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Monday, July 25, 2011

Elliott Wave

The Elliott Wave Principle is named after Ralph Nelson Elliott who did most of his work on wave patterns in the 1930s and 1940s.  Mr. Elliott contends that social, or crowd behavior trends can be recognized in the price trend activity in the financial markets. Elliott came up with thirteen patterns or "waves," that he suggested recur in the markets.  Linking those waves together he suggested helps to identify larger versions of those same patterns that occur over longer periods of time.

The basic patterns in Elliott's theory is what is known as impulsive waves and corrective waves. An impulsive wave is made up of five sub waves and moves in the same direction as the larger price trend. A corrective wave is made up of three sub waves and moves against the trend of the next larger size. For a more in-depth discussion on the Elliott Wave patterns there are many books available on the topic including Elliott Wave Principle, by A.J. Frost and Robert Prechter.

The Elliott Wave principles have a strict definition for what ultimately proves to be a valid wave formation and therefore should be understood and used carefully as confirming evidence in making trading decisions.  The principles are meant to indicate potential, or probabilities of possible future price action in the market. Some wave patterns have lower probabilities of giving indication of future price action than others and strongly bias the investor to understand the principles behind the theory first before interpreting market action based on wave analysis. 

On the graph below, the first small sequence is an impulsive wave ending at the peak labeled (1). The larger price trend is up and the end of the small sequence of waves is also the beginning of a larger sequence of waves shown with numbers in brackets on the graph. This is not followed by a corrective wave but what appears to be another impulsive wave of two peaks and three troughs.  Then a corrective wave occurs labeled with the letters A,B and C.  This wave ends at the 3rd point in the larger wave pattern (in brackets on the graph).  Two more impulsive waves complete the larger wave pattern. 

There is a tie in to the Fibonacci sequence that Elliott believed was significant.  Fibonacci numbers are a series of numbers that are in a sequence such that each successive number is the sum of the two previous numbers (1, 1, 2, 3, 5, 8, 13, 21, 34, 55 etc.).  Elliott believed that the number of waves that exist in the stock market's pattern is reflected in the Fibonacci sequence of numbers. Fibonacci numbers are intriguing in that any number is approximately 1.618 times the preceding number and approximately 0.618 the following number.  There is a good resource for further investigation of Fibonacci numbers written by Edward Dobson called Understanding Fibonacci Numbers.

The Elliott wave theory says that market price moves in recurring wave patterns.  Small wave formations link together to form larger wave formations.  There is some value in being aware of the theory and knowing how to apply the theory to financial markets.  In certain instances, the small corrective waves, labeled with the letters A, B and C, can be identified quite clearly especially after secondary corrections in the overall markets.  Usually the price action between A and B is a period of expanding volume.  The price action between B and C often form with diminishing volume and after C, price is said to have broken out of the pattern and is usually accompanied by increasing volume.  This is sometimes the start of the next primary swing in prices.

Technical and fundamental analysis

The common thread between technical and fundamental analysis is the study of trends.  Where technical analysis is the study of trends in price and volume, fundamental analysis concerns itself with economic and corporate growth trends and the projection of performance based on trends of relevant factors.

The basis of all long term trends in price and volume for any tradable is fundamentals.  Technical analysis thrives on the study of changing supply and demand patterns.  In the study of trends it is important to determine significance in changes in underlying perceptions of value that result from fundamentals and the forecasts of future performance.  A balanced understanding of the two disciplines can provide an excellent basis for a successful trading experience.

As with technical analysis, there are many fundamental tools that are purposed toward early identification of trend reversals.  A corporate growth rate forecast might be revised as a result of an earnings warning, or perhaps as a result of a sudden or continued decline in industry sales reports, or by association of sector move.  Forecasts that are a continuation of the most recent trend and do not range very far into the future can be measured against longer term forecasts as a ratio that may give a fundamental analyst a stronger knowledge of the conditions of market valuation. 

An expanding triangle usually cannot sustain the pattern.  Penetration is often to the down side. A drop in P/E might mean lower price and constant earnings, or constant price and lower earnings or some variation of the two. If the pattern held, a rising P/E could peak in 5 or 6 years. This usually means price has increased more than earnings. In a positive growth environment that could speak highly of price in the next 5 or 6 years.  But it also could mean that price holds steady while earnings continue to decline.  The key to the interpretation of this approach is to have a strong sense of earnings.  There are many combinations of technical tools and fundamental analysis.