There is undoubtedly a romance involved in trading, many of us enjoy discussions surrounding Fibonacci due to its romanticism. The mathematical purity, history, the links to nature and the infinite qualities simply adds to its legendary allure. There are several other mathematical models associated with and often applied to trading, that evoke both a sense of mystery and curiosity. For example; the Elliott wave principle, which also has a direct correlation with the Fibonacci sequence and retracement.
We’ll defer to the standard orthodox definition of Elliott wave and briefly explain its history, before discussing using a simple application of the principle and indicator on your charts.
Ralph Elliott discovered the underlying social principles and developed the analytical tools that constitute his Elliott wave principle in the 1930s. His contention was that market prices develop in specific patterns, now referred to as “Elliott waves”. Elliott posited that;
“because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable.”
Naturally, the mathematicalproof of the Elliott wave’s plausibility has been subject to much debate since its creation. In an era in which over 90% of equity trades on the NYSE are conducted by HFT computers, up from 70% in 2010, you begin to wonder how much credence the robots pay to crowd behaviour and sentiment. However, the counter argument is that, as the sophisticated algorithms (robots) develop more sentient capabilities, they may detect changes in sentiment far more efficiently than human intervention, making the Elliott waves more pronounced.
Amongst market technicians, wave analysis is accepted as a component of their profession. The Elliott wave principal is included in the exam analysts must pass, in order to earn the Chartered Market Technician (CMT) accreditation developed by the Market Technicians Association (MTA).
The Elliott wave principle (EWP) proposes that collective investor psychology, loosely defined as crowd psychology, moves between optimism and pessimism in natural rhythmic sequences. These mood swings then create patterns which are demonstrated in the price movements of all markets.
As a form of technical analysis traders attempt to spot market cycles and therefore forecast market trends, by identifying:the extremes of investor psychology, the highs and lows in prices and other collective crowd behaviour factors.
In Elliott’s model market prices oscillate between an impulsive (motive) phase and a corrective phase. Impulses get subdivided into five lower degree waves; alternating between impulsive and corrective. Waves 1, 3, and 5 are impulses, whilst waves 2 and 4 are retraces of waves 1 and 3. Corrective waves also become subdivided into 3 smaller waves, beginning with a five wave countertrend impulse, then a retrace, then another impulse.
In bear market conditions the Elliott theory proposes that the dominant trend is downward, therefore the pattern is reversed; five waves down, three up. Motive waves always move with trend, corrective waves against.
In theory any time frame could be used for placing EWP on your charts. However, as always it must be noted that Elliott developed his hypothesis before the advent of modern trading over the internet, using adjustable time frames. The accepted time frames in Elliott’s creative years were typically weekly and monthly, therefore attempting to use EWP on any time frame below the daily might be considered redundant. However, advocates suggest that due to the maths involved, the peaks and troughs of psychological sentiment can be easier to recognise on lower time frames.
The purpose of this article is to introduce readers to the concept of the EWP, there are trading sites dedicated to the subject and books have been written on the wave principle. Therefore it’s essential that, as curious investors and traders, you DYOR (do your own research) with regards to the subject, should you see any potential benefits for your trading methods.