THT’s Market Analysis Part 2

Part 1 was very basic and I kept it that way on purpose, let’s have a look at Elliott Wave (EW) analysis and how it would have been applied to recent market activity – apologies but this is going to be a long drawn out post, but you need to see EW in action to see its good and bad points

If you are new to EW or don’t understand it, you’d be better off taking a look at this link and downloading the relevant free lessons from the experts :

The Elliott Wave Principle

In the 1930s, Ralph Nelson Elliott, a corporate accountant by profession, studied price movements in the financial markets and observed that certain patterns repeat themselves. He offered evidence of his discovery by making a number of accurate stock market forecasts. What appears random and unrelated, Elliott said, is actually tracing out a recognizable pattern once you learn what to look for. Elliott called his discovery “The Wave Principle,” and its implications were huge. He had identified the common link that drives the trends in human affairs, from financial markets to fashion, from politics to popular culture.

Robert Prechter, Jr., president of Elliott Wave International, resurrected the Wave Principle from near obscurity in 1976 when he located copies of R.N. Elliott’s books in the New York Public Library. Robert Prechter, Jr. and A.J. Frost published Elliott Wave Principle in 1978. The book received enthusiastic reviews and became a Wall Street bestseller. In the late 1970s, gloom was pervasive, but in Elliott Wave Principle, Prechter and Frost called for a roaring bull market akin to that of the 1920s, to be followed by a record bear market. As the stock market rose, knowledge of the Wave Principle among private and professional investors grew dramatically.

When investors and traders first discover the Elliott Wave Principle, there are several reactions:

  • Disbelief that markets are patterned and largely predictable
  • Joy at having found a “crystal ball” to foretell the future
  • And finally the correct, and useful response – “Wow, here is a valuable model I should learn to use.”

Just like any system in nature, the closer you look at wave patterns, the more structured complexity you see. It is structured, because nature’s patterns build on themselves, creating similar forms at progressively larger sizes. You can see these fractal patterns in botany, geography, physiology and the things humans create, such as roads, residential subdivisions… and – as recent discoveries have confirmed – in market prices.

The first step in Elliott wave analysis is to identify patterns in market prices. At their core, wave patterns are simple; there are only two types: “impulse waves,” and “corrective waves.”

Basic Elliott Wave Pattern

Impulse waves are composed of five subwaves (labeled as 1, 2, 3, 4, 5) and move in the same direction as the trend of the next larger size. Impulse waves are so named because they powerfully impel the market.

A corrective wave follows, composed of three subwaves (labeled as a, b, c), and it moves against the trend of the next larger size. Corrective waves accomplish only a partial retracement, or “correction,” of the progress achieved by any preceding impulse wave.

As the figure above shows, one complete Elliott wave consists of eight waves and two phases: five-wave impulse phase, whose subwaves are denoted by numbers, and the three-wave corrective phase, whose subwaves are denoted by letters.

R.N. Elliott was not an ivory tower theorist. He set out to observe and then describe how the market actually behaves. Later he realized that his model had an important theme of self-similarity and a relationship to nature. There are a number of specific variations on the underlying pattern, which Elliott meticulously described and illustrated. He also noted the important fact that each pattern has identifiable certainties as well as tendencies. From these observations, he was able to formulate numerous rules and guidelines for proper wave identification. A thorough knowledge of such details is helpful in understanding what a market can do, and at least as important, what it will not do.

You have just begun to learn the power and complexity of the Elliott Wave Principle. So, don’t let your Elliott wave education end here. Join Elliott Wave International’s free Club EWI and access the Basic Tutorial: 10 lessons on The Elliott Wave Principle and learn how to use this valuable tool in your own trading and investing.

So there we have a basic explanation of the EWP – the trouble is markets don’t make their price swings perfectly!  This is why EWP only works some of the time as often non-perfect swings cause confusion and more importantly losses!  My major issue with EWP is that it forces you to have an opinion and by being tied into an opinion you don’t consider being wrong and when you are proved wrong you’ll have a decent sized loss to contend with – ouch!

REMEMBER – there is NO market analysis that works greater than 80% of the time, EWP looks and sounds brilliant but it has roughly a 50% success rate! (I can’t verify these figures as I’ve not sat down to look at the statistics nor do I intend to waste my time doing so)  Even the top EW guy in the world when trading in a trading competition years ago did NOT use EW to trade with/from exclusively – If he did not use it primarily then why should it work for you.

The problem with EW is the complex corrections, I’ve found that the simple zig-zag of an A-B-C correction is easily tradeable, but through in a complex correction and it’ll knock you off course – one’s occurring right now in the S&P500 and I’ll cover it in my charts in this post – the best simplified explanation and version of EWP is contained in the green book I recommend on the left – Robert Miners “High Probability Trading Strategies”

If market swings start to overlap then it’s highly probable (but not guaranteed) that you are in a corrective phase of the market, the good part about EWP is that If you correctly identify the stage the market is in, such as part of the 5 wave IMPULSE, then it is quite easy to predict where price will hit! Quite a statement for me to make and I’m afraid that you do not know for certain the exact labelling of the waves on your chart until a longish period of time has passed – If you’re like me you don’t have the chance of trading price action from the past only price action from tomorrow!

Look at the visual example above – Let’s assume that the labelling is correct and the ABC correction is the END of the price decline and that we expect more bullish waves , the next move WILL BE for point B swing high to be taken out and point 5, also if we knew for certain what Impulse wave of the higher degree had completed during the waves 1-5 bull move then we could with high probability predict where the next bullish advance (wave) would end!

Now before we look at some charts you have to understand that within the past 3 years the real EW experts have got the wave counts/labelling WRONG a few times on the S&P500 index – you can go for months anticipating your in an Impulsive wave where in fact it’s the impulse part of a corrective wave!  I’ll not get into the details but the eventual outcomes could wreck someones trading account because they’ll be fixated on being proved right on the outcome.

EW is highly subjective, if you asked 10 EW experts to label the same chart you would get a difference of opinion on the wave count!  Believe me labelling charts is not as easy as the labelled example above shows.

Let’s have a look at a few charts, all of the same sections on the S&P500 Index but I’ve tried to keep each chart as simple as possible for clarity – also remember this is a dumbed down version of EW and not a thorough analysis.  Most of the notes and analysis are documented on the charts:

So we can see that what we expect and what actually happens in the markets can be totally different, If and when you get your EW labelling spot on you can with high probability hit target tops and bottoms, but when the market shifts slightly so that EW swings aren’t as pronounced labelling could get you into a lot of trouble.

You can use Fibonacci levels to identify these turning points without the use of EW – I’ll save that for another lesson

Again the EW experts during the late 1980’s and throughout the 1990’s were calling for a market crash of manic proportions, they knew it was coming but their timing was 2 decades off, throughout that time obviously their wave counts had to be continually revised – now if you were trading them you might have got badly burnt!  Until a few days ago the EW experts were convinced prices were heading down in a particular wave labelling, I’m afraid with prices going above the March 2012 high that thinking & wave count is now incorrect.

I’m not saying that Elliott Wave is the answer, it provides structure and labelling to the highs and lows that a market makes but until the market moves to confirm that labelling you’ll never truly know what’s unfolding.

From a entry and stop position placement using EW can be highly accurate, precise and help minimise losses as your entry points and stop placement levels can be placed within a tick of where you are right or wrong on your call of the market!  Rather than a I’ll enter here and place a stop 50 ticks away because I always use a 50 tick stop!

BUT what you can do is associate the Fibonacci levels with market swings – Many people link EW with Fibonacci, the only reason that theres a connection is that the markets typically reach Fibonacci levels for their swings and if you’ve a properly labelled EW structure you can project it’s ending place – this is a LEADING indicator and too be honest you don’t need the EW labelling.

I hope that you are able to see how and when EWP works and fails – If this is a strategy that you could use then explore it further, it’s how I came to understand and explore the use of Fibonacci levels within my trading and gave me the insight to explore the use of Fibonacci ratios.

Please note that the area of Elliott Wave is fairly extensive and I’ve just scratched the surface here – you would be a fool to use what I’ve provided here to trade with, but hopefully I’ve helped you to understand this area a little – whether you use it or not in future.

Clearly this final chart I have introduced shows 5 clear waves down, if this was a true impulsive wave of a bear market then the start of wave 1 (March 2012) would NOT be exceeded because it invalidates key EW rules – therefore the 5 wave structure I have labelled MUST be some other impulse wave within a different wave label and as you can see this has only been known for certain ONCE the March high/start of wave 1 (down) had been taken out – therefore you now need (if you can be bothered) to relabel your charts and forget about any money lost trading the assumed wave of the past few months!

The Hovis Trader

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