Ralph Nelson Elliott discovered in the 1920’s that stock markets do not behave, as many thought, in chaos but in harmony. Why? It is difficult to state but most probably due to investors' emotions and psychological influence. All this points to the fact that due to the eruption of our emotions on markets, the market itself could be interpreted as a living organism with harmonic movements, whether in shape, proportion or even time.
Basically, Elliott stated that market swings whether in an increase trend or decrease trend moved in repetitive movements which he called waves. In his typical wave structure market movement was made up of five waves in the direction of the trend and three waves forming a corrective movement.
There are many rules regarding the structure of the waves and the following are some of the most significant:
1. Wave 2 cannot break the bottom of wave 1 in an increase trend and cannot break the top of wave 1 in a decrease trend.
2. Wave 3 cannot be shortest in term of length and time, in comparison to waves 1 and 3.
3. Wave 4 cannot break the top of wave 1 in an increase trend and cannot break the bottom of wave 1 in a decrease trend.
4. Wave 4 cannot be longer than wave 2.
Example:
1. Rule one is not broken as wave 2 represents 78.6% of wave 1.
2. Rule two is not broken as wave 3 is the longest of all waves in the direction of the decrease trend.
3. Rule three is not broken as the bottom of wave 1 is not broken by the top of wave 4.
4. Rule four is not broken as wave 4 represents 78.6% of wave 2.
As seen on the USACAD market this decrease was followed by corrective movement ABC.
As impulses, corrective movements can also be characterized by specific relations within their structure and will be talked over in future presentations.
Conclusion:
Many believe that the Elliott Wave Theory can only be used on structures that have already been formed and that it is very unlikely to use this tool in real time investments. I believe that this is not true. Many great traders like Ed Seykota, Bryce Gilmore and Robert Miner make use of this tool with great success. It is not easy to specify where in the five wave structure the current market movement is and this could lead to many losing transactions due to the fact that investors may believe that they are in one specific wave whilst being in another. Personally, I do not seek which wave I am currently encountering but I do analyze markets and trade on the basis of many of Elliott’s rules assigned to specific structures with strong concentration on corrective movements and their possible end. If you are able to recognize when a correction has ended then you may be on the right track to making money. Why? Because after every correction a new top or bottom could follow, enabling investors to assign a minimum reach of market movement. When trading a minimum reach or in other words the investors trade target is very significant because this decreases the effect of destructive emotions such as the fear of loss or the greed to earn more.
For any questions or remarks write to:
Omar Arnaout
Omar.arnaout@xtb.com