Commander in Pips: Today we shift to something absolutely different from the classical approach to technical analysis. This will let you to see how many fold ways of market analysis are. And who knows, possibly this will become your favorite approach to dealing with markets. I’m speaking about Elliot Wave Theory.
Pipruit: I hope you’re not speaking about electromagnetic waves.
Commander in Pips: Absolutely not. But before our conversation, I want to warn you that we can’t cover this topic totally and with huge details. The point is that applying of this approach is rather sophisticated and demands a lot of hard work to learn multiple, if not say numerous nuances. One of the widely avowed specialists on EW (Elliot Wave theory) is Glen Neely with his book “Mastering Elliot Wave: Presenting the Neely Method: The First Scientific, Objective Approach to Market Forecasting with the Elliott Wave Theory”. That book contains about 220 pages. As you understand we can’t cover such a level of detail in our school. But don’t worry – we will appoint all basic principles and crucial rules for applying Elliot Wave theory. So you will be able to understand what this theory all about and how it works. Also, as usual, we will show some examples with charts.
Commander in Pips: Sure. So let’s start with some introduction. All this stuff has begun in 1920s-30s. Mr. Ralph Nelson Elliot (1871-1948), was an accountant and business executive of a Railroad Company that worked in Mexico and Central America. In 1929 he was forced to retire due to serious physical malady. Mostly due this event he has turned to investigation of Dow Jones Index historical data for the previous 75 years.
Pipruit: Well, I think that it should be enough. If I find myself interested in EW, I will be able to find some books and learn it with more scrutiny, right?
Commander in Pips: He analyzed charts from yearly to half-hourly. In August 1938 he detailed the results of his studies by publishing his third book (written in collaboration with Charles J. Collins), called The Wave Principle. Elliott said that while the stock market prices may appear random and unpredictable, they actually follow predictable, natural laws and can be measured and forecast using Fibonacci numbers. Later, he had to add and improve his book…
Pipruit: Ok, ok. It’s very interesting… What the major idea of his theory?
Commander in Pips: Well, according to his theory there are two major forces that move markets – psychology and emotions. Emotions could appear from some outside influences. Today we can point such sources as mass media – CNBC, Bloomberg and other channels, Fed statements, macro data releases and others. Under these reasons, markets do not behave in chaotic manner, but in repetitive cycles.
Mr. Elliot said, that as upswings as downswings are driven by this collective psyche or emotions, and hence these human characters are based on the nature – they repeat again and again. That’s why by the way he used Fibonacci numbers, because they also come from nature and hence should be easily combined with Wave theory without any contradiction, since they both are based on nature.
He called these upward and downward swings as “Waves” and said that if you able to estimate what wave is currently take place – you will be able to estimate further price movement. It’s obvious that you should have enough skills to correctly identify these repeatable patterns in price behavior.
Commander in Pips: In fact, followers of EW theory who do apply it in practice try to estimate the definite wave that is taking place currently. This allows them to estimate further price movements and potential reversal points.
Commander in Pips: You’ll have the chance to check this statement in practice, son, but now the second important part of the theory. The EW theory is based on idea of “compounding” or fractals. In general, a fractal is a type of structure of some object, where part is similar to whole thing. And the whole thing consists of repeatable parts. The most obvious example is a snowflake, but there are many others examples of fractals in our world. This quality also comes from nature and because of that it is also suitable for EW Theory.
Pipruit: Hm, it looks not too difficult.
Commander in Pips: Ok, I’ll show you. This is a picture of snowflake, right? This is a fractal, because - see the rays of snowflake – they are absolutely similar to each other, but the whole snowflake consists of such repeatable rays.
Pipruit: That was some magical abracadabra, right?
Pipruit: All right! Looks like I’ve got it. But how it could be applied to EW?
Commander in Pips: Very simple – here is a complete market cycle according to EW theory. First, we see two major swings – one swing up, and one swing down. Then swing up divides on 5 waves, marked with -, while downswing on three waves [A] – [C]. Each wave is divided on sub waves, but they look absolutely akin. This is fractal. See – the move from the initial point to  consists of 5 waves that marked with (1)-(5). But the whole swing up also consists of 5 waves.
Pipruit: Cool, I’ve got it. But how somebody could clear up such a mess?
Commander in Pips: You get to the root of this method, son. This is relatively simple to estimate the waves on the past price moves, but much harder to do it in real time and make a forecast. But, in general, it could be done.