(This article originally appeared in SFO magazine's Nov. 2008 issue. You can read Part I here.)
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Reading the Wave Analysis Map
So now that you have a wave road map in hand, let's talk about how to apply it to the actual terrain of financial markets.
When I look at a price chart for the first time, my first task is to identify any completed five-wave and three-wave structures. Once I do that, then I can interpret where the market is along the pre-defined path and, from there, where it’s likely to go.
Say we’re studying a market that has reached the point shown in Figure 2. So far we’ve seen a five-wave move up, followed by a three-wave move down.
But this is not the only possible interpretation. It's sort of like having a GPS that tells you that you've arrived, when you've actually got miles to go. In this example, it is also possible that wave (2) hasn’t ended yet; it could develop into a more complex three-wave structure before wave (3) gets under way. Another possibility is that the waves labeled (1) and (2) are actually waves (A) and (B) of a developing three-wave upward correction within a larger impulsive downtrend, as shown in the “Alternate” interpretation at the bottom of the chart.
According to each of these interpretations, though, the next imminent movement is likely to be upward. That tells you more than most technical analysis systems do.
Alternate Elliott wave counts are an essential part of using the Wave Principle. They are neither “bad” nor “rejected” wave interpretations. Rather, they are valid interpretations that are given a lower probability while the count works itself out. If the market doesn’t follow the original preferred scenario, the top alternate usually becomes the preferred count. I consider alternate counts to be similar to detours -- just a different way for the market to get to where it’s going. How many times do you actually go from point A to point B non-stop in your travels? Admit it, you have to stop to grab a bite to eat or ask for directions once you realize you’re lost. After consulting the map, you get back on track toward your intended destination. The new path represents an alternate count.
This seeming ambiguity about a wave structure illustrates an important point about the Wave Principle that, in my opinion, is often misunderstood. The Wave Principle does not provide certainty about any one market outcome. Instead, it gives you an objective means of determining the probability of a future direction for the market. At any time, two or more valid wave interpretations usually exist. Unlike actual physical roads that exist, price movements in financial markets are always changing, and the best you can do is be somewhat confident of whether they are moving up or down. That's the kind of confidence that the Wave Principle provides.
Think of Investing as a Trip
Here's my advice: View the Wave Principle as your road map to the market and your investment idea as a trip. You start the trip with a specific plan in mind, but conditions along the way may force you to alter course. Alternate counts are simply side roads that sometimes end up being the best path. Elliott’s highly specific rules keep the number of valid interpretations to a minimum. The analyst usually considers the “preferred count” to be the one that satisfies the largest number of guidelines. The top “alternate” is the one that satisfies the next largest number of guidelines, and so on.
There are only three hard-and-fast rules with the Wave Principle:
- Wave two cannot retrace more than 100% of wave one.
- Typically wave four does not end within the price territory of wave one but may do so from time to time in highly leveraged markets.
- Wave three is never the shortest wave of an impulse.
Elliott’s rules give specific “make-or-break” levels for a given interpretation. In Figure 2, for example, if the move labeled (2) continues below the level of the beginning of wave (1), then the originally preferred interpretation would be instantly invalidated. By eliminating subjectivity, the rules help you firm up your investment strategy -- and reduce your risk.
“Are We There Yet?”
You’ve heard that irritating question, "Are we there yet?," from the back seat just about a million times. Every map has a scale, and it’s the scale that helps me determine how many miles I have to travel before I reach my destination. When using the Wave Principle, Fibonacci relationships are the scale.
Many investors today know that Fibonacci ratios are used for market forecasting. But few realize that Fibonacci analysis of the markets was pioneered by R.N. Elliott.
The use of Fibonacci ratios requires a valid Elliott wave interpretation as a starting point. Unfortunately, many non-Elliott analysts try to find Fibonacci proportions between market moves that are not related to each other in any way. This has made the approach appear to be far less valuable than it is.
Elliott wave analysis has two chief insights concerning Fibonacci relationships within waves:
First, corrective waves tend to retrace prior impulse waves of the same degree in Fibonacci proportion. For example, wave (2) in Figure 2 retraces 38% of wave (1). That’s a common relationship. Other frequent wave relationships are 50% and 62%.
Second, impulse waves of the same degree within a larger impulse sequence tend to be related to one another in Fibonacci proportion. For example, common relationships include wave three traveling 1.62 times the distance traveled by wave one of the same degree. When that occurs, wave five often tends toward equality with wave one of the same degree.
Planning the Trip
Just as I sit down and plan my trips before shoving off, I rely on wave interpretations and Fibonacci relationships to help establish investment strategies and reduce risk exposure when I analyze the markets for our clients. Investors use these same wave analysis methods to help decide where to get into a market, where to get out and at what point to give up on a strategy.
The Wave Principle lets you identify the highest probability direction for the market, as you also adopt an optimum position to take advantage of it -- all while protecting yourself against lower probability outcomes. You couldn't ask more from your own GPS.
By the way, we did make it to Cades Cove on our way back across Smoky Mountain National Park. I turned off my GPS and consulted my map. The old tried and true worked like a charm.
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