Looking at my weekly Nasdaq 100 (NDX) chart today, I was wondering where this market is going to wind up. Which led me to see if there was an obvious (my emphasis) wave structure that I could see for the index. I then remembered a boyhood picture of Will Rogers with his quote that "spinning a rope is fun if your neck ain't in it". I feel that way about Wave analysis: its fun to do, as long as I don't get too caught up in just trying to analyze with just an Elliott Wave perspective. I see traders and analysts from time to time that project far out into the future with this theory. They seem to get lost in the analysis as it can get complex. NOT! It's really fairly simple.

My first chart, absent a full explanation just yet, is the weekly NDX chart with my enjoyable mental challenge relating to how many distinct NDX upswings (waves) there have been; i.e., the rallies that ended at 1, 3 and wherever 5 ends. Moreover, this bull market wave structure was preceded by the bear market signature wave pattern, a 'classic' A-B-C bear market formation.

My purpose in this article and one or two more is to explain basic wave theory and provide a basic overview of bullish and bearish wave patterns. Wave analysis often provides a fantastic tool to understand the current trend, which is what it's all about for me: a way to answer certain kinds of questions.

Writing about Elliott Wave theory and practice is putting myself out on a limb a bit relative to the trader/analyst types that are pretty much all Elliott Wave, all the time. Even with my more basic analysis of it, readers often get confused or skip the topic altogether. Moreover, no topic is surer to get me some e-mails on this subject that suggest I might be an idiot or something, because "actually, the correct wave count of the chart you showed is actually blah, blah, blah.

Wave patterns, as in "Elliott waves", are not discussed generally except by 'practitioners' of a somewhat arcane art and it appears that only the 'initiates' understand what the heck they (the practitioners) are talking about or think they do. TOO BAD cause it's a nifty tool to have in your technical toolbox. Moreover, its not all that complicated as I said, but a certain language is involved and a different way of 'seeing' trends unfold so it takes a certain amount of explanation and seeing examples of stock and index patterns from a wave perspective.

Not all market trends trace out an obvious wave structure. I go for wave analysis as another technical tool WHEN I see certain obvious such patterns unfolding. Under such circumstances the theory is uncanny in predicting the unfolding trend; which, not doubt, is why the theory has many die hard adherents. I preface this Trader’s Column on Elliott wave concepts by saying that I am NOT a devotee of wave analysis, as I don't try to predict trends based solely on this theory.

I will use anything that 'works' in predicting an unfolding market trend, even if that indicator, pattern or theory doesn’t work all the time or at least obviously so. Overbought/oversold indicators don't have predictive value all the time, nor does seeing an apparent double top always signal a downside trend reversal. However, such tools and concepts work well enough, often enough, in my 'checklist' of things that guide my trading recommendations and decisions.

WAVE PATTERNS

I've been struck over the years by the tendency to make market analysis more complex than is necessary, perhaps due to the tendency to make some specialized analysis techniques an ideology out of methodology. This is especially true of Elliott wave theory and analysis.

If you are like me you may come to agree, if you 'try out' the principles, that the wave theory of Ralph N. Elliott is something that can help in making some very profitable trading decisions. A check of the price pattern will then come to include noticing the basic wave structure WHEN it is apparent or obvious. I emphasize this last point as I'm not an Elliott wave practitioner so to speak. That is, I have not joined the company of fellow investors and traders with a chart/technical bent, that invest large amounts of time interpreting and re-interpreting the wave structure in detail at all times.

As I explain in my (Essential Technical Analysis) book, Ralph Nelson Elliott, referred to as R.N. Elliott (1871-1948), was not quite a contemporary of Charles Dow (Dow was born in 1851 and only lived to 1902), but he was influenced by Charles Dow's theories on the behavior of the stock market. R.N. Elliott was not well-known as a hugely successful stock investor and speculator as far as I've learned.

However, his Elliott wave principle is better known today than it ever was in Elliott's lifetime, which is not to say that he didn't attract significant notice among some important market advisors and professional money managers at the time he wrote on the market. Elliott had an accounting background and worked with the railroads, including in Central America where he contracted a severe illness in the late-1920's. Due to this he spent his next several years bed-ridden, giving his active mind a lot of time to turn to a study of the stock market.

The build up and crash of the U.S. market over the course of the 1920's was something that Elliott knew well as an avid follower of the market. By 1934 and after, Elliott’s own comprehensive theory of market behavior became defined and his predictions at times began to amaze certain market professionals in terms of their forecasting accuracy. By 1945 Elliott was operating his investment advisory service from a Wall Street office and publishing "The Wave Principle" based on his market ideas.

Distilling what you need to remember about Elliott wave analysis is the idea (as with Dow) of their being three components to a trend. You will hear about '5' waves, but that is because a bull market is said to consist of 3 UP waves or movements, inter-spaced by 2 corrective downswings. The 3 upswings are called impulse waves. This is the basic bull market structure: an advance, a retracement of that advance, another very strong advance, followed by another correction, followed by a third rally.

In a bear market, there are also 3 parts to it in terms of wave theory: the first is a declining wave, followed up a rally retracing some of that prior decline, followed by a final downswing. Both the bull and market patterns/waves are seen in my first chart above (current NDX, weekly). The bear market pattern is easy to remember as an A-B-C pattern of down-up-down price swings. A bear market always begins and ends with declines.

A key point is that sometimes a clear cut wave pattern is seen sometimes not. Sometimes you have to switch to longer-term weekly charts to see the overall wave structure. When bull or bear pattern IS clearly and easily seen, it allows a better forecast of how the trend may unfold. For example, the first impulse wave in a bull market trend is the weakest, but after the corrective pullback that follows, the next impulse wave, wave three, is often a VERY strong and prolonged move. This is also clearly seen in my first chart. The middle strongest rally in the case of my NDX weekly chart ends at the number 3 seen on the above chart.

BULL TREND: The first rally is counted as 'wave 1', the price pullback/drop that follows is 'wave 2'. The most common pattern is for the next rally, 'wave 3' in Elliott terms, to be the 'MONEY' wave. It's the middle or second advance in a bull trend that is often the most powerful. This insight might suggest, for example, going in more heavily in terms of trading index calls, on the second rally, wave-3. 'Wave-4' is the second corrective pullback. Even numbers 2 and 4 are the countertrend moves, the downswings in an overall advance. 'Wave' 5 (the 3rd impulse wave) is the last part of a bull trend and the trickiest to predict duration and price targets.

The duration and intensity of a wave 3 advance often is the period of the biggest/'easiest' gains of an entire bull trend, whether that trend is a few days (short-term), a few weeks to months (intermediate-term), or a matter of years (primary or major trend). In a bearish A-B-C wave pattern it is also the second price swing, in this case DOWN, that carries the farthest. Accurate understanding of an unfolding trend that's cyclical in nature with a beginning, middle and END, is quite valuable when you have an idea of what follows.

Fellow Market Technician Association member (and past president), Robert Prechter has been the best-known of the market advisors and analysts that have made wave analysis popular from the 1980’s into the early new millennium. As Bob has pointed out about the wave theory, like the other principles of technical analysis, it is not always necessary to understand WHY a technique works, as long as you can employ the technique to a profitable end.

In a major bull market trend of 3 up waves and 2 corrective down waves (totaling 5 waves) are often pretty apparent. Waves 1, 3 and 5 will be advances or the 'impulse waves', with waves 2 and 4 being counter-trend moves or 'corrective waves'. The totality of the component moves of a bull trend, 3 up, 2 down, is a 5 wave advance in wave terminology.

BEAR TREND: After the 5 waves of a major bull market trend which can go on for years (bull markets being significantly longer than bear markets), a major bear market has often followed. This consists of a 3-part decline; one having 3 component waves. The first part is a decline, followed by a rally, followed by another decline. The Elliott wave convention is to note bear trends with the letters A, B and C (or a,b,c) letters at the completion of each wave, to distinguish between the 5 wave advance (waves 1-2-3-4-5) that came before.

The 'A' and 'C' waves are the declines, with the intervening 'B' wave a corrective (countertrend) upswing. Note that the number or letter designation is put at the end or completion of each wave; i.e., at the top for an upswing, at the bottom for a decline. Major bull and bear markets on this monthly IBM chart.

The entire bull market/bear market sequence in Elliott wave terms is a 5-wave up, followed by an A-B-C down. The cycle then repeats.

Elliott talked about alternation in wave duration and strength. While wave 3 is typically longer and stronger than wave 1, if waves 1 and 3 are about of equal length, wave 5 will tend to be a more prolonged advance. Conversely, major bear market down wave 'A' is usually of shorter duration, but if prolonged look for the down move 'C' to be relatively shorter.

As with other technical analysis techniques, a surge in average volume (if you have volume figures such as in individual stocks) will help identify the strongest part of an overall move. Longer term charts, such as weekly are favored over daily charts in terms of seeing and defining the dominant wave patterns.

The above two historical charts are examples of bull and bear market trends that unfold with the 'classic' (Elliott) wave structure of a 5 up-wave bull market and a 3 down-wave bear market trend. There are countertrend moves always. I should note for the overhead SPX chart that it's not typical for the down move '4' to exceed the low end of downswing '2'. I could be on thin ice in wave terms to label it as I have. Another major rally followed.

The thing with the concluding rally in the 1-5 sequence, 'wave 5', is that it can be hard to predict where it might end. There are '5th wave failures' where the last rally falls short of the peak reached by the 3 wave prior advance. Conversely, and as seen above, the concluding wave 5 advance was a second very strong and prolonged run up. The peak of wave 5 was above the wave 3 peak, which is the more typical pattern.

As a discussion of the countertrend moves adds another layer of complexity to wave theory, I will save this for a second Trader's Corner article on this subject of wave analysis of trends. Maybe there will be a 'part 3' also. It's worth read Precter's book or his edit of RN Elliott's book also; both are fairly short! Looks simple so far and this is the first impression I want to convey of wave theory and patterns. I no longer write from California's central coast where, in Santa Cruz, the surf's usually up and the waves good. Until the quiz later (kidding!), just enjoy the waves.


GOOD TRADING SUCCESS!