Elliot Wave Theory: A First Look

April 15, 2012 Market Updates, Succesful Investing Skills No Comments

Elliot Wave Theory can add a lot to your trading and provide helpful hints that can mitigate your greed on the upside and calm your panic selling to the downside. Both of these concepts are something that all serious traders need to learn if they want to make money trading stocks and commodities. Hopefully this simple introduction to Elliot Wave Theory will prompt you to delve deeper into the subject so that you can take full advantage of all the clues that the theory can provide when you are trying to decide when to enter, stay or a leave a trade. Before we get into the basics of Elliott Wave theory, let’s take a minute and see what’s been going on with gold and monetary policy lately.

Market Update

Jim Sinclair was interviewed this week on King World News and had this to say regarding gold’s current trading range.

“$1,650 is a comfortable number (for central planners). Haven’t you seen the tremendous jawboning and market intervention to hold gold in that range at $1,650? $1,764 and they lose control. That begins the move which is exponential.”

The on again off again comments of the Federal Reserve regarding QE3 has been used as a tool to keep gold in a comfort zone for the lords of monetary policy. This will not last that much longer because the inflation data is turning ugly for almost everything that American consumers buy. The Fed will be forced to devalue the dollar further in order to keep the government from going bankrupt due to the profligate spending policies of the current occupant of the White House.

There is no concern for the future of the country, only the naked lust for totalitarian power that motivates the President’s desire for a government controlled European style nanny state.

The mythical “recovery” that the mainstream media is pushing is the direct result of central bank bond purchases and record low artificially induced interest rates. It was recently reported that the Federal Reserve purchased 61% of the government debt that had been issued by the U.S. Treasury in 2011. Add that to the debt that the Fed has purchased since 2008, and we are looking at more than $2 trillion in just the first two attempts at quantitative easing. Round three will be the catalyst that sends gold and silver to record new highs. Now is definitely not the time to be talked out of your physical gold and gold stocks!

Elliott Wave Theory: A First Look

The basic principle of Elliott Wave Theory is contained in its name. The theory implies that market prices will rise and fall in recurring patterns, similar to ocean waves, that can allow traders to identify high probability trading opportunities. This is by no means an exact science, but these patterns reoccur so often that every trader should recognize them as they develop. It is pretty simple, because if we can recognize where a stock is within the wave, we can make a better determination of whether to stay with the stock for more gains, or sell it before it starts to correct. The key word here is a “better” determination, because as in everything, there are times when the theory does not apply as accurately as we would like.

A Brief History

Elliott Wave Theory was developed by Robert Nelson Elliott and his theory was made popular by Robert Prechter. His theory establishes the correlation between crowd behavior and how, when it changes, it affects the movements of the price in individual stocks and indexes. The Elliot Wave Theory established basic patterns for the understanding of how crowd behavior moves in clearly defined trends.

Mr. Elliott was a well respected accountant, that took ill and had a lot of time to study the stock market during the 1930′s, while he was recovering. His theory explains what he named the “impulse wave”, which is a 5-wave sequence, which is followed by a 3-wave sequence. These waves will normally occur whether the price is going up or down.

When you look at the Elliot Wave Theory in deeper detail, you will notice that when you take a chart from any type of stock and remove the timeline, along with the valuation and place it next to another stock, there will be striking similarities in the the price movement of the charts. The Elliot Wave Theory explains this reoccurring pattern as a result of human psychology which as we all know through experience, is pretty predictable.

Basic Wave Sequences

In a bull market, a five wave pattern defines the rising trend which is broken up by a 3 wave downward corrective action. The following chart is courtesy of stockcharts.com which is where you should go if you want to learn more than just the basics of Elliot Wave Theory.

After the impulse up waves of the 5 wave move, a 3 wave declining trend is likely to occur. After it is complete, the stage is set for another 5 wave impulse up rally. This also applies during downward trends, with the down moves being a 5 wave series followed by a 3 wave corrective up phase. The following chart from stockcharts.com illustrates a 3 wave corrective action which will normally follow a 5 wave impulse up move.

Elliott Waves should be used along with other supportive data, such as Fibonacci numbers, because everything you are trying to do should be supported by as many corresponding disciplines as you can throw at the data. Finding a wave pattern that completes at a strong Fibonacci support or resistance level can offer another clue as to the reliability of your conclusion about changes in the direction of the trend.

Elliott Wave Theory, when combined with Fibonacci numbers can provide an edge to your trading. Any clues that you can get that will alert you to potential changes in the trading patterns of a stock or an index that you are interested in can potentially increase your profits dramatically. I highly recommend that those of you that are interested in Elliot Wave Theory make time to take advantage of the many advanced discussions that are available to you on the internet. Hopefully, this first look at the power of the theory will spark your interest and lead you to explore the theory further.

Till next time, good luck and good trading!