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Saturday, March 7, 2009

An Elliott Wave Primer Part 1


(Note: This part one explains broad Elliott Wave concepts and how they apply to the stock market. Future parts will explore more technical details and how they can be applied to price movements. After all, your here because you want to make money!)

Attempting to explain Elliott Wave (EW) theory in one post is a daunting task. On the surface, EW theory is a simple concept. Putting it to daily (successful) practice in daily market movements is a mixture of art form and science.
I adhere to the basic principles as laid out by Ralph Nelson Elliott himself and expounded upon by Frost and Prechter in "The Elliott Wave Principle" (abbreviated - EWP), first published in 1978. EWP is pretty much the "bible" of EW theory. You need no other book or source. The amazing part is that virtually nothing has changed even from Elliott's time. The theory is pretty much entirely intact as it was laid out in the 1930's. There are no "evolving" concepts (other than further developing social mood studies and theories) nor is there a need for them to evolve. Frost and Prechter seemed to have nailed it in EWP. This is key concept #1: EWP is all you need to learn basic EW theory. Its definately all you need to trade the stock market as far as price movements are concerned.

In this post, I'll explain broad EW concepts in terms of the realm of social mood. I will not try and overwhelm the novice, nor underwhelm the experienced. I will focus on key EW concepts that one should strive to understand and explore further. So here it goes, I'll start with basic concepts and build them into higher concepts. These concepts are not necessarily in a chronological order.


Why not just dive into price movements and technicals? I will at some point, but the first thing any trader must learn about stock market prices is how sentiment and pyschology factors into the economic cycle of things. EW theory in fact is a theory of social progress which explains perfectly both sentiment and "investor pyschology".

Key Concept #2: Brief History Lesson: Ralph Nelson Elliott studied stock charts in the 1930's (as a hobby), particularly the post-1929 crash. He discovered that prices move in a certain 5 wave advancing structure and a 3 wave corrective structure. This structure is now known as an "Elliott Wave". He showed his work to a friend, and that friend noted that the structure reminded him of the Fibonacci ratio. (Fibonnaci was a 13th Century Italian mathematician ahead of his time) This was a profound discovery (largely by accident), that stock prices move in a certain form and seemed to be governed by rules of a natural order. In other words, none of it was truly "random" in the larger sense. Elliott wrote a book about it all.

Key Concept #3: Mankind's' socio-economic mood, or humankind's progress through time, advances in a basic 5 wave sequence and corrects in a 3 wave sequence at many degrees of trend. It seems to be nature's preferred way.

Key Concept #4: Fibonacci Sequence of Numbers, the Golden Ratio, Fibonacci ratio table. This is not "numerology" but rather mathematics. Google "Fibonacci" or look at Wikipedia for more info its too much to try to explain in full. The key concept is that nature's progress and underlying governing mechanism can be, to a certain extent, be explained using mathematics. For instance a snail's shell has a spiral design and a galaxy formation seems to have a basic natural growth order. This order relates to Fibonacci mathematical concepts.

Key Concept #5: Mankind's social progress through time appears to be governed by the same mathematical Fibonacci expressions and Elliott Wave structures of 5 wave advance and 3 wave decline at large degrees and small. The key concept is that mankind's social progress is NOT based on a series of random events, nor is it based on a continuous feedback loop. It seems to be rather based on a wave structure that is measurable in its advance yet flexible enough to allow a freedom of variety.

Key Concept #6: Waves are building blocks and are part of bigger waves. The basic 5 wave structure, occurs at many degrees of size from the micro to the Grand Supercycle to the millenial and perhaps beyond. So mankind's social progress is always advancing through time, 3 steps forward, 2 steps back at many layers. The 2 steps back seems to be a necessary correcting mechanism. Nature's way of correcting progress when we get too far ahead of things.

Key Concept #7: Where you are in the wave structure is relative. If we could somehow see and measure social progress from the beginning of time to where we are today, it would be a HUGE structure, yet looking from afar, that structure would be forever going up (progress). You would be able to discern parts of the structure that went down. These would be correction periods. And the structure would continually build upon itself always advancing and correcting at many degrees of trend.

Suppose we could "zoom in" on a period of time and we see a sharp rise and a peak followed by a long decline. Perhaps we would be looking at the advance of the Roman civilization and the large decline (corrective period) was the "Dark Ages". If you were living in the Dark Ages, and you were cognizant of your situation, you wouldn't think mankind was progressing at all but in decline. Its relative. In the same respect suppose you were living in a period of that large decline "Dark Ages" but you were experiencing a "mini-bull" period of social advance. Life might be good for you.

So you see you could be living in a period of long decline at a very large degree, yet if your lucky you might catch a smaller "up" wave of progress within that larger downtrend. Like Einstein's theory of relativity, it matters where one is at when referencing something larger (or smaller). The easiest way to explain is if you catch a nice 5% market rally in an overall harsh bear market. It certainly is relative!

If you were living in the Great Depression enduring hardships followed by World War II, you'd think mankind's days were numbered and we were on the brink of total destruction. Its relative.

In the same breath, if you were sitting on top of the world in March 2000 with a portfolio worth $10M of tech stocks, you see nothing but upside and cannot see how things can go bad. Its relative to where you are in the wave structure.

Key Concept #8: The Stock Market is the "perfect" mechanism to measure where mankind's social progress is at in the wave structure. The act of trading and buying billions of shares by millions of people is very much a social act, even if we do not see each other. Hence, the market acts as an indicator, sometimes amazingly fine-tuned. Its a gauge. Think of it as a voltmeter measuring fluctuating voltage in an electrical circuit. Suppose you knew that the underlying voltage you were measuring has a certain pattern, you would be able to, with a high degree of confidence, predict its future movements somewhat. At the very least, you can predict on what the market should NOT do, which is sometimes just as useful information.


Ever see a documentary on how social creatures such as the common honey bee interact in many fascinating social ways that amaze us? Well, think of the stock market as the ultimate amazing social measuring instrument. No one person "controls" things per se. Its a social endeavor.

Key Concept #9: Economic activity is largely a social, progressive type of endeavor. When social progress, or "mood" is in an advancing stage of the structure, mankind increases economic activity. In its most basic explanation, when we are in a good mood (in a progressive stage of the wave structure at some degree) we BUY (increase in economic activity) things. When we are in a bad mood, we SELL (decrease in economic activity) things. And it really doesn't matter what. Stocks will suffice. And since the stock market leaves it "trails" and patterns, we can interpret where we are in the larger pattern of social progress. This pattern has been recorded in one form or another for hundreds of years.

Key Concept #10: Waves move first, fundamentals follow. This is the hardest part for some to accept. We have been taught that all actions cause reactions and in a large sense that seems certainly true on an individual scale. But on a collective social scale, some larger forces are likely in play and something governs those forces.

We have been taught that there is a "feedback loop" and that this is what caused "A" to lead to "B". But what one has to accept is that mankind's' socio-economic progress is governed by waves of progress and waves of decline. And that this progress is somehow hard-wired into our genetic code perhaps.

Certainly as market technicians we constantly utilize "sentiment" indicators and certainly we validate that social sentiment is part of why stocks go up and down. The big mistake is that we tie these ups and downs largely to strictly feedback loops, or "news" events. EW theory teaches that socio-economic progress is not determined by feedback loops and hence, wave structures allow us to predict with a reasonable degree of certainty future directions of social progress on the large and small degree of trend no matter what the fundamentals.

Yet we also recognize the fact that the stock market is typically "forward-looking" or about 6 months ahead of fundamentals either on the upside or the downside. Do you want to know why this is? Elliott Wave Theory, of course!

I cannot stress how important this concept is. When mankind's socio-economic mood is on the upswing, we increase economic activity and hence prices go up, people buy things (even if they are inflated or in a bubble) and we generally feel good. Eventually we "peak" in that mood by some hard-wired genetic code that can often be measured with some accuracy. We use Fibonacci-based mathematics to help us measure.

That old saying "when you reach the top, there is nowhere to go but down" is certainly true. The saying its "darkest before the dawn" is also true. This occurs at many degrees from the small to the large. From world civilization picking up the pieces in the aftermath of world war, to the mini joy a team experiences in accomplishing a championship win. So goes the wave structure. I suspect most any social endeavor can be applied.

Key Concept #11: The stock market (largely) does not follow "news". This is THE very hardest part, particularly of older traders, to accept. If you can accept that markets move first, then fundamentals follow, I must convince you that markets largely do not follow news events. Hrmm I need to explain.

The media is largely a social endeavor! The media is a reflection of social mood. They write stories and report things attempting to interact and "explain" why events are happening. The media are not leaders. The media has a "herd" mentality and certainly the saying "If it bleeds, it leads" is true. Doom and Gloom sells, and so does ultimate victory. Yet we do not trade or read news events as a social unit. So we tend to see a headline splattered all over every media outlet and we see the market nose-diving (or going up) and our brain ties the 2 together thinking "Yes!" that is why "X" is happening because "A" is causing it. We absolutely convince ourselves and if we interact with others in discussion, the conviction becomes that much stronger. Wrong!

"X" is happening largely because it was READY to happen in the wave structure. Hint: The media makes stuff up out of thin air. "Investors are Worried Belgium is Defaulting on Debt" or some stupid headline you've seen them all. Oh really? How does that reporter know that is causing billions of shares to decline? Did they conduct a poll? Or did they engage in herd mentality because that's the "News of the Day". For every silly headline and talking head that "explains" why things are happening based on what their little brain thinks, I would be a zillionaire. Its nauseating.

Why does "Buy the Rumor" and "Sell the News" work and sometimes in reverse? Because the wave structure was ready for it to happen! Its that simple. Remember the media is a reactive social endeavor and largely a herd mentality exists. The media typically reflects social mood. Its somewhat of a barometer for sentiment. That's why when you see nothing but bad, horrific news that the stock market is going to zero, you should be ready for a historic rally because after all, its darkest before the dawn, yes? But don't buy too early, that last bit of decline can still wipe you out if your don't know where you are in the overall wave structure.

Buying at 743 SPX looked "smart". Certainly the news was bad, etc etc. But not so smart when the market gapped down and you got trapped and unwisely held as it visited the mid -600's. Happens all the time. My larger point is news media is a good contrarian source at very extremes, but only in a general sense.

One can largely trade successfully just looking at the charts not ever following the minute to minute "news". You could trade in a bubble using wave theory and chart patterns and normal technical indicators, and if I may go so far as to suggest, you would likely do a lot better. Although it wouldn't be practical nor fun. We are, after all social creatures. My main point is this: Trust the wave structure more than the media. Talking air balloons.

(I have never watched a CNBC show - that is the truth. I do however watch booyahead occasionally and do the opposite).

I do follow the news though if only for confirmation of fundamental decline or advance. the waves moved and now I expect a drop in economic activity. 3 months later, that drop is confirmed. You get what I mean? The news helps to validate wave theory more than anything.

Some people will swear by news events. And that is ok. I have observed that some traders through long practice or some innate genetic skill likely are in tune with the markets wave movements even if they do not realize it. They "swear" its trading "news" events or whatever the method. In the end whatever works!

But also in the end, once you understand why things happen and will likely happen (wave theory) you can rest a bit more peaceful at night, knowing there is a decent probability that you will be correct. You won't be getting up at night turning on Bloomberg news "hoping" that futures turn toward your trading direction. That's no way to go through a swing trade.

Key Concept #12: The government is the ultimate consensus group. This concept is not really a tenet of basic EW theory. It is however something that Robert Prechter has more fully explored as part of his socio-economic EW theories. I feel its important to understand.

What I mean is that government can only react. They can only do things by consensus which is why what they do is usually the very worst and we would be better off if they did nothing. Government is the ultimate pinnacle of social herding. And following the herd usually gets you in trouble in the long run. They enacted policies that enabled the bubbles that we have experienced over the last decade. And they will enable policies that surely just as much will ensure a swift decline. Such is the nature of government. They are not leaders. But they can be dictators. And "we the people" will enable them to do it. Wave theory ensures it.

One thing can be sure: They react at wave bottoms and tops at the larger degrees. So do not be too worried about the Plunge Protection Team" (PPT) actions, as when actions do come, it will be a point in the wave structure that was ready for a turn anyways, i.e.- "the bottom". Government is the ultimate contrarian.

Its also instructive to note that on the way to extreme wave tops they enabled the very worst policies and lax regulations. But in the end, the government we get is what we deserve. That saying is also largely true.

We got corporate leaders that are a reflection of the majority of society's current social moods and values at large. And when we as a social unit are peaking at the top of a grand superccyle wave and experience a tremendous amount of social greed, we can only expect our "leaders" reflect this general social pattern. We point the finger at everyone else but ourselves. Some of us are only bitter because we did not manage to "get our slice", not the fact that greed is ultimately a destructive social behavior trait. The wave structure ensures it will correct.

But I am starting to digress.

In the end, Nature keeps us from getting ahead of ourselves. When we get too complicated, nature has a way of simplifying things again. Somehow this was hardwired into our genetic code by our Creator if you will. Elliot Wave theory attempts to unlock these secrets. Knowing key concepts helps one to know what to expect in the future, not just with stock prices but applying it to any social concept is valid.

Unfortunately at the end of severe declines in social mood, fascism and major wars break out. But if we realize why things happen and the likely outcomes, maybe we can lessen the end results, both at the tops and bottoms. But, you can predict, ironically using wave theory itself, that this will likely never happen.

Next part I'll dive more in the technical aspects of EW theory, and where we are in the grand cycle of the wave structure both large and small and how it can help make money from it.

4 comments:

  1. Dan -- This is excellent work. It's a wonderful synopsis and I am looking forward to reading more.

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  2. This was done very well ! You have a talent for teaching.

    Thank you very much...

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  3. thank you for taking the time to explain this in this wonderful synopsis

    ReplyDelete