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So You Wanna Learn Elliott Wave Analysis?
The closer you look at wave patterns, the more structured complexity you see.
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By Alan Hall
Tue, 01 Dec 2009 14:15:00 ET |
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So You Wanna Learn Elliott Wave Analysis?
For more reading on the basics of Elliott wave analysis, please read all parts of the series: Part I, Part II, Part III, Part IV, Part V
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When investors and traders first discover the Wave Principle, there are several reactions:
- Disbelief – that markets are patterned and largely predictable by technical analysis alone.
- Joyous “irrational exuberance” – at having found a “crystal ball” to foretell the future.
- And finally the correct, and useful response – “Wow, here is a valuable new tool I should learn to use.”
Just like any system or structure found in nature, the closer you look at wave patterns, the more structured complexity you see. It is structured, because nature’s patterns build on themselves, creating similar forms at progressively larger sizes. You can see these fractal patterns in botany, geography, physiology, and the things humans create, like roads, residential subdivisions… and – as recent discoveries have confirmed – in market prices.
Natural systems, including Elliott wave patterns in market charts, “grow” through time, and their forms are defined by interruptions to that growth.
The structured progress and regress is essential to all forms of growth. That this “punctuated growth” appears in the financial markets is only natural. As Bob Prechter, the world's foremost Elliott wave expert, says, “Everything that thrives must have setbacks.”
The first step in Elliott wave analysis is identifying patterns in market prices. At their core, wave patterns are simple; there are only two of them: “impulse waves,” and “corrective waves.” Impulse waves are composed of five sub-waves and move in the same direction as the trend of the next larger size. A corrective wave follows, composed of three sub-waves, and it moves against the trend of the next larger size. As the picture below shows, these two patterns form similar structures of larger sizes, or “degrees,” as R.N. Elliott, the discoverer of the Wave Principle, called them:
The above pattern begins with waves 1, 2, 3, 4 and 5 that together form wave (1) – a five-wave, impulsive structure that tells us that the trend at the next larger degree is also upward. If you were reading this in real-time, and the rest of the pattern was not visible, it would also warn you to watch for a three-wave correction.
Corrective wave (2) in the chart above is followed by waves (3), (4), and (5), to complete an impulsive sequence one degree larger – labeled 1 circled, sometime written as ((1)). This is followed by a three-wave correction of the same degree: wave ((2)) (labeled A-B-C).
One way to think about corrective waves is that because they move against the next larger trend, they lack the strength to unfold into a full five-wave move. Whatever the reason, the fact that corrections are weaker than the impulse waves creates that necessary "interruption" I mentioned earlier and causes the progress and regress that defines nature’s growth structure. Here's a picture of A-B-C correction in an actual market, the U.S. Dollar Index -- with immediately bullish implications. (Chart excerpted from EWI's Mon.-Wed.-Fri. Short Term Update, Nov. 30, 2009 issue.)
(Following this bullish forecast, the U.S. Dollar Index rallied from near 75 to near 89 by summer 2010.)
Well, that's the gist of it. Congratulations, you've begun learning the basics of Elliott wave analysis! Now read Part II of this five-part series, where we address the labeling of wave patterns in real time and show you how to use this valuable tool in your trading.
Learn more about the method that has kept Robert Prechter out of the herd and in the game for more than three decades. It's broken up into 10 free lessons across 50 pages, so it's easy to read and review at your leisure. DETAILS>>
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Tags: Elliott wave, Elliott Wave Principle, U.S. dollar