Getting Wavy With Elliot Waves
Technical analysis is a proven tool that has helped traders identify key entry, stop, support, and resistance levels. However, there are so many types of technical indicators out there that many get lost in the massive textbooks dedicated to the subject.
One such set of indicators that many investors need to know, and may already be familiar with albeit unknowingly, can help to boost trading profits. Traders should learn to utilize Elliot Waves as a tool for identifying retracements in price actions.
How does it work?
Elliot Wave Theory postulates that price actions follow patterns that only get disrupted by one-time events, or unique initial conditions. The theory is actually an application of chaos theory, for the nerds amongst us, which has been used in everything from art to quantum physics.
The Elliott Wave Principle posits that collective investor psychology moves between optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price movements of markets at every degree of trend or time scale. Importantly, each smaller wave is part of a larger, longer-term wave, as identified by chaos theory.
A basic example of an Elliot Wave is known as the 5-C wave. This name is given because it means that there are five identifiable legs to the initial move higher before the large retracement occurs, which usually contains three moves. And yes, this looks a lot like a head-and-shoulders top, a formation that many investors are familiar with.
The first leg, known as the 1-wave, is the start of the pattern. It is usually hard to identify and occurs when the news is mostly bearish on a given security. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.
The second leg, known as the 2-wave, is a retracement of the first leg. Wave two corrects wave one, but doesn’t extend beyond the starting point of wave one or cancels the pattern. Typically, the news is still bad. Volume should be lower during wave two than during wave one and prices usually do not retrace more than 61.8% of the low of Wave 1.
Wave three is usually the largest and most powerful wave in a trend. The news is now positive and by wave three's midpoint, consensus will often jump into the trade. Wave three often extends wave one by a ratio of 1.68:1.
Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5.
Finally, wave 5 is the last and most powerful wave. Prices generally rise to new highs but other technical indicators such as MACD tend to diverge showing new weakness as prices rise. The news at this point is almost universally bullish and volume is at its highest at the beginning of the wave.
Then it all falls apart...
The retracement begins. Unexpectedly, or at least usually so, prices drop in the A-wave of the retracement but news remains positive and the chorus of “buy-the-dip” singers is in full chant. Look for higher volume, increased implied volatility in options, and higher open interest in futures to confirm that the move is the start of a downtrend and not another interim wave. After all, it could just be a wave 6 of the uptrend and a higher, stronger move is yet to come. But the divergence in volume between the two scenarios is key here.
In the B-wave, prices correct back higher but are usually less than 38.2% of the move lower. Low volume on the bounce and a failure to gain back substantial ground are key and many start to see the head and shoulders top forming.
Lastly, the final corrective wave, the C-wave brings prices back down. Sentiment turns bearish quickly and investors begin to accept that a new bear market is in store. Prices may bounce higher in shorter periods but the trend is still for lower lows. In this case, prices tend to drop at least as much as the A-wave and usually is equal to 1.618 times the A-wave.
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