ELLIOTT WAVE THEORY – NOT ALL BUNK
Here’s a shocker - most technical analysis does not work! The
key word here is “most.” That being said, I’d like to elaborate
on the positive side of the Elliott Wave Theory. In it’s simplest
form the theory is that the primary trend in prices, whether up
or down, is 5 waves in the primary direction with a 3 wave correction
in the opposite direction. This pattern repeats until the primary
trend changes. If you have not studied this theory and the associated
Fibonacci numbers theories, you are better off. Do not run out
and buy any books on it. It’s all very complicated and the real
fact is that most times you never know where you are in wave counts.
You are as apt to read the waves wrong as you are right. This
is especially true with a stock trading in congestion (trading
between new highs and lows.)
This theory got a big play when one of the investment letter
writers predicted, based on his study and refinement of the theory,
that the Dow would rise from 1000 to 3000 which it did in 1987.
But the second part of the prediction was, that after the market
crash, we were going into the second depression/dark ages. On
the way to 3000, the writer was treated like a god. But I digress…
The real value of this tool is in monitoring the 3 wave corrective
phase in a bull market. What happens in a three wave 1-2-3 correction
is normal and often typical of a correction to a powerful advance.
Let’s take a strong move up, that temporarily runs out of gas
(no more buyers, or better said, there are more sellers than buyers).
The price reverses. Markets are not efficient and often overshoot
on the way up. They need time to “digest” the gains.
What does that mean and how does this chart pattern work? Traders
have profits, and as an advance runs out of steam and momentum
slows, many are quick to lock profits. Thus, reversal days are
common and tend to be strong, as all the short term traders rush
to sell at the same time. That often marks the top of the run
up for the time being. Sometimes the market does not go down again
the next day. It may take many days of churning back and forth
to define the top. Whether the market goes down the next day or
not, after the top is put in, more sellers than buyers want to
trade. As per the basic rule of the market, if money wants out,
the market declines. That is leg 1 down in the correction. That
wave ends when the selling pressure abates and there are buyers
now willing to step in, feeling the price is cheap, or perhaps
better said, is a good value. Bargain hunters buy, pushing the
price part way back to the top. That is wave 2 of the correction.
But as soon as the price advances, sellers come back into the
market. These are the people who wished they had gotten out at
the top, so they perceive the new rally price as an opportunity
to get out at a decent price. This causes the price to reverse
downward again. And as it does, many other long traders previously
on the fence, throw in the towel which accelerates the selling
to a new lower low price in the correction. When the selling abates,
buyers come back in, and the price reverses and starts up again.
The correction is complete, and the up trend resumes, as the last
of the weak holders of the stock have been shaken out.
This process sometimes is fast and sharp and the pattern is unmistakable
and simple. However it often takes weeks or even months, and the
wave counts, with sub waves, get complicated. If the stock is
eventually going to make new highs, but has to correct a previous
big move up, it is going to take a moderate amount of time, often
3-8 weeks or longer. Some traders look for a short correction
and a simple form of the 1-2-3 Elliott wave correction. They buy
the first up day that marks the bottom of the final 3rd
wave down and then place their stop below the low of that day.
However, it is often a hard trade to make with low risk, as the
first day up forming wave 3 is usually not a narrow range day.
What is worth looking for is this 1-2-3 correction, then a quiet
consolidation afterwards of 3-7 days that takes place a bit above
the low. Usually buying on strength from a break out from that
consolidation represents a much lower risk trade.
The above chart of the recent correction in CALM is a textbook
example. Also, look at the daily and weekly charts of QQQ, the
NASDAQ proxy. There was a perfect example of this 1-2-3 correction
that lasted five weeks and ended August 15th. By looking at weekly
charts, the pattern becomes clean and simple. Looking at the
same weekly chart over two years, you can see the same corrective
3 waves very clearly after the market made a top in December 2002
after advancing from the market bottom in October of 2002. That
1-2-3 correction lasted until February when the correction was
completed and since then the market has been moving strongly higher.
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