R.N. Elliott introduced the concept of counting waves in 1938 after a stomach condition kept him bedridden most of the previous decade.
An accountant and railroad executive who was forced into early retirement, Elliott studied the historical movement of the Dow Jones Industrial Average to pass the time. What he discovered was that markets move in recognizable patterns called waves.
“The stock market is a creation of man and therefore reflects human idiosyncrasy,” is how he put it.
Elliott’s basic rules can be summed up in a few sentences. Impulse waves are movements in the direction of a larger trend. A complete impulse wave count is labeled 1-2-3-4-5, where waves 1, 3 and 5 are in the direction of the trend and waves 2 and 4 are corrective or countertrend moves. Wave 2 cannot be larger than wave 1; in other words, from a bottom or top, a second wave retracement cannot create a new high or low. If it does, the first low or high was labeled prematurely. Also, wave 4 cannot enter into the territory of wave 1, except in diagonal triangles. Finally, wave 3 cannot be the shortest of the three impulse waves.
As any experienced trader knows, markets seldom take the shortest path to a destination. In contrast, the main appeal of Elliott wave analysis is its adherence to simple, specific and predictable rules and definitions.
Not surprising, given that Elliott developed the Wave Principle by studying historical charts, his labeling technique is an effective method for describing patterns after the fact.
Still, using the principle for predicting current market behavior is tempting and, sure enough, the patterns of strongly trending markets are relatively easy to count. But, all too often, traders lose money clinging to naive hopes of simply counting waves. It turns out that predicting real-life market action is much more complex.
EXPANDING YOUR WORLD
Profiting from the Elliott Wave Principle is a serious challenge if it’s used in isolation. For a pure Elliott wave technician, or Elliottician, it’s frustrating when a wave count becomes less than perfect, for example, when waiting for that last wave of a wave 5 to develop, only to see the markets reverse violently in the opposite direction without completing that last move.
One way to overcome this is to project the charts into the future by overlaying a Fibonacci matrix on wave analysis. This method reveals the guiding force behind the seemingly random markets and can account for irregular moves as the attainment of specific target levels, regardless of the resulting wave pattern.
There are a few different methods for formulating a market outlook that take advantage of Elliott wave. For example, in the first quarter of this year, using a combination of Elliott/Fibonacci and Gann techniques, it was possible to make a case for a market high at 1320 in the S&P 500 occurring in the second week of May, which was months in advance of the actual move. As it happened, 1326 was reached on May 8.
Then, the sell off from the May highs brought the index to just below the 1242.45 support that had to hold. Once it vibrated around 1245 for most of June and then again in July, the larger Fibonacci projections were not complete and the call was made that the S&P would reach its Fibonacci projection at 1360.
Since reaching that level in October, we’ve seen attempts at further gains but not before the creation of an important pivot at 1360. This level, invisible to most at the summer lows, is now the most important test for the end-of-year rally.
At the end of November, the S&P 500 was again being pulled higher toward the 1400 area. The New York Stock Exchange (NYSE) also sold off drastically in May, which seemed impulsive, indicating its high was in, but the decline didn’t continue. Its important Fibonacci level was still at work behind the scenes, pulling it up like a magnet. That level is 9240 to 9314, as shown in the monthly chart in “Fibonacci at work,” below.
First, the Fibonacci projections are highlighted along with a channel and a cycle indicating that a turn is due soon, but this might not be the time to hang on for every last point. The weekly chart has now created excellent resistance against a smaller Fibonacci measured move and an Andrew pitchfork (see “Week in, week out,” below). The result is a conflict between the weekly and daily charts. One needs a bit more of a move, but the other looks finished.
From here, indicators call for additional gains, but with a consolidation first before trying to take out the previous highs. The market will likely vibrate around the Fibonacci target of the daily chart as it decides if it will attempt the higher target on the weekly chart.
If the NYSE is successful in reaching its weekly target at 9240/9314 in 2007, the S&P will be forced to follow and reach the 1440/1460 area.
TRICKS OF THE TRADE
Many traders think reading a book or using computer-generated counts will make them money, but it takes more than just a little knowledge of basic Elliott setups to be able to call the market.
One of the more unique Elliott wave corrective patterns is the contracting triangle. The triangle consists of five corrective A-B-C waves, not impulses. They usually appear at a fourth wave, but they also can be a “B” or “X” wave. “As GOOG as it gets” (below) shows that a triangle was indeed playing out. The five moves of the triangle are labeled A-B-C-D-E.
When spotted early, trading within this triangle can become predictable and precise using simple Fibonacci projections to go long and short against the trendlines. This might seem easy enough in hindsight, but in truth it takes a skilled technical analyst to observe the pattern while it’s still actionable, which in this case can be done by predicting where the end of each wave should be.
In triangles, more often you will see a wave reach a 0.618 to 0.786 of its preceding wave in the same direction. So, you would look for wave “D” to finish at 0.618 to 0.786 of the “B” wave. Wave “C” will try to be 0.618 to 0.786 of the “A” wave. Wave “E” will try to be 0.618 to 0.786 of the “C” wave.
Looking at the triangle in GOOG, a short trade from the completion of wave “B” would have had a target for wave “C” and also a stop, as wave “B” should not trade above the “A” wave high. Here, the actual price moved exactly to the 0.618 measured level, but if expectations prove incorrect, Elliott analysis offers a level to place your stop with minimal risk of loss.
The best trade from this triangle was buying the “E” wave as it came close enough to the “C” wave to create a $3 stop loss while the reward was $125. Wave “E” is typically created by actual news. Say a triangle has been building and wave “D” finishes as bad news flows into the market, creating a sharp sell-off. Take 0.618 to 0.786 of wave “C” and find a projection, preferably one with other Fibonacci targets as confluence. Then, draw a line at the bottom of wave “C.” You now have some targets and a stop because going under the C wave rules out a triangle.
But, assuming a triangle indeed unfolded in the chart, after making some steady money trading with the technique just described, you’re then ready for a “thrust.” Because you’ll usually spot triangles just prior to the market’s ultimate Fibonacci target, in a distribution phase or accumulation in a downtrend, the compression in this pattern will culminate in a powerful jump, which aims for that Fibonacci target. To calculate other targets, measure the widest part of the triangle and add that measure to the bottom of the “E” wave.
Another rewarding pattern is the ending diagonal (see “All chopped up,” below). This pattern is wedge-shaped and occurs at the end of a move. This setup is found in fifth waves and “C” waves. Here also, each wave is like a magnet toward the same Fibonacci levels as the contracting triangle.
The fourth wave in a diagonal must overlap its first wave, unlike the impulse waves. This pattern is terminal and indicates exhaustion of the larger movement. The reward is that the diagonal’s return to its point of origin takes only one-third to one-half of the elapsed time of the whole pattern’s formation, which, if you trade correctly, allows you to cash in quickly.
Learning to analyze the markets is a process. Through the past 70 years, Elliott’s Wave Principle has been used to penetrate the complexities of large markets by a variety of traders in numerous disciplines and levels of experience, from day-traders and retail investors to the most successful and respected analysts. But Elliott wave is more of an art than a science and to yield consistent profits in modern markets, with their billions of dollars of derivatives and hedge funds, we must go beyond the basics.
Each day markets vibrate around decades-long Fibonacci projections, and the more these projections become active drivers influencing the markets, the more Elliotticians are counting waves created as prices react to this web of Fibonacci Matrix.
Traders need advanced techniques forged in real-time trading and analysis, like those presented here based on a unique combination of wave principle, Fibonacci and other proprietary indicators to separate themselves from the pack.
These are the next generation of technical tools created for a new millennium of trading.
Dominick Mazza is a technical analyst and founder of Tradingthecharts.com. The Web site specializes in the technical approach to the commodities markets using Elliott Wave, Fibonacci, cycles and proprietary indicators.
