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Lesson #1
-- Lesson #2 ---
Lesson #3 ---
Lesson
#4 --- Lesson #5 |
 Lesson
#5 -- The
Elliott Wave Theory
I sincerely hope that you've found the first four
lessons of this trading course useful. Throughout the past several lessons
I've shown you key information on what ETFs are, covered the basics of ETF trading,
and given you the tools
and data you'll need to research these unique securities on your own. I've even spent an entire
lesson (Lesson Four) describing exactly how I go about doing my research
when I make my trade recommendations.
As I've noted throughout these lessons, I am a technical
analyst. Unlike many technicians, however, I combine technical analysis with
fundamental research. I believe that you can interpret the chart signals
better if you have a firm understanding of the inputs that help draw those
charts. While the patterns themselves are part of that feedback loop, so too
are the fundamentals.
However, the single most important tool I use is the
Elliott Wave Theory. (In fact, it is so important that I ultimately decided
to write an entire book -- Applying Elliott Wave Theory Profitably --
on the subject.) The Elliott Wave Theory (EWT), also called the Elliott
Wave Principle, was developed by an accountant, Ralph Nelson Elliott, during
the 1930s. Elliott had been ill and spent years studying stock market price
patterns. He also wrote a market newsletter and became famous for some
incredible market calls that he made over the years.
When Elliott died, EWT began to fade away until Robert
Prechter Jr. and A.J. Frost brought it back to the forefront in the 1980s.
Prechter was one of the first analysts to call for the Dow to reach 2,000
(upside) and also correctly forecast the crash in 1987.
EWT is an extremely complex form of technical analysis
that takes years and years to master. I am going to give you some of the
basics so you can avoid some common mistakes that others frequently make.
Once you use Elliott, you will almost certainly embrace it. And, when my
upcoming book on Elliott Wave Theory finally hits the printing presses in
the summer of 2003, I am sure you will want to buy it! :)
1. THE MOST
IMPORTANT THING YOU NEED TO KNOW ABOUT EWT
2. SO, A BULL MARKET ISN'T FIVE WAVES UP?
3. HOW DO I FIGURE OUT WHERE WE ARE?
4. I'VE HEARD PEOPLE TALK
ABOUT ELLIOTT WAVE RULES. WHAT ARE THEY?
5. WHAT IS A FIBONACCI?
6. CAN YOU USE ELLIOTT WAVE FOR TIMING?
7. WHAT DO CORRECTIONS LOOK LIKE?
8. WHAT ELSE SHOULD I KNOW?
9. CONCLUSION
(1.) THE
MOST IMPORTANT THING YOU NEED TO KNOW ABOUT ELLIOTT WAVE THEORY
Many of you have probably heard all about the five-wave up
and three-wave down pattern that describes Elliott Wave cycles. Sadly
though, this simplistic description is just plain wrong. The most important
thing that you should know is that five wave moves are not best described as
a bull market, but instead as something known as an "impulse move"
or "impulsion". An impulse move can be up or down, and always
comes in five waves.
The famous three-wave pattern that you see in all the
pretty stylized charts (like the one shown below) is known as a correction.
Corrections can get pretty complex. The one shown below retracing the
five-wave impulse move is known as a zigzag. Interestingly enough, a zigzag
is comprised of a pair of five-wave impulse moves!
(2.) SO,
A BULL MARKET ISN'T FIVE WAVES UP?
Not necessarily, at least not as a bull market is commonly
defined. For example, many Elliotticians (as those who use EWT to forecast
the markets are often called) currently believe that the stock market is in
the midst of a secular bear market that could take many more years to
complete. The first part of that bear market ended in October 2002 as a
complete five-wave pattern lower. That was "wave-A" down of the
bear market, which began in 2000. As of early 2004, wave-b of that
correction may have ended. Given that the S&P 500 was down about 50%
from its highs and the Nasdaq fell at one point nearly 80%, in 2002 I wrote that the ensuing rally will be
considered a bull market by most, and that has certainly been the case. At that
time I suggested that the Nasdaq could more than double and the S&P
might rally by 50% or more. The Nasdaq missed my target by a bit, but came close.
The S&P also came near my projections. The timing of my projections was also spot on.
(3.) HOW
DO I FIGURE OUT WHERE WE ARE?
Funny you should ask. Elliott is all about market
psychology. It is often compared to Dow Theory for just that reason. Each
wave, at least when we are referring to major market cycles, should exhibit
certain behavioral signposts.
The following explanations use the common terminology of
bullish being up and bearish being down to make it easier to follow. That
means I will refer to wave-1 as being a bullish five-wave cycle. However, I
could talk about wave-1 being the start of a five wave down move as well.
When wave-1 begins, the market still believes the prior
trend is active. Using the classic idea of wave-1 being the start of a
five-wave bull market, everybody sees wave-1 as just another correction in
the bear market. The economic news is probably still negative as well.
However, volume should be fairly decent and you should see a clear five-wave
pattern develop.
Wave-2 often "confirms" that the old bear is
alive and kicking. Unfortunately for the bears, prices do not make a new
low, and volume is usually lower than it was during wave-1. Wave-2 can
retrace virtually all of wave-1, but usually only corrects 50-62% of that
move.
Wave-3 is what Elliott Wave analysts dream about. It is
usually the most powerful leg in a five-wave impulsion, and it divides into
five waves itself. Volume explodes. The move typically traverses at least
162% of the distance traveled by wave-1, and it often extends further. This
is when the whole world starts to buy into the trend.
Wave-4 is another correction against the trend. It is
often the most difficult wave to count. Usually it retraces between 23.6% and
38.2% of wave-3. With one exception, it can never overlap the extreme price
point of wave-1. That means in an up move the low of wave-4 can never move
below the high of wave-1. In a down move, the top of wave-4 must be equal to
or lower than the bottom of wave-1.
Fourth waves often last for a very long time. I've seen
them take longer to complete than the time it took the first three waves to
run their course. This is especially true when the first three legs reverse
an extreme overbought or oversold condition and complete very quickly.
Investors see wave-4 as an opportunity to add to their
positions. And, if they are nimble, they're usually correct. However, as we
will see, most don't get the whole picture.
Wave-5 is the final stage of an impulse move. Typically,
the market exhibits price momentum divergences as this leg nears completion.
Volume is lower than it was at the wave-3 peak. Classical technicians would
say that, at least at its latter stages, this five-wave impulse move
exhibits distribution (if wave-5 is the end of a bull market move) -- smart
money is exiting its positions in anticipation of the upcoming A-B-C
correction.
I will go into more detail regarding corrections elsewhere
in the lesson. In short, wave-A often exhibits similar characteristics, as
far as market sentiment is concerned, to that of wave-1. However, wave-A can
either be three waves or five waves. A five-wave move is a sign of a more
powerful correction of the just completed five-wave impulsion.
Wave-B is often a cross between wave-2 and wave-4. Its
pattern is often sloppy and difficult to recognize. It can develop over a
long period of time. And, as I will discuss later, unlike second waves,
B-waves can retrace more than 100% of wave-A.
Wave-C combines some of the characteristics of wave-3 and
some of wave-5. It can range from 62% of wave-A to 162% the size of wave-A,
and occasionally can even run further than that. The market at this point
believes that we have a new long-term trend in the direction of wave-C, just
in time for it to reverse. The latter stages of wave-C will exhibit signs of
smart money accumulation (assuming wave-C was the end of a bear market
move).
(4.) I'VE
HEARD PEOPLE TALK ABOUT ELLIOTT WAVE RULES. WHAT ARE THEY?
There are really only two rules. (1) Wave-2 can never
retrace more than 100% of wave-1. (2) Wave-3 can never be the shortest wave.
There are some additional tendencies and rules with exceptions that are
worth noting here:
- Wave-4 can never overlap wave-1 except in the special
case of a diagonal triangle.
- Wave-2 and wave-4 usually alternate in characteristics.
In other words, if wave-2 is meandering, then wave-4 will be fast and
furious. If wave-2 corrected a large part of wave-1, then wave-4 will
probably be a shallow correction. Some people call this the "rule
of alternation". I call it the tendency of alternation, because it
does not always work.
- Wave-5 usually exhibits price momentum divergences
compared to momentum at the top of wave-3.
- The distance traveled by wave-5 should not be greater
than the distance traveled by the first three waves combined.
- Wave-5 and wave-1 are often the same size in price
and/or time.
- Wave-A and wave-C are often the same size in price and
time.
(5.) WHAT
IS A FIBONACCI?
There is a number series whereby the nth number in the
series is equal to the sum of the prior two numbers in the series.
Elliotticians start that series at zero, and it continues as follows:
0,1,1,2,3,5,8,13,21,34,55,89 and so on. The ratio of the nth divided by the
n+1st number in the series, as n approaches infinity, is 0.618. n/(n+2) is
0.382. n/(n+3) is 0.236. The inverses of these three numbers are 1.618,
2.618 and 4.236.
Elliott wave analysts usually look for corrections to
retrace one of the ratios shown above (0.236, 0.382, 0.618). They also use
50% (0.50) as well as 0.764 (1-0.236) and 0.782, which is the square root of
0.618. Personally, I use 0.236, 0.382, 0.500, 0.618 and 0.764). The inverse
ratios are used to determine price targets.
Note that when computing price targets correctly, you
should really use percentage price moves and not points, unless you are
computing a very small price move relative to the value of a stock.
Consider a stock whose first wave was a rally from $10.00
to $20.00. That is 100%. If wave-2 corrects to $13.82 (61.8% of $10.00) and
wave-3 is 1.618 times wave-1 in points, that would mean a rally of $16.18,
taking the stock to $30.00. While that is more than 100%, it is nothing
close to a 162% rally ($36.18).
(6.) CAN
YOU USE ELLIOTT WAVE FOR TIMING?
Yes you can. I have found that many wave cycles find
symmetry not only in price, but also in time. Wave-5 and wave-1 often take
the same amount of time to complete. If not, the relationship may be by a
Fibonacci ratio such as 0.62 or 1.618.
I have also found that many three-wave and five-wave
cycles complete in a Fibonacci number of days. That is, the time to complete
a move will often be 34-days, or some other number in the Fibonacci number
series. Note also that when I count days, I only count trading days -- no
holidays, no weekends.
One thing to be aware of, however, is related markets. If
U.S. equities turn, there is a good chance that some foreign equity markets
might turn at the same time, even though they might not have the exact same
day count due to different holiday schedules.
(7.) YOU
MENTIONED THAT YOU WOULD TALK MORE ABOUT CORRECTIONS. WHAT DO THEY LOOK
LIKE? I'VE NOTICED THAT A LOT OF THE TIME, PRICES DO NOT SEEM TO HAVE VERY
CLEAR PATTERNS
You are correct. Sometimes it is very difficult to get a
clear handle on a wave count. That is when you know you are in a correction.
Impulse moves should be fairly clear. There are several kinds of
corrections. They are:
- Zigzag
- Flat
- Irregular
- Triangle
- Double three or triple three
I have already described what a zigzag is. It is the most
powerful type of correction and is made up two impulse moves connected by a
three-wave move.
A flat (see below) is also three waves. The first leg,
wave-a, is three waves on its own and goes opposite the currently active
impulse trend that it is correcting. Wave-b is also three waves and retraces
all or most of wave-a. Wave-c is an impulse move and usually reaches towards
the wave-a extreme.
An irregular (see below) is very similar to a flat. The
only difference is that wave-b retraces more than 100% of wave-a. It is
usually a sign that the trend that it is correcting is very strong. For
example, an irregular fourth-wave correction of an upward move would see a
new high, past the wave-3 peak. That is a sign of underlying strength in the
trend. Wave-c may be attenuated in such a case, but usually is still at
least 62% as large as wave-a. The corrections shown below are corrections of
larger bear trends.
Triangles are essentially the same pattern you've read
about in standard technical analysis books. They take five legs to complete,
unlike other corrections, which traverse three legs. However, unlike impulse
moves, all of the legs of a triangle sub-divide into three-wave patterns.
They can be symmetric, ascending or descending. Note though that in Elliott
Wave, an ascending triangle is not necessarily bullish and a descending
triangle is not necessarily bearish.
A double three or a triple three is essentially any of the
above patterns connected by something know as an "X wave", which
is also a three-wave cycle. That is, you could have a flat, followed by an
x-wave, followed by a triangle, followed by an x-wave, followed by a zigzag.
(8.) WHAT
ELSE SHOULD I KNOW?
As I'm sure you can no doubt tell by now, Elliott Wave is
incredibly complex and it can be incredibly subjective. As long as you keep
in mind the sentiment factors that fit a pattern, you will be okay. Also,
you must always understand where or when a wave is likely to start and end,
and place your stops accordingly.
It is very easy to slip into a situation where you are
waiting for a correction to get you out of a bad trade. However, if your
analysis was wrong in the first place, why should your expectation for a
correction be the correct forecast? If you are wrong, then you should
usually take your medicine and go on to the next trade.
(9.) CONCLUSION
I have barely scratched the surface here. There are
many more patterns to learn about. I have not discussed terminal triangles,
extensions, or channeling. I have not shown you many of the similarities
between Elliott and classical technical analysis. All that would take a
book, and if you're interested in reading such a book, then you're in luck!
My most recent book, "Applying Elliott Wave Theory Profitably",
has been published by John Wiley & Sons and is now available at
bookstores everywhere.
Thanks again for reading my five-part ETF trading course,
and good trading in the weeks ahead!
Steven Poser
Editor
The ETF Authority
New York, NY
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