Monday, March 5, 2007

Elliot Wave Theory

This current market volatility is a great time to learn about the Elliot wave theory and how to look for it during this current bear stretch we are currently witnessing courtesy of the Shanghai index collapse on February 27, 2007.

The Elliott Wave Theory is named after Ralph Nelson Elliott. In the 1930s, Ralph Nelson Elliott found that the markets exhibited certain repeated patterns contrary to the chaotic perception at the time both past and present. His primary research was with stock market data for the Dow Jones Industrial Average. This research identified patterns that recur in the markets. These patterns trade in repetitive cycles, which he pointed out were the emotions of investors and traders caused by macroeconomic events or the predominant psychology of the masses at the time.

Elliott explained that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns or as he called them, "waves". Very simply, in the direction of the trend both upwards (bull) and downwards (bear), expect five waves. Any corrections against the trend are in three waves. Three wave corrections are lettered as "A, B, C." These patterns can be seen in long-term as well as in short-term charts. Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. The recognition of smaller patterns fitting into bigger patterns, coupled with the Fibonacci relationships (another blog) between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid risk/reward ratios.

The 5 – 3 Wave Patterns

Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern. The first 5-wave pattern is called impulse waves and the last 3-wave pattern is called corrective waves.

Here is a short description of what happens during each wave. I am going to use stocks for this blog since stocks is what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds, gold, oil, or futures. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.

Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to rise.

Wave 2
At this point enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.

Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find about the stock and want to buy it. This causes the stock’s price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.

Wave 4
People take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to “buy on the dips”.

Wave 5
This is the point that most people get on the stock, and is most driven by hysteria and a “me too” following. This is when the stock becomes the most overpriced. On the end of Wave 4, more buying sets in and the prices start to rally again. The Wave 5 rally lacks the huge enthusiasm and strength found in the Wave 3 rally. The Wave 5 advance is caused by a small group of traders. Although the prices make a new high above the top of Wave 3, the rate of power, or strength, inside the Wave 5 advance is very small when compared to the Wave 3 advance. Finally, when this lackluster buying interest dies out, the market tops out and enters a new phase, the ABC corrective pattern, typically caused by contrarians shorting the stock starting the corrective pattern.


The A-B-C wave correction pattern follows the 5 wave impulse pattern

There is only one pattern in a simple A-B-C correction. This pattern looks like a Zig-Zag . A Zig-Zag correction is a three-wave pattern where the Wave B does not retrace more than 75 percent of Wave A. Wave C will make new lows below the end of Wave A. The Wave A of a Zig-Zag correction always has a five-wave pattern. In the other two types of corrections (Flat and Irregular), Wave A has a three-wave pattern. Thus, if you can identify a five-wave pattern inside Wave A of any correction, you can then expect the correction to turn out as a Zig-Zag formation.

Wave B is usually 50% of Wave A and should not exceed 75% of Wave A

Wave C is either 1 x Wave A or 1.62 x Wave A or 2.62 x Wave A, in this wave the multipliers for Wave A are based off Fibonacci ratios

Elliott based part his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Thus Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns he had identified. There have been many theories about the origin and the meaning of the patterns that Elliott discovered, including human behavior and harmony in nature. In fact, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves. These rules, though, as applied to technical analysis of the markets (stocks, commodities, futures, etc.), can be very useful regardless of their meaning and origin.

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