Riding the (Elliott) Wave to Profits
April 9, 2001
How many of us would like to go back a year and have another chance to spot the market patterns? Well, obviously we can't do that, but there are steps we can take to educate ourselves and be ready for the next up move - and the down move that will invariably come again. One of the steps we can take is to learn about Elliott Waves and their significance in the trading markets.
The Elliott Wave Theory, developed by Ralph Nelson Elliott, says the behavior of the masses tends to trend and reverse in recognizable patterns. Although there are many social applications of the Elliott Wave Theory, here we are concerned with how it applies to trading in the markets. The "masses" are traders and the trends and reversals refer to the prices of stocks, commodities, and futures, etc.
We all know that nothing goes up in a straight line; nothing comes down that way, either. Yet, if being successful in the markets is a 50/50 proposition of 1) buying when something is going up and 2) not having it turn around on you right after your purchase, why does trading success seem so elusive?
Elliott sought to answer questions like this in a graphical manner, and developed his theory that patterns of ascent and decline move in sequence with the Fibonacci series.
Fibonacci, an Italian mathematician who lived nearly 1,000 years ago, developed a sequence of numbers that applies to cycles of growth and decline (although, at the time, he was just trying to unravel the mystery of rabbit reproduction!). The Fibonacci sequence starts with the numbers 1 and 2, adds them together to find the third number in the sequence - 3 - and then adds the most recent 2 numbers in the sequence to find the next number: 5. This sequence is repeated as follows:
1,2,3,5,8,13,21,34,55,89,144& and so forth, to infinity.
Fibonacci realized mathematical relationships exist among the numbers in the sequence beyond the first 8 numbers. For example, dividing 55 by 89 equals .618. So does dividing 89 by 144, and this pattern continues infinitely. Another relationship is the division of 89 by 55; and 144 by 89, both of which equal 1.618. This continues ad infinitum, too. There are many other "Fibonnaci Relationships" and interesting numerical patterns, but I just want to introduce you to the basics here.
OK, now back to Elliott Waves. The question, you no doubt ask is: "what do Fibonacci numbers have to do with Elliott Waves?"
Elliott's theory, as applied to the markets, postulates that there are predictable reversals in price patterns, and uses Fibonacci numbers to predict the prices and time sequences for which the reversals will occur.
An Elliott Wave Sequence consists of 5 distinct waves, and can be either an up or down sequence. For an up sequence, there are 3 major waves to the upside, and 2 minor waves to the downside. In the graphic below, waves 1, 3 and 5 are the major (impulse) waves, and 2 and 4 are the minor (corrective) waves.
Figure 1: Elliot Wave, Up Sequence
Elliott also postulated that there is a corrective wave sequence, shown here by A, B, C, after the completion of a full 5 wave sequence.
What would a down sequence look like? It's as simple as literally flipping the graphic above upside down.
Figure 2: Elliot Wave, Down Sequence
Now you can see that waves 1,3 and 5 are still major waves, but they are to the downside, not the upside. However, the corrective phases of waves 2 and 4 are to the upside this time.
Why is it important to understand Elliott Waves? Because it reinforces the truth that nothing moves in a straight line. In the top graphic sequence showing an up move, there were pullbacks and points of entry for those who were adept at spotting them. In the down sequence (flipped chart), there were up moves within the larger down move (look at waves 2 and 4). If you weren't careful, you might have been caught by purchasing at these points.
Now, when applying the Elliott Wave Theory to real life, you might well understand that the Nasdaq has been in a very strong Elliott Wave Sequence to the downside over the last year. Looking at the chart above, which shows a down sequence, we are currently in the 3rd wave down. At some point, we should see a medium-term rally in prices as we move into the 4th wave, only to see it turn around and likely take out the lows we are currently seeing. Do you remember the rally in the Fall of 2000? Take a look at the 2nd wave of a down move. It shows an up rally (correction), only to be followed by an extreme move downward (wave 3). How many of us got caught because we didn't know the pattern? I did, but never again!
Let's look at a current monthly chart of the Dow Jones Industrial Average [DJIA], courtesy of Trading Techniques (tradingtech.com), which markets an Elliott Wave software package.
Figure 3: Monthly Chart, DJIA
I find this chart quite fascinating because it shows 15 years of monthly data on the Dow Industrials and a 3rd wave that began in 1987, which ran for more than 12 years! Of course, using different time frames (i.e., weekly and daily) will show many different wave sequences within the 12-year up wave. You ask, "which time frame should I be using?" And the answer is "one that corresponds to your personality and desired time in a trade." If you are a very short-term trader, perhaps the 60-minute or daily time frame is what you should look at. For position traders or spread traders, perhaps a daily or monthly time frame and sequence of Elliott Wave patterns is best.
Looking again to the monthly Elliott Wave Analysis on the Dow Jones Average, we see that the average ran from 2,000 in late 1987 to almost 12,000 in very early 2000. It is currently in an A-B-C corrective pattern, as shown by the red letters. The black monthly price bars indicate no definitive direction in the market (the A-B-C waves are present in the first two graphics in this article, as well).
The chart shows we are currently in a corrective pattern after having completed the 3rd wave of the Elliott sequence, and the software is calling for the 4th wave to be completed with further down moves. However, since the chart shows an A-B-C pattern with uncertainty, it is possible that the chart could come out of this corrective pattern and make new highs without reaching the range indicated by the two 4s (on the right-hand side of the chart). In this case, it may re-label the new high as the third wave. Or perhaps the current red C will be labeled as the 4th wave completion; and the new highs in the future labeled as moves toward the completion of the 5th wave up.
I remember one of the best traders I know telling me months ago that Broadcom (BRCM) was going to sink to 50 or below. At the time, Broadcom was in the 120s! Take a look at Broadcom's chart, below, from last January.
Figure 4: BRCM, January, 2001
Broadcom was in a down move sequence (easy way to tell: wave 3 was a down wave) and wave 4 was a corrective up move that ran from about 75 to 135. No doubt, this was large enough to fake out millions of traders. It was also large enough to allow enormous profits for those trading with a shorter time frame and the right tools. What this chart is telling us is that as soon as the 4th wave was completed, there would be more selling. Interestingly enough, the chart shows the 5th wave of the Elliot Wave Sequence down even further than the 50-level that my friend predicted, to about 20 more than 100 points below where it was trading at the time! I didn't believe it could happen and told him so, but take a look at the activity since that time:
Figure 5: BRCM, November, 2000; April, 2001
The stock is now down at about the 20-level that Elliott Wave Analysis (and this expert trader I spoke with) predicted at the end of January!
Perhaps the greatest use of Elliott Wave Analysis I've seen among traders is for the avoidance of bad trades. I know from personal experience that, had I been aware and adept in the use of Elliott Wave Analysis in the past, I would have stayed out of certain trades and been better for it. I also would have spotted the reversal of the Nasdaq and avoided trading through last summer. I remember traders coming into the Optionetics office last summer, crying that the Nasdaq was in a strong Elliott Wave down move, rattling off the wave numbers, etc. It was all a foreign language to me then, but they were right. What I've done since then is added Elliott Wave Analysis to my arsenal of trading tools. I think you'd do well to do the same. Educate yourself now so you can leave the wounds of the last year behind you, boost your confidence, and be ready for the bull and bear markets that we will see in the future.
Happy (and safe) Trading!
Ed Hecht
Staff Writer & Trading Strategist
Optionetics.com ~ Your Options Education Site
ehecht@optionetics.com
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