Technical analysts believe that studying charts with the details of past volumes, prices and trading patterns can enable them to predict future trends.
In this article, we will focus on the use of Elliott Wave Principle as a means of identifying trends in market prices.
In theory, the underlying concepts can be applied to trading CFDs in stock indices such as the Dow, S&P 500, FTSE 100, currencies or commodity markets, such as Brent crude oil.
Equally, it could also be applied to trading in less established markets such as cryptocurrencies like bitcoin.
Developed by former US accountant Ralph Nelson Elliott in the 1920s and 1930s, the Elliott Wave Principle seeks to forecast trends in market prices.
Using the stock market as his main focus for research, Elliott charted contemporary and past behaviour of investors.
In this way he felt able to isolate certain recurring patterns.
By studying such patterns, advocates of Elliott´s approach attempt to map the market´s recent behaviour with a view to projecting its next moves.
Today, a key proponent of Elliott Wave Principle is Robert Prechter, president of Elliott Wave International.
Prechter has led the publication of newsletters attempting to predict market moves since 1979.
Indeed, Elliott Wave International appears to have been having some recent successes in its market forecasts.
For instance, the January 2018 issue of Elliott Wave International´s Financial Forecast publication correctly predicted a sharp sell-off in bitcoin.
Meanwhile, an edition of its Theorist newsletter in late January 2018 also correctly projected a pull back for the NASDAQ.
Elliott´s book, “The Wave Principle”, was first published in 1938.
His work rests on the core belief that markets trade in repetitive cycles, which Elliott referred to as waves.
According to the Elliott Wave Principle, crowd psychology creates natural waves that oscillate between optimism and pessimism.
Elliott termed trends, or the principal direction of prices, as “impulsive” waves. He described price corrections that go against the overall trend as “corrective waves.”
Bull and bear
The model depicts market prices as switching between an impulsive and corrective phase across all trend time scales.
At the same time, the impulsive or corrective phases can both apply to either upward or down moves in prices.
In a bull market, we would see five waves in the upward part of the cycle followed by three waves in the downward timeframe. In a bear market, we would see the pattern in reverse, so five waves in the down cycle followed by three waves in the up.
Not all the smaller waves making up the upward or downward part of the cycle are moving in the same direction.
Impulse waves are divided into a set of five waves of smaller magnitude, themselves alternating between impulse and retrace stages. Waves one, three, and five are impulses while waves two and four are smaller retraces of waves one and three.
Meanwhile, the corrective waves are divided into three waves of lesser magnitude. These would be a counter-trend impulse, a retrace, and another impulse.
In his book from 1938, Elliott pinpointed nine degrees of waves. These could run into decades at the “Grand Supercycle” end of the spectrum or intraday at the “subminuette” level:
1. Grand Supercycle
New bull phase
As an example, suppose the market has entered a new bull phase. In the first wave, as the new up trend gets underway, some traders are tentatively entering long positions while others are exiting short positions.
Following a retrace in wave two of this new bull phase, the up-market trend more purposefully kicks in. In this third wave, investors appear more convinced that the market is indeed in an upward trend.
The retrace in wave four is dominated by profit taking rather than doubts about the overall bull trend. In wave five, yet more investors go long, as the bull trend gathers an increasing number of followers.
From this point, the corrective, three-wave phase begins, as more investors with long positions take profits. There may also be some concerns from fundamental investors over valuations.
However, once the three-wave corrective phase has run its course, the bull sentiment returns, and the market begins a new five-wave impulse phase once again.
In the Elliott Wave Principle, the five waves of a motive phase have a Fibonacci relationship with all eighth waves of the full cycle.
Each wave has a Fibonancci relationship with other waves or phases.
Fibonacci ratio comes from the work of 13th-century Italian mathematician Leonardo Fibonacci.
It is devised from a number sequence where the sum of two adjacent numbers sums to the next highest number (1, 1, 2, 3, 5, 8, 13, 21 ...).
Using Elliott Wave
So, how do you use the Elliott Wave Principle in trading?
In simple terms, the trader can take a position to benefit from the main direction of travel but look to exit or take contrary positions when a reversal appears imminent.
On the plus side, as wave patterns appear in every time frame, for instance on a monthly, weekly, daily and five-minute chart, the Elliott Wave Principle can be useful for those of us looking to profit from trading CFDs on a daily basis.
It could also be potentially used by investors to help them with longer-term strategic positioning.
If you want to begin experimenting with the Elliott Principle, the starting point is to study various charts and attempt to spot a five-wave impulsive phase and a three-wave corrective phase.
Critics have warned that Elliott Wave Principle does not consistently pinpoint when a wave commences or ends.
Others contend that Elliott´s theory may well be out of date as there have been a number of social and economic changes since the 1930s.
At the same time, if you begin to use the principle, it does not mean that you have to stop using fundamental analysis.
You may well want to combine technical theories such as Elliott Wave with the fundamental signals such as changes in the economic backdrop.
Equally, the Elliott Wave principle can also be potentially combined with other analytical tools such as Bollinger bands and volume-weighted average price (VWAP) crosses.