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Similarities between Technical Analysis and Elliott Wave Analysis

By Editorial Staff
Wed, 22 Dec 2010 15:15:00 ET
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Anyone interested in Elliott wave analysis is also interested in technical analysis, since they are both based on interpreting patterns on price charts. Whether or not you have studied Edwards and Magee's book, Technical Analysis of Stock Trends (a classic now in its 9th edition), you might like to know that many of the patterns they describe are also Elliott wave patterns -- but by different names. Here's a brief overview taken from A.J. Frost's and Robert Prechter's own classic, Elliott Wave Principle.
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Excerpted from Chapter 7 of Elliott Wave Principle by Frost and Prechter
Technical Analysis
The Elliott Wave Principle not only supports the validity of chart analysis, but it can help the technician decide which formations are most likely of real significance. As does the Wave Principle, technical analysis (as described by Robert D. Edwards and John Magee in their book, Technical Analysis of Stock Trends) recognizes the "triangle" formation as generally an intra-trend phenomenon. The concept of a "wedge" is the same as that for Elliott’s diagonal triangle and has the same implications. Flags and pennants are zigzags and triangles. "Rectangles" are usually double or triple threes. "Double tops" are generally caused by flats, "double bottoms" by truncated fifths.

The famous "head and shoulders" pattern can be discerned in a normal Elliott top (see figure above), while a head and shoulders pattern that "doesn’t work out" might involve an expanded flat correction under Elliott (see figure below). Note that in both patterns, the decreasing volume that usually accompanies a head and shoulders formation is a characteristic fully compatible with the Wave Principle. In the figure above, wave 3 will have the heaviest volume, wave 5 somewhat lighter, and wave B usually lighter still when the wave is of Intermediate degree or lower. In the figure below, the impulse wave will have the highest volume, wave B usually somewhat less, and wave four of C the least.

Trendlines and trend channels are used similarly in both approaches. Support and resistance phenomena are evident in normal wave progression and in the limits of bear markets (the congestion of wave four is support for a subsequent decline). High volume and volatility (gaps) are recognized characteristics of "breakouts," which generally accompany third waves, whose personality, as discussed in Chapter 2, fills the bill.

Despite this compatibility, after years of working with the Wave Principle we find that applying classical technical analysis to stock market averages gives us the feeling that we are restricting ourselves to the use of stone tools in an age of modern technology.

The technical analytic tools known as "indicators" are often extremely useful in judging and confirming the momentum status of the market or the psychological background that usually accompanies waves of each type. Indicators of investor psychology, such as those that track short selling, option transactions and market opinion polls, reach extreme levels at the end of C waves, second waves and fifth waves. Momentum indicators reveal an ebbing of the market’s power (i.e., speed of price change, breadth and in lower degrees, volume) in fifth waves and in B waves in expanded flats, creating "momentum divergences."
Since the utility of an individual indicator can change or evaporate over time due to changes in market mechanics, we strongly suggest their use as tools to aid in correctly counting Elliott waves but would not rely on them so strongly as to ignore wave counts of obvious portent. Indeed, the associated guidelines within the Wave Principle at times have suggested a market environment that made the temporary alteration or impotence of some market indicators predictable.

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The Elliott Wave Principle is a detailed description of how financial markets behave. The description reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific Elliott wave patterns in price movements. Each pattern has implications regarding the position of the market within its overall progression, past, present and future. The purpose of Elliott Wave International’s market-oriented publications is to outline the progress of markets in terms of the Wave Principle and to educate interested parties in the successful application of the Wave Principle. While a course of conduct regarding investments can be formulated from such application of the Wave Principle, at no time will Elliott Wave International make specific recommendations for any specific person, and at no time may a reader, caller or viewer be justified in inferring that any such advice is intended. Investing carries risk of losses, and trading futures or options is especially risky because these instruments are highly leveraged, and traders can lose more than their initial margin funds. Information provided by Elliott Wave International is expressed in good faith, but it is not guaranteed. The market service that never makes mistakes does not exist. Long-term success trading or investing in the markets demands recognition of the fact that error and uncertainty are part of any effort to assess future probabilities. Please ask your broker or your advisor to explain all risks to you before making any trading and investing decisions.