This Trader's Corner is a bit different in the sense that
Wave Patterns in Trends, Pt.1
written by me last in this space on 10/28 is a useful read prior to this one, as it gives some background for understanding movements of a trend in terms of a 'wave' structure; Elliott wave that is, named after R.N. Elliott who devised the theory. (Like Dow theory, Elliott's ideas comprised a theoretical construct about how the market works; and difficult to 'prove' also.)
To recap a bit on Elliott Wave (EW) theory: An UP trend (bull move) commonly breaks down into 3 advancing 'impulse' waves, with 2 intervening counter-trend pullbacks that all together make up a 5-wave structure. The END of a wave is where we put the number or letter. A typical look to a 5-wave bull trend is in a chart I notated a few years back.
I've had a current favored 'wave count' and structure in my mind when working with my next chart, that of the current weekly Nasdaq 100 (NDX). Levels are as of the 11/10/10 close. (Weekly chart dates reflect the Fri. end of the trading week.)
No doubt you'll notice the similarity of my 'idealized' wave structure projected for coming weeks outlined below to the pattern traced out above. These common EW patterns; that is, the 5 wave UP structure and the 3 wave DOWN, is so common that it bears paying attention to for what could be ahead in the unfolding trend. However, if the trend doesn't go according to the wave pattern projected, don't loose sight of trading what is ACTUALLY happening. There's plenty of other ways of looking at the market, both technically and fundamentally.
A related rule of waves and wave structure as proposed by Elliott is the Rule of Alternation, which suggests that the strength of a move (price distance carried) will alternate; e.g., a stronger longer move will follow a relatively lesser advance and vice versa. And, if the first correction is relatively shallow, the next one will be deeper.
Bear markets or declining trends usually subdivide into the 3-part "A-B-C/a-b-c" structure, which is illustrated both in my preceding chart (the 2007-2009 'A-B-C' major bear market) and in the chart below which highlights a short-term declining 'a-b-c' wave. So as not to think that a wave structure projected for a stock or index trend only applies to longer-term charts, the S&P 100 (OEX) Index chart here from my historical chart file is of hourly closes for a 6-week period and is also a 'typical' (small case) 'a-b-c' or the down-up-down structure of an overall decline. A decline is not just the parts when prices are selling off, but also includes the characteristics of an intervening rally.
The foregoing is my working knowledge of Elliott wave theory in a very small nutshell. I don't claim to be someone who knows all there is to know about wave patterns but I do see valuable trading clues in knowing for example from experience that the 2nd upswing (wave 3) in an advance is quite often longer and stronger than the 1st rally (wave 1).
Conversely, estimate the trading value of 'knowing' that a decline takes the form typically of a down-up-down pattern and that the second decline, wave 'c' in EW terms, is the move that is usually most prolonged and steep (as seen above in the weekly NDX chart). The second sell off (wave C)in a major bear move is the equivalent of the blast off in the common pattern for a second (wave 3) advance in a major bull move.
FURTHER BREAKDOWN OF WAVE PATTERNS:
There is a further subdivision of the larger wave structure and its value is in helping you figure out when a particular move may in a FINAL stage of completion.
Applying a different kind of alternating rule, Elliott found that impulse waves or up moves in bull market trends (advancing waves 1, 3, and 5), also 'break down' into a smaller bullish wave-5 structure. The counter-trend waves 2 and 4, as downswings and contrary to the overall uptrend, also break down into the bearish a-b-c (down-up-down) pattern, only as smaller moves within the bigger wave structure that it fits in.
Conversely, an A-B-C (or a-b-c for waves of a 'smaller degree') bearish downtrend tends to having TWO moves in the direction of the trend which are down ('A' and 'C') and 1 counter-trend up wave 'B'. The moves in the SAME direction as the down trend (A and C) break down into a 'smaller' 1-5 structure, whereas the counter-trend upswing 'B' breaks down into a smaller a-b-c pattern.
Here, some sample charts will help in 'visualizing this, which is more complex in words than on the chart. In this deeper drilling into wave theory, it's helpful to memorize this simple rule:
Moves in the SAME direction as the overall trend (up OR down) break down into further smaller 5-part patterns.
Moves AGAINST the trend (up OR down) that is ongoing, break down into the bearish A-B-C/a-b-c wave structure.
An advancing trend that has 3 impulse waves up (1,3,5) and 2 counter-trend downswings making a 5-wave structure, also breaks down into smaller 1 to 5 and a-b-c patterns per the example shown in the chart below from an earlier period:
Moves in the same direction as the up trend above break down into smaller 5-wave patterns, whereas the counter-trend downswings 2 & 4 break down into smaller a-b-c (down-up-down) price swings.
A declining or bear market trend of an A-B-C/a-b-c (down-up-down) decline breaks down further into smaller 5-wave component moves for the 'A/a' and 'C/c' waves that are in the direction of the down trend. The 'B/b' wave rebound that is counter to the trend, is broken down further into a, b and c component moves, only in this case the direction of the price swings are UP-down-UP, as shown by going back to the OEX hourly chart:
An example chart from my (Essential Technical Analysis) book seen next, shows both bull and bear market markets for bellwether IBM and breaks down the 5-wave Bull and the A-B-C major Bear market (capital letters are used for a major trend) in some detail:
The EW 'breakdowns' can get pretty complex but to counteract wave fatigue, I tend to stay mostly focused on intermediate (2-3 weeks to 2-3 months) price swings and not the smaller wave patterns. I guess what you would expect from an options and stock trader. Although more of a trader than just long-term investor, I still aim to get into and stay in option positions during the bigger (fewer) price swings. Especially as involves getting in EARLY in a trend.
Imagine seeing this unfolding wave structure on the daily price chart. For example, it can be figured above that wave 3 (the 2nd big advance) is in a completion phase when the 'smaller' 5th and 'final' up wave (as part of bigger wave 3) is underway. This knowledge of how market moves tend to unfold would suggest getting READY to trade out of calls and go into puts during the probable last segment (smaller wave-5) of the big up wave-3, especially when there are some confirmations from other technical indicators or patterns (e.g., a trendline break) that there's a reversal underway.
Examples or how I have labeled a wave beginning and end, are for demonstration purposes as part of my attempt to provide basic concepts of how a trend could be seen in terms of EW structure.
I use ideas gleaned from the wave principle in patterns where the wave structure appears pretty clear cut. The success of successfully identifying a 'classic' textbook wave structure to me is in whether it provided EARLY recognition of a trend that led to a profitable trade/investment.
I envision a final Traderâ€™s Corner article (part 3) on this subject next week to go further into using the Wave principle to help dissect trends; e.g., how wave theory differs in defining long-term trends, how to use wave analysis along with other technical analysis tools and what are some wave characteristics. As to this last point, a '3 wave' for example, surging higher in a typical power move, will have a different feel than the sometimes more tentative, sometimes faltering, up waves 1 and 5.
In the meantime, surfs up and the waves are out there somewhere!
GOOD TRADING SUCCESS!