When most people start trading in their own accounts, whether their style is to trade frequently for the short-term or to take a longer-term, “swing trading” view, they are inclined to look for a “system,” a foolproof, repeatable and easy to understand analysis that will tell them where the market is headed.
They quickly learn that while there is no shortage of people claiming to have such systems, for a price of course, none actually exists. Even in these days of algorithmic trading, mathematical formulae don’t drive markets, people do, and people mostly respond to news and fundamental conditions.
The most useful technical analysis, therefore, is one which takes that into account, and rather than attempting to predict the next move, gives an understanding of the probable shape and intensity of that move once it is underway. Elliott wave theory is the best-known analysis that does that. It has certainly stood the test of time, having been around since Ralp Nelson Elliott published The Wave Theory in 1938.
What made Elliott wave different then and today is that it is based on psychology and sentiment, not pure mathematics. Yes, Elliott does use Fibonacci numbers, a sequence based on the relationship between prime numbers that was first noticed in the thirteenth century, to predict the size of some parts of the pattern, but he maintains that the direction of the “waves” that form a move comes about because of the way we think, not a mathematical formula.
The basic idea in its original form is that moves happen first in five waves, three in the direction that news suggests interspersed with two corrective waves. Thus, a move has the zigzag shape that people often draw when asked to demonstrate a chart.
There are some technicalities about the names of and relationships between the wave and such, but the psychology behind them is far more important. They start when all the news points one way and the market moves in the logical direction. In the case of the example above that would be good news, but it can also be bad, as has happened recently in the stock market. At some point, traders who were in on that move early take a profit and there is a correction. However, the fundamental news hasn’t changed, and when that correction takes the price back close to the starting point, it once again attracts buyers or sellers in a bearish move.
That pattern then repeats, and by the time we get to the fifth wave, even the doubters and habitual contrarians capitulate. They join in and/or their contrarian positions are squeezed out, creating wave five. Elliott analysis, in its most basic form, is just a matter of understanding where we are in a news and trader sentiment cycle.
That is the case right now with the move down in stocks after the Aug. 16 high.
For investors, an Elliott interpretation of the recent chart for the S&P 500 is a good news/bad news kind of thing. The good news is that clearly, we are in wave five, so an end is in sight. The bad news is that wave five, because it is about capitulation, often tends to be the longest motive wave in bear moves.
For investors, therefore, if you have taken out some defensive positions or a hedge on the way down, you can hold onto them for a while longer as the short-term outlook is still bearish. If, however, you have held on to this point, don’t become a part of the capitulation trend that precedes a reversal. Sit tight, at least until the next pattern forms.
Elliott purists will no doubt have problems with all the above, pointing out that wave patters are fractal, for example, meaning small patterns exist within larger ones, and that if you pan out on the above chart with that in mind you will get a different view. That may be true, but it doesn’t change the basic outlook on where we are right now in the observed pattern. That suggests we will go lower, then reset. An analysis technique that has been around for ninety-four years and is still considered relevant must have something going for it so, until the news changes or the market tells me otherwise, I will be basing trading on those assumptions. You might want to consider doing the same.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.