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Technical Analysis: Basics of Elliott Wave Theory


How this tool helps us understand human nature.

Editor's Note: See the author's previous article, Primer on Technical Analysis. Also see his most recent market update, Bears Fire Warning Shot Across the (S&P) Bow.

MINYANVILLE ORIGINAL A more detailed form of technical analysis is called Elliott Wave Theory.

On the surface, Elliott Wave is a unique way to understand why the market does what it does, and a detailed tool that allows us to project future price moves by extrapolating the fractals and patterns found on the charts. The theory runs far deeper than that, though.

At its core, Elliott Wave helps us to understand something much more meaningful than markets: It helps us to understand human nature. The patterns formed in the market are, in part, a direct reflection of investor knowledge, and more importantly, investor sentiment. Like most things in the world, sentiment fluctuates in cycles.

You can often observe the symptoms of this cyclical tendency in news reports. One week, you'll see nothing but happy headlines, as sentiment hits a positive cycle and everyone forgets about all the troubles in the world:

"Rally Takes Off as Market Cheers Job Report"

"Stocks Rise as Greece Agrees to Austerity Measures"

"Dow Closes Higher After Bernanke Announces He's Dying His Beard" (If you were rooting for that sentence to end without the last two words – shame on you!)

Then a short time later, it's as if everyone forgot how "good" everything was just a few moments ago, and suddenly it's nothing but bad news again:

"Rally Crumbles as Market Boos New Jobs Report, Which Was Pretty Much Exactly the Same as the One They Cheered Last Month"

"Stocks Collapse as Investors Realize They Don't Actually Know What Austerity Means"

"Dow Suffers Biggest One-Day Loss on Record When the Market Realizes It's Afraid of Snakes"

Even the exact same news item can be received well on one day and poorly on the next – highlighting my point that sentiment is cyclical. In reality, outside of certain "black swan" events, the news doesn't drive the market directly -- it merely reports what the market did after the fact and attempts to explain it. Otherwise, good news would always cause the market to go up, and bad news would always cause it to go down.

The other problem with news is that, even if it were a prime mover of the market, it always arrives too late for you to make use of it. If you're dead set on trying to assign a "reason" for what the market did that day, you could simply look at the closing prices to figure out whether sentiment was good or bad (up = good; down = bad), and then make up your own random explanation, just like many news article seem to do: "Market Crashes as Investors Realize That "Your" and "You're" Are Actually Two Different Words."

Fortunately, we don't need to pay attention to the lagging-indicator news, because these sentiment cycles often leave clues telegraphing their arrival and departure. These clues are found in the price patterns. As we discussed previously, all the collective knowledge of investors is reflected in the numbers on the charts.

By tapping into that knowledge, Ellliott Wave Theory can, at times, recognize and anticipate the sentiment and cycles in advance. And since sentiment goes a long way toward driving the price, we can then either:

1. Anticipate the market's future price movements before the moves actually occur, or;

2. Gain a reasonably accurate window into what's likely to occur if the stock or index crosses a certain price threshold.

The market's price movements are, in the end, a reflection of human nature. And here's where things become truly fascinating:

By rule of intrinsic design, human nature must be universally reflected in all human constructs, be they markets, governments, or otherwise. Once you unveil one universal aspect of human nature, you are often able to locate the same common thread running throughout other human activities.

This is one of the fascinating things about Elliott Wave Theory: It seems to apply to patterns found not only in markets, but in the rise and fall of nations, and even entire civilizations (as well as the ebb and flow of many other things in the natural world). I have studied and applied it for many years, and continue to be in awe of its frequently uncanny ability to anticipate the future.

It is important to note that Elliott Wave Theory was derived from back-testing.

Back in the 1930s, R.N. Elliott studied decades of charts at various time frames, and discovered that there were certain patterns which repeated across all time frames. These patterns were of a fractal nature; in other words, the patterns on the one-minute chart join together to make up identical larger patterns on the hourly charts, which in turn make up identical larger patterns on the daily charts – and so on. He developed Elliott Wave Theory as an attempt to quantify and explain these patterns.

Next, we'll examine the underlying patterns that form the basis of Elliott Wave Theory, and we'll take a look at some past and future predictions made using the theory.

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