Trading Techniques – The Elliott Wave Apr12

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Trading Techniques – The Elliott Wave

The Elliott wave principle is primarily a trend-following school of technical analysis that describes market movements as waves. In Elliot wave theory each market movement, or wave pattern, is designated with a numeric label and a behavioral designation-impulsive (trending) or reactive (corrective). It is named after the market analyst R. N. Elliott, who published his ideas in two books: The Wave Principle (1938) and Nature’s Laws-The Secret of the Universe (1946). Elliott wrote that a market movement, whether a bull move or a bear move, always could be broken down into five separate waves, with three being impulsive, or trending, moves and two being corrective, or counter trending, moves. The two corrective waves separated the three trending waves.

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The trending waves themselves could be broken down into five smaller waves of the same sequence as the overall move, and the corrective waves often fulfilled predictable retracements and broke down into three waves – two impulsive separated by one corrective.

Elliott believed the Fibonacci summation series was the basis of his wave pattern. He theorized that it is crowd psychology that moves the markets, and since that was no more than the collective actions of individuals and since individuals, like all living things, are rhythmic, their actions can be predicted. He also proposed that there are waves within waves, with each smaller time frame mimicking the larger formation, a phenomenon we now know to be fractal geometry.

The Elliott Wave Drawback

According to his detractors, one of the drawbacks of Elliot’s theories is that they are too subjective, with analysts needing to update and adjust their wave counts regularly as the market moves. “Ellioticians” seem to say that market direction is predetermined but then adjust their wave counts when the market doesn’t play out the way they had scripted it to.

We feel that the trader and market forecaster Cynthia Kase summed it up best in her 1996 book Trading with the Odds: “Elliott’s theories about the market in general and his view that there is a natural law that governs the market are correct in broad terms.” The fact that traders such as Kase, along with Bill Williams and Justine Williams-Lara, the traders and authors of the Trading Chaos trilogy of books, continue to use the wave count in their trading also gives Elliott’s theories credibility.

My description of the Elliott wave here is relatively short considering the weight the theory carries with many professional traders. Elliott’s wave theory and observations and use of Fibonacci numbers were groundbreaking, and there is no shortage of excellent descriptions of how his theories are applied in today’s market, including Kase’s works.