Elliot Wave part 2 - How It Works

Elliot Wave Thoery part 2. In this post we'll tackle what the Elliot Wave Theory is and what it's rules and guidelines are. We'll do a quick and simple example of how we can apply it. As usual, there are free reference guides provided at the end,
photo courtesy of Wikimedia Commons.

This is part 2. If you haven't read part 1 yet, it might be a good idea to do so.

In more technical terms, what is the Elliot Wave Theory?

It is a theory that collective investor sentiment naturally shifts from optimistic (greed) to pessimistic (fear). And this natural shifts in sentiment is visible in price movements in any timescale.

(However, in my personal opinion, it works better if viewed long-term)



How is this shown in price movements?

It appears as nested 5-wave patterns. In the bull market: 1 up, 2 down, 3 up, 4 down, and 5 up. (The reverse is true for bear markets)
Elliot Wave part 2. In this post we'll tackle what the Elliot Wave Theory is and what it's rules and guidelines are. We'll do a quick and simple example of how we can apply it. As usual, there are free reference guides provided at the end,


After the last wave, a correction occurs in a downward, zigzag pattern (shown as A, B, C in the image above)

It also relies on Fibonnaci sequence and that impacts several of it's guidelines.

Wait, how come it goes down? Doesn't the stock market earn ~10% in the long-term?

It doesn't really go down all the way. The theory states that wave2 (in a bull market) corrects wave 1 but doesn't go below the "bottom" or start of wave1. And wave4, which corrects wave3, won't go all the way down to the "peak" of wave1 (except in rare cases).

So even after the ABC correction, you'll still end up with some gains (assuming you invested during wave1).

Assuming I will subscribe to this theory, what do I need to know?

Well, it has three rules:
  • Wave 2 never retraces more than 100% of wave 1.
  • Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.
  • Wave 4 does not overlap with the price territory of wave 1, except in the rare case of a diagonal triangle.

Simple, right? Well, actually it has 1 million guidelines. Well ok, not a million; but it does have a lot. But we'll just tackle the most common ones:
  • When Wave 3 is the longest impulse wave, Wave 5 will approximately equal Wave 1.
  • The forms for Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, Wave 4 will be a flat correction. If Wave 2 is flat, Wave 4 will be sharp.
  • After a 5-wave impulse advance, corrections (abc) usually end in the area of prior Wave 4 low.
  • Wave 2 usually doesn't retrace more than 61.8% of wave 1. 
  • Wave 3 is often longer than wave 1 by a ratio of 1.618:1. 
  • Wave 4 typically retraces less than 38.2% of wave 3


Ok, so how does it work? How do we apply it?

I have to stress I'm not an expert. But if we look at how the PSEi chart, and apply the rules and guidelines, here a few hints we'll get from the Elliot Wave Theory (or at lest from my basic understanding of it):
Elliot Wave part 2. In this post we'll tackle what the Elliot Wave Theory is and what it's rules and guidelines are. We'll do a quick and simple example of how we can apply it. As usual, there are free reference guides provided at the end,
photo courtesy of www.tradingeconomics.com/
  • Wave 2 is over, so we have no use for the first rule.
  • Wave 3 cannot be the shortest, and based on the chart it is longer than wave 1. But otherwise, rule 2 is of no use yet.
  • Rule3 is more useful in this example because wave 4 cannot overlap with the price territory of wave 1, it means wave 4 cannot go lower than ~4,000 (worst case scenario; there's no rule or guide saying it will go down that low) 
  • And actually, guideline 6 tells us wave will 4 will probably not go down below ~5,300 (based on how wave 3 has performed so far)
  • Guideline 4 and 5 are not useful right now.
  • Guideline2: Wave 2, isn't exactly flat, but it's not sharp. So wave 4 should be sharp. And with two trading days with huge 6% declines (last June and in the 3rd week of August), that seems to be the case.
  • Guideline1: Wave 3 is longer than Wave 2, so wave 5 is either as long as wave 3 or it is longer. We'll assume wave 3 is the longest, since rule2 says it usually is. That means wave 5, when it comes, will move up the index by ~2,600 points (on the assumption wave 1 was Dec. 31, 2002 - Jun. 28, 2007; 1018.41 - 3665.23). Assuming a 5,300 bottom, that's means a ~7,900 peak for wave 5.
  • Guideline3: This means after the wave 5 peak, we'll suffer a huge correction that can bring us near the wave 4 low. However, that could be 5,300 or the previous low of ~5,600-5,700.

So what did we really learn? Well, not much is certain except that the market will be volatile. But we already knew that, right?

But what I really like about this is the long-term picture. If you subscribe to the theory, even tough it's technical analysis, you won't be jumping in and out of the market and maybe loosing money in the process.

Instead, you can put things in perspective. Sure, we just suffered a huge dip. But if you wait for the bottom to be confirmed and then invest, you can sit and let your winners run.



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Free Reference Guides:

http://stockcharts.com/school/doku.php?id=chart_school:market_analysis:elliott_wave_theory

http://stocata.org/ta_en/elliott.html

http://www.investopedia.com/terms/e/elliottwavetheory.asp

http://www.investopedia.com/articles/technical/111401.asp

https://en.wikipedia.org/wiki/Elliott_wave_principle




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