9min read
PREVIOUS ARTICLE Take Pairs Trading To The Next... NEXT ARTICLE Technical analysis: MACD...

Elliott Wave (EW) principle has a tarnished reputation among traders because it has been misunderstood and misused. Unlike a simple moving average (SMA) generated using charting software-for example SMA is calculated by summing the closing prices and dividing the sum by the number of periods-Elliott Waves cannot be reliably plotted by a computer. Therefore, the wave counting has to be done manually, making it subject to the bias of the reader. Secondly, there are many websites that claim that EW could bring great trading success to subscribers, but after signing up for the advisory service, the only one who becomes successful and wealthy is the website’s owner.

It is not surprising that EW is sometimes viewed as an unreliable and hard to manage tool. Additionally, who wants to follow a forecast that sounds like: “If stock X does not move lower, it is going to move higher because it is in the minuette wave of the intermediate cycle?” We all know that a market can move up, down or sideways, and therefore an ambiguous forecast won’t make us more knowledgeable; it would not provide us with the desired competitive edge.

The other reason that EW is not very popular with the novice trading crowd is that it does not work well on shorter time frames (less than a trading session). The cause is that constant updating and wave counting is very time consuming and not speedy enough to react to rapid market price changes on a 10 or 15 minute time frame chart. Since the margin requirement for overnight held positions are higher than those not held overnight, some traders simply do not feel comfortable holding a position overnight, EW is not an efficient or desirable short-term forecasting tool.

Calmer Waters

At this point you probably wonder why EW is still a popular trading tool and how come it has so many wave counter enthusiasts?

The reason is that after a rigorous counting training process, the EW principle graduates are very confident in their ability to use this tool to trade and make money. Bringing up the simple moving average example again, the learning curve for EW students is longer but some say more rewarding. My experience has taught me that it is a useful tool to identify trends on longer time frames, such as weekly and monthly. Also, I noticed that it is really important to make sure that the trends are in the same direction. For example, if I consider purchasing a stock because of a daily set-up, the weekly dominant trend should be bullish as well. Another valuable lesson that I learned was that it is important to stay informed about upcoming market or stock specific announcements. I do not wish to be unknowingly in a trade before an industry conference announcement or a CEO appearance on CNBC. That news could throw (at least temporarily) technical analysis indicators out of the window.  Another factor to take into consideration is whether you want to apply any type of forecasts, and particularly technical analysis to stocks that have enough liquidity, so a large order does not disturb the equilibrium and become a huge market mover.

Although reliable, EW is just a tool; therefore, I do not use it by itself. Bollinger bands and moving averages crossovers, for example, are confirming indicators that I look at to gauge the direction of the market.

Elliot Wave Surfing Lesson

Now that we got our feet wet with the “How To” and “What Not To,” let me tell you a little bit about the developer of EW principle and the logic behind this indicator.

The father of EW principle is Ralph Nelson Elliott. Just like other technical analysis heavyweights (see Bollinger Band and RSI articles) his contribution to the field came about mostly accidentally and later in life-he did not start his career as a trader or technical analyst. For that matter, Elliot was forced to retire early due to poor health. Out of boredom, he occupied his time studying the behaviour of the stock market. His attention to detail and fascination with market psychology drew the attention of a leading researcher and investment company at the time, since he was able to accurately forecast the end of stock market bottom in 1935. This company, Investment Counsel Inc., ended up supported him into publishing The Wave Principle in 1938.

The EW principle is based on Fibonacci’s “golden” ratio, which states that the sum of any two consecutive numbers becomes the next number in the sequence. For example: 3+5=8, 5+8=13 and so on. The series is: 1,2,3,5,8,13,21,34,55, etc. At first look, this sequence does not tell us much, but Martin J. Pring, in Technical Analysis Explained, noticed that the numbers 5, 8, 13, 21, 34 and 55 correspond to time spans between stock market peaks and troughs for the last century. Pring found 32 instances of market tops and bottoms that lasted from 5 to 55 years since 1916. For this reason alone, technical analysts cannot ignore Fibonacci’s ratio.

Dwelling into EW a little further, it is worth mentioning a few words about the actual waves. EW principle has two types of “waves.” The first type is the “impulsive wave,” which in turn has five subordinate waves, which move in the same direction as the dominant trend. The second and smaller type of wave, the “corrective” wave, moves against the larger trend, as the name implies. The corrective wave is divided into 3 sub-waves. Think about it this way: the impulsive wave is the one that works toward a major goal, and the corrective wave works against it, trying to hold it back (see theoretical wave pattern below). Now you see why EW is not easily applicable to a 15-minute chart and why it takes some time to master it.  There are eight waves in total, and the charts do not always provide us with a clear picture about when a wave starts or ends, this is why some subjectivity is also necessary, but can also be detrimental.

Waves (1), (3) and (5) are the impulsive waves (in the direction of the primary trend). Waves (2) or (4) are the corrective waves because they represent pullbacks in the trend. The corrective phase is defined by three cycles known as (a), (b) and (c) – see the right side of the chart.

Furthermore, the waves, according to their length, are divided as following: grand super cycle, which has eight super cycle waves. Each of the latest waves contain eight cycle waves followed by primary, intermediate, minute, minuette and subminuette waves. No wonder that EW principle is neither for the faint of heart, nor for traders who are not fully committed to learning it.

 >> BACK TO THE NEWSLETTER: Click here to read other articles from this week’s newsletter