaction in the market is pivotal. It is how markets move. RN Elliott pointed out the fractal nature of the stock market, i.e. that such moves can be replicated in any time frame even within mini time intervals. He also showed that trends evolved in a more complex manner than Dow contemplated.

Elliott introduced alternative names for action and reaction in the markets. He referred to them as being Impulsive Waves, and Corrective waves. He showed that Dow’s primary trend of 4 or more years, could be subdivided into 5 waves, and Dow’s secondary or reaction movement, into 3 waves. But his theory becomes even more complicated when these moves are further subdivided.

Calling them waves I initially found confusing. It conjured up an image for me of curved rising and falling segments in a single completed wave. In fact each so-called wave is a largely lineal movement of price first in one direction, then in the opposite.

Call them what you will, fits and starts, ebb and flow, proactive and reactive etc. there is always an initial movement from a status quo after a change in trading circumstances, or even just a rumour of such. The next, and opposite movement, is created not so much by further news release(s), as by traders acting in response to the newly adjusted price by for example taking profits in a rising market; looking perhaps to re-enter their position after the ensuing corrective move is spent.

Existing shareholders after a large price range (and volume)  day face decisions as to whether to sell some of their stake for profit, or to add to and  pyramid their position.

Non-shareholders on the other hand must evaluate the opportunity for further gains presented by a strong impulsive move; they are then faced with a timing dilemma; to get on board at market or to wait hoping for a more favourable entry price.

It is the longer term investors who determine whether or not the impulsive move, or trend of a security, will continue. They may be outmanouvered by traders in the short term.  But with more patience in a rising market, they will emerge well in front.

Categories: Trading opinion


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