Today we've asked Kenny Mann of Traders day Trading to share his ideas on Elliot Wave Theory and why you should be interested as an investor.
Elliott wave theory suggests that stock market prices tend to ebb and flow in recurring wave like patterns that can enable us to identify high probability trading opportunities. The knowledge gained from recognizing where the market is within one of the wave patterns, can help us to stay in a trade longer so as to maximize profits, whilst also ensuring that we know when to get out, if the market should turn against us.
What is Elliott Wave Theory?
For most people with even a passing interest in stock markets and trading, the name Elliott is usually a very familiar one. Ralph Nelson Elliott was a well respected accountant who through ill health, had a lot of free time on his hands and spent much of it studying the stock market. It was the 1930’s and a particularly interesting time in the markets.
Elliott observed that prices often moved in trends and patterns that were, to a certain degree, all very much the same. The patterns appeared to consist of waves which themselves then evolved into larger waves, he called his observations, Wave Theory. Today it is known as Elliott Wave Theory. The wave theory remained relatively unknown until the 1970’s with the release of Frost and Prechter’s, Elliott Wave Principle. This bestseller continues to be regarded the definitive guide to Elliott Wave Theory, and as one of the classics on technical analysis. Find out how to get the Elliott Wave Principle online, free.
If you take one stock market chart for something like oil, and you remove all information relating to any time frame or values, and you place this next to a trading chart for something completely different, what you will notice is that they share many significant similarities.
The reason for this, so Elliott Wave Theory suggests, is that stock markets are heavily controlled by human psychology, and human psychology is fairly predictable.
We humans are a pretty predictable bunch at heart. Knowing this fact, and combining it with the principles of the Elliott Wave Theory, it is possible to observe trends in the stock markets, and foresee changes in advance of them occurring.
Elliott Wave Basics
The basic principle of Elliott Wave Theory is simple. Over periods of minutes, hours, days, weeks, months or even many years, trends will often follow a cyclical wave pattern, most usually considered to consist of three progressive waves (Impulsive Waves), broken by two regressive waves (Corrective Waves). The five wave pattern will then be followed by a corrective three wave move in the opposite direction, to form a complete Elliott Wave cycle.
The first wave will see a progressive change in stock value in the direction of the new trend. This is where the smart money is getting in. Prices can sometimes seem to struggle to make any headway as many traders continue to trade with the previous trend. However, by the time wave 1 has run its course, the market should be displaying some subtle signs of having turned. Often, the turn will be very apparent.
Second waves are corrective and as such, by definition, can never retrace more than 100% of the first. Trader’s who were convinced the previous move was another corrective phase congratulate themselves on calling it correctly. However, the new trend finds some strength, and goes on to power ahead in a third wave. Wave 3 is usually the most significant and longest period within a trend. It is a period of mass participation as it becomes obvious to the vast majority which direction the markets larger trend is now moving in.
As wave 3 runs out of steam, traders begin to take some profits and the market enters another corrective phase in a Fourth wave. However, once again the underlying strength returns and the trend resumes as it enters in a Fifth wave. Fifth waves are distribution phases where the remaining traders that have been in denial, finally accept that the markets larger trend is now going against them. These traders are now forced to liquidate their losing positions and may even decide to reverse their trades, just as the trend is completing.
We have all been there, where we have been forced out of a position just to see the market turn. It is a classic novice trader mistake, but one which can still happen to even the more experienced traders who have got their timing wrong.
Using Elliott Wave analysis can usually help us to recognize where the market is in the current trend. This knowledge greatly reduces the chances of us entering into a position too early, and then getting forced out again at precisely the wrong time.
Corrective phases are slightly more complex, they generally consist of three waves, but there are several possible combinations of patterns that may form within those three waves. The example shown here following the five wave advance is a three wave zig zag pattern.
Practical Application of Elliott Wave Theory
There are a number of ways in which the knowledge and application of Elliott's Wave Theory can be used to both predict stock market trends as well as to provide a certain degree of reassurance during times when values may be decreasing. Understanding that
these decreases may well be correctional, and be preceding a subsequent growth period can provide a distinct advantage when trading both over the short and longer term.
One of the problems is that it can be difficult to identify the patterns accurately enough to make significant decisions. However, by following a few simple rules and guidelines, Elliott wave can become an extremely powerful tool that every trader and investor should at least have a basic understanding of.