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If you were a lone bull in a herd of stampeding buffalo, your survival instincts would tell you to follow the herd, regardless of its direction. The same is true for the successful trader or investor maneuvering within the financial herd called the Stock Market. As trader psychology changes, so do the Markets.
The Elliott Wave Principle captures the essence of trader psychology. It is an effective, visual representation of traders’ human nature to follow ‘in a crowded path’ extreme optimism followed by extreme pessimism, and then repeat the process again and again. The Elliott Wave patterns capture the continuous unfolding of the extremes depicted as Stock Market sentiment.
Traders cannot rely on news and events to drive the Stock Market. History has shown that news and events related to the Market have no consistent effect on its direction because of the influence of unfolding Market sentiment. For instance, Market reaction to the same news can be extremely positive at one given time, but then extremely negative at another given time.
Elliott Wave patterns display to the trader the most likely future Market direction based on current pattern structure. By understanding Elliott Wave pattern characteristics, a trader can identify higher probable outcomes from lower probable outcomes thereby reducing investment risk.
The classic Elliott Wave patterns consist of impulsive and corrective waves. An impulsive wave moves in the same direction as the current trend and is made of five sub-waves. A corrective wave moves against the current trend and is made of three sub-waves.
The formation of sub-waves can be extremely varied. However, general tendencies to note for trading purposes are as follows:
The first sub-wave in either an impulsive or corrective wave can be difficult for a trader to accept because it is the fist wave to run counter to currently prevailing direction;
The second sub-wave in either an impulsive or corrective wave may pose an opportunity for the trader to respond if he/she missed the first sub-wave as it represents a partial retracement of the first sub-wave;
The third sub-wave of an impulsive wave can be the most predictable and strongest of the sub-waves as momentum has been established;
The fourth sub-wave of an impulsive wave may demonstrate more volatility in its retracement than the second sub-wave; and
The fifth sub-wave of an impulsive wave and the third sub-wave of a corrective wave may be less predictable and more volatile than the other sub-waves because they are determining the end to the larger wave.
In addition, traders can increase their probability of success by placing entry and exit points near levels favoring a change in Market direction. For example, placing an entry for a long position near the start of an upward impulsive wave has a higher degree of being successful than placing an entry for a long position near the end of an upward impulsive wave.
Forecasting Market direction from Elliott Wave patterns does not provide certainty, but rather a probability of Market direction. There can be more than one valid interpretation of wave patterns, each carrying a probability of being an accurate portrayal of Market direction.
Traders should keep in mind that it is typical for Elliott Wave patterns to be continually reassessed and altered as Market sentiment unfolds to provide a higher probability of Market forecast. Alteration of wave patterns should be viewed not as a weakness, but as a strength. To be sure, the Market is quite dynamic; therefore, any tool used to help forecast the Market must be dynamic, too.
It is important to note the principals and use of Elliott Waves have persevered for over 70 years, when in 1938, in collaboration with C. J. Collins, R.N. Elliott introduced ‘Elliott Wave Principals’. Mr. Elliott believed that while stock market prices may appear random and unpredictable, they actually follow predictable, natural laws that can be measured and forecast by implementing wave patterns based on Fibonacci number analysis, also pioneered by Mr. Elliott.
Mr. Elliott theorized that common waves are characterized by Fibonacci proportions of 38%, 50%, and 62%. Impulsive waves relate to one another in Fibonacci proportions and corrective waves tend to retrace in Fibonacci proportions.
Mr. Elliott, encouraged so greatly by the response to his theory in the investment world, expanded it to apply to all collective human behaviors. His final and most comprehensive work titled ‘Nature’s Law-The Secret of the Universe’ was published in 1946, two years before his death.