Riding the Elliot Wave

By David Waggoner

(Observer's note: This is again by David Waggoner on Elliot Wave. Later I'll post more about "golden spiral" when I see some good articles on it.)

Eliminate all other factors, and the one which remains must be the truth.
– Sherlock Holmes, The Sign of the Four

I am an Elliottician. I believe there's a deterministic natural rhythm to the markets that's called the Elliott wave principle (Ewp). I believe it to be truth. Unlike many other technical indicators, it works all the time and it's only the analyst's interpretation of it that fails. The pattern is always there and it's always correct. Everything else is periphery; fundamentals, all other forms of technical analysis, even social evolution itself. Everything that's rooted in behavior follows the natural rhythm of the Elliott wave principle. It's a law like gravity and electricity. And like gravity and electricity, we don't have to fully understand it in order to use it.

I call myself TheMarketDetective. I spend each day, every day, tracking and interpreting the truth. I report my sleuthing in my analysis. I will attempt to explain my analysis for those who want to learn my methodologies, but I will also present actionable opportunities based on clues I uncover in the market that anyone can use.

Forecasting the future with the Elliott wave principle is scientific in its approach; there are 13 simple patterns to the Elliott wave principle that connect and combine in a limited number of possibilities. By identifying Ewp patterns in charts, we can use logic and Fibonacci mathematics to deduce which other Ewp patterns most likely will follow suit. Often, there are several alternatives, but sometimes we can fine tune it to only one possible outcome.

There are two types of wave combinations that occur, impulsive and corrective. Impulsive combinations are found in the direction of the larger trend in force, and corrective patterns are primarily in the direction opposite that trend. Therefore, the manner in which the patterns come together can provide important clues regarding the primary direction of trend.

In order to get to the scientific part you must first correctly interpret the wave patterns - not always an easy thing to do. In fact, this part may be more art than science. For me, being right more often than being wrong came only after thousands of hours of practice. Perhaps I can shorten the learning curve for you. If you want to learn more about the Elliott wave principle, the best place to start is the biblical text; Frost and Prechter's: Elliott Wave Principle.

The wave principle spans the whole of social evolution. I'm only going to focus on the part we can trade. In the three charts that follow, I will provide my perspective of current cycle, primary, and intra-day Ewp patterns.

I'll start with the cycle trend. I call this chart, Prechter's revenge. Robert Prechter Jr. believes that 2000 was the top of the Super Cycle: a 5 count impulse wave up that started in 1932. When the market rallied back from the 2002 low and made a new high, most market watchers quickly dismissed his thesis (and with it the Elliott wave principle). More recently he suggested that 2000 was in fact the top and we are in the midst of a corrective flat. In a classic case of crying wolf syndrome, no one believes him. I do.

I have never seen anyone else attempt to provide a detailed wave count to substantiate his flat theory, but I have done so here. I have also added a probable path of decline based on common Fibonacci wave relationships (in price only: not time).

Prechter's Revenge

It's tempting to go all in short and wait it out isn't it? There are other possibilities however, so it's probably best to focus the lens on multiple timeframes in order to maintain a total perspective, and trade the cycle trend one wave at a time.

Change always starts at the smallest degree and ripples out to the larger degrees. Let’s look at the chart below labeled primary trend for more clues.

At the level of primary trend, based on the evidence of Elliott wave rules, guidelines, and Fibonacci ratio analysis, we have probably completed five waves down and three waves up. The question now is have we resumed the down trend, or are we in a downward correction of the counter-trend correction (which is up), which I will call a correction of the correction.

Primary Trend

The wave patterns are often difficult to interpret short-term at this degree, so I will focus the lens one degree lower to see if the evidence is clearer. Elliott wave patterns are believed to be fractals. Different time frames fit together like Russian nesting dolls. By examining the smaller time frames we can gain detailed insight into the probable direction of the larger ones. Conversely, we sometimes rely on the larger ones to see the forest through the trees when the shorter time frames become too complex. It is a constant balance of interpretation.

In the chart labeled 60 minutes, we can see that on April 7th of this year, we completed the counter-trend corrective combination up called a double zigzag. The end of this pattern clearly indicated a turn, but is it the turn?

Again, based on the evidence of Ewp rules, guidelines, and Fibonacci ratio analysis, I interpret the recent downturn to also be more corrective in nature than impulsive. The wave count shown on 60 minutes is another double zigzag with a close to perfect 11 Fibonacci ratio (outside numbers). It is the cleanest interpretation I can identify on intra-day charts.

However, we're at a crucial test point. We can only sustain a very limited continued downside without a significant 3-wave bounce for this to remain the highest probability. A small extension of the last wave down into Monday’s close, say 1320-1322 would be the preference. This happens to coincide nicely with a .500 Fibonacci retracement of the entire counter-trend double zigzag up from the bottom (inside numbers), a common retracement.

60 Minutes

If this thesis is correct, and we bounce, one of two things will happen. We either resume the counter-trend rally up toward our next Fibonacci target (Read about Fibonacci ratio targets here), or get a significant 3-wave bounce, similar in degree to the bounce on April 10th, and then turn back down. If we bounce and turn back down, it will be the last wave of a correction of the correction. The Ewp rule states that corrective waves can only extend to 3 corrective combinations. We've either completed or are a fraction away from completing two of the three allowed in this wave set. Another turn down after a bounce would also most likely end at 1322 or 1307.

It's important to always look for alternatives with Elliott wave analysis. When I have options to choose from, then I'm confident that good detective work will guide me to the correct one. If and when my preferred option fails, however, I usually have an alternate count/thesis to fall back on. Unfortunately, this happens more often than I would like.

There is a technically feasible impulse wave count combination down from the April 7th high on an intra-day basis (see the chart below: Ugly Duckling). It's undesirable in its symmetry and it contains minor rule breaches. It's clearest on a chart of the E-minis. On the other hand, the Fibonacci ratios are acceptable, and the daily time frame is starting to look like it could turn into an impulse swan.

This is our alternate wave count. It increases in probability if we're unable to get the expected bounce before turning down again. If the slide continues without a significant bounce, and we don't bounce until 1307 -- and we will bounce at 1307 if we go there on this trip down -- then I give the ugly duckling a higher probability. The reason is simply that a 1:1.618 Fibonacci ratio is more common for an impulse wave3 than a corrective wave. It can still be a corrective wave, but the odds will have shifted in favor of our possible swan.

If it comes to this, then the bounce from 1307 will be the next critical test. If we can bounce above 1352, then a correction of the correction thesis returns to front and center. If we can’t, then the ugly duckling will remain our primary thesis and we prepare to head lower. The reason is another rule: wave 4 never moves beyond the end of wave 1.

An impulse wave count down from here would also slightly diminish the cycle trend 2nd wave count thesis. If we are in the 2nd wave at cycle degree, a .382 retracement of wave1 is the least common Fibonacci ratio target.

Ugly Duckling

I've covered a lot of material. If you do not have prior exposure to Ewp, and you are still reading this, you might think that there is Kool-aid in my water supply. No doubt about it, this is extreme technical analysis. Predominant thinking cannot even clear the first hurdle of considering that the markets are deterministic, let alone that the pattern can be interpreted by a lone trader with a data feed and a PC rather than the world’s fastest super computers and a room full of quantitative analysts.

All I ask is that you keep an open mind. I'm confident that I will present you with some accurate market calls that cannot be derived from any another type of analysis.

I've already condensed the unlimited possibilities of a random walk down to just a few probabilities.