Real prices for coffee sank to a 30-year low in 2001, and for the next three years, nearly every gain was quickly erased. The low-price, sideways trend was so persistent that "coffee widows" became common in Central America and elsewhere, as men literally walked off their farms to look for other work. Then in early 2004, coffee started to make a more meaningful move.
In Elliott wave terms, coffee's reversal behaved according to a predictable sequence of ups and downs: A lengthy three-wave "correction" had given way to the first five-wave impulse of a new "motive" trend. The essential Elliott wave pattern, shown in Figure 1, is five waves in one direction, corrected by three waves going in the opposite direction.
This wave pattern appears at every degree of trend, progressing ever upward with corrections along the way, as shown in Figure 2.
To know this shape and progression helps traders discern what might come next in the markets they follow. So, for instance, if a five wave-move appears complete, a correction of three waves is about to ensue. Conversely, if a three-wave correction appears complete as coffee's did in 2004 then it's time for an impulsive five-wave series.
In Elliott Wave Principle, A.J. Frost and Bob Prechter explain the details this way:
There are two modes of wave development: motive and corrective. Motive waves have a five-wave structure, while corrective waves have a three-wave structure or a variation thereof. Motive mode is employed by both the five-wave pattern and its same-directional components, i.e., waves 1,3, and 5. Their structures are called "motive," because they powerfully impel the market. Corrective mode is employed by all counter-trend interruptions, which include waves 2 and 4. Their structures are called "corrective," because each one appears as a response to the preceding motive wave yet accomplishes only a partial retracement, or "correction," of the progress it achieved.
When it comes to understanding these patterns in price charts, the best teachers are the markets themselves. In essence, following the markets becomes a "real-time classroom." Coffee offers a great example: On May 19, 2004, Daily Futures Junctures showed the daily coffee chart shown here as Figure 3. Editor Jeffrey Kennedy identified a "corrective" pattern via the a-b-c legs (green circled labels) within the downward trend of wave 2 (red label), and here's what he wrote:
"The reason this is significant is that three-wave patterns are corrections or countertrend moves. This means, at minimum, a full retracement of this decline will occur."
He also explained the upward line at the conclusion of the pattern by saying, "Considering the longer-term wave count, I believe the advance from 69.40 is the beginning of a third wave, targeting initially 75.95 (where wave 3 will equal a 1.618 multiple of wave 1)."
Coffee's reversal also taught a more nuanced lesson that Jeffrey focused on in the June 2004 issue of Monthly Futures Junctures. His "Trader's Classroom" feature spelled out an innovative method of drawing and using trendlines. Coffee's chart at the time showed a near perfect example of an impulsive wave penetrating a corrective trend channel.
Along with the charts in figures 4 and 5, Jeffrey explained,
"My theory is simple: Five waves break down into three channels, and three waves need only one. The price movement in and out of these channels confirms each Elliott wave.... In Figure 5, you can see that most of the January selloff in Coffee was within one channel. Since price action within one channel is typically corrective, I still considered the larger trend to be up. This approach was helpful in alerting Daily Futures Junctures subscribers to ... Coffee on May 19th."
Obviously not all patterns are as clear as the one we present here, nor do prices always unfold according to the textbook. Yet here's what we do know: Pattern analysis is about letting the market be the teacher in all of our forecasting services, that's never the exception, and always the rule.