Simple use of Elliott Waves by Darren Winters
To many people, the title of this article could be seen as an oxymoron. That is because Elliott Waves are considered difficult to interpret by the average investor. Well, we couldn’t agree more! However, if you can learn even their basic function, it can help with your analysis of where a stock is going to move in the future.
A single article such as this can’t possibly give you a complete understanding of Elliott, so we would recommend the book, ‘The Elliott Wave Principle’ by Robert Prechter and AJ Frost. Alternatively, if you want to learn it’s best application, Steve Copan is putting his master works together in his ‘market matrix’ which you can register your interest in by going to www.activetech.co.uk.
THE BASIC STRUCTURE
The ‘Wave Principle’ was discovered by Ralph Nelson Elliott who found that “crowd or social behaviour trends and reverses in recognisable patterns.” Elliott found that the stock market moved in harmony with some mathematical models found in nature. From this, he was able to develop a system of market analysis. Elliott identified thirteen patterns or waves of movement that could be applied at different time scales.
In the markets, momentum takes place over five specific waves. In figure 1, three of these waves form the underlying direction and are known as ‘impulse’ waves (waves 1,3 and 5). These waves are separated by two countertrend waves (waves 2 and 4).
Impulse waves will always consist of five sub waves in structure whereas corrective waves generally have a three wave structure. Looking at figure 2, you can see that after a five wave sequence has completed, it will correct via what Elliotticians call and ‘ABC’ correction. Once this correction has completed, another 5 wave sequence can commence.
It is worth noting that although a correction has three waves, wave A can have 3 or 5 waves within it; wave B has only 3 waves; and wave C has 5 waves.
A basic rule which is extremely useful to know is that wave 2 cannot retrace more than 100% of wave 1. So if you look at figures 1 and 2, you will see that wave 2 does not fall below where wave 1 started. Also, wave 4 cannot retrace more than 100% of wave 3. Again, you will see in the diagrams that it has not fallen below where wave 3 started.
PSYCHOLOGY OF EACH WAVE
Possibly the most important part of Elliott waves is understanding what the general market sentiment or psychology is like at each stage. The diagram below illustrates what the sentiment picture will be like during each wave.
The bottom of the 5 wave structure is usually accompanied with bad news or a recession, depending upon which timescale you are looking at. Wave 1 is named as the rebound from these undervalued levels. Wave 2 re-tests the lows although does not carry through to new lows. At this point, investors still believe the market is going to go lower. Wave 3 is the powerful wave where the strength of the market is improving along with the economy. By the end of this wave, most investors now believe the market is going to continue going up.
Then wave 4 comes which is seen as a disappointment putting some investors off the market. At last comes the final advance with wave 5. At this point, the majority of investors have accepted that the markets are going to continue heading up, after witnessing the previous moves. Sentiment can reach bullish extremes at the end of this wave.
Using this in real life, if you look at a chart of the S&P 500 which starts in early 2003, you will see that wave 1 moved up from the lows in March, then wave 2 retraced back in April. Wave 3 carried through to the June highs with wave 4 ending in October. Finally, wave 5 finished in March of this year at 1163.
SUMMARY
I have been limited in what I can explain due to the fact that Elliot Waves would need the entire content of the newsletter to explain. However, if you can take a 2 year chart of a stock or index, you can probably start to recognise where the impulse and corrective waves occur. By doing this, you may see where the future larger moves may be coming. It is well worth you investigating this fascinating form of analysis further.
Darren Winters
A single article such as this can’t possibly give you a complete understanding of Elliott, so we would recommend the book, ‘The Elliott Wave Principle’ by Robert Prechter and AJ Frost. Alternatively, if you want to learn it’s best application, Steve Copan is putting his master works together in his ‘market matrix’ which you can register your interest in by going to www.activetech.co.uk.
THE BASIC STRUCTURE
The ‘Wave Principle’ was discovered by Ralph Nelson Elliott who found that “crowd or social behaviour trends and reverses in recognisable patterns.” Elliott found that the stock market moved in harmony with some mathematical models found in nature. From this, he was able to develop a system of market analysis. Elliott identified thirteen patterns or waves of movement that could be applied at different time scales.
In the markets, momentum takes place over five specific waves. In figure 1, three of these waves form the underlying direction and are known as ‘impulse’ waves (waves 1,3 and 5). These waves are separated by two countertrend waves (waves 2 and 4).
Impulse waves will always consist of five sub waves in structure whereas corrective waves generally have a three wave structure. Looking at figure 2, you can see that after a five wave sequence has completed, it will correct via what Elliotticians call and ‘ABC’ correction. Once this correction has completed, another 5 wave sequence can commence.
It is worth noting that although a correction has three waves, wave A can have 3 or 5 waves within it; wave B has only 3 waves; and wave C has 5 waves.
A basic rule which is extremely useful to know is that wave 2 cannot retrace more than 100% of wave 1. So if you look at figures 1 and 2, you will see that wave 2 does not fall below where wave 1 started. Also, wave 4 cannot retrace more than 100% of wave 3. Again, you will see in the diagrams that it has not fallen below where wave 3 started.
PSYCHOLOGY OF EACH WAVE
Possibly the most important part of Elliott waves is understanding what the general market sentiment or psychology is like at each stage. The diagram below illustrates what the sentiment picture will be like during each wave.
The bottom of the 5 wave structure is usually accompanied with bad news or a recession, depending upon which timescale you are looking at. Wave 1 is named as the rebound from these undervalued levels. Wave 2 re-tests the lows although does not carry through to new lows. At this point, investors still believe the market is going to go lower. Wave 3 is the powerful wave where the strength of the market is improving along with the economy. By the end of this wave, most investors now believe the market is going to continue going up.
Then wave 4 comes which is seen as a disappointment putting some investors off the market. At last comes the final advance with wave 5. At this point, the majority of investors have accepted that the markets are going to continue heading up, after witnessing the previous moves. Sentiment can reach bullish extremes at the end of this wave.
Using this in real life, if you look at a chart of the S&P 500 which starts in early 2003, you will see that wave 1 moved up from the lows in March, then wave 2 retraced back in April. Wave 3 carried through to the June highs with wave 4 ending in October. Finally, wave 5 finished in March of this year at 1163.
SUMMARY
I have been limited in what I can explain due to the fact that Elliot Waves would need the entire content of the newsletter to explain. However, if you can take a 2 year chart of a stock or index, you can probably start to recognise where the impulse and corrective waves occur. By doing this, you may see where the future larger moves may be coming. It is well worth you investigating this fascinating form of analysis further.
Darren Winters
posted by Darren Winters at 11:55 AM
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