In order to be able to capitalize on a price movement, we must be able to define what that movement is. It must have an beginning and end, and other attributes that define it.
Price Moves in Waves
Elliot Wave Theory is a discipline of technical analysis that "Counts" the price advances and declines, categorizing them, so that the technician can then forecast what the next wave will be. Basic tenets of this discipline are:
1 - Price is in either a "Impulsive" or "Corrective" Wave. Impulsive meaning that it is a Primary movement either up or down, while the Corrective movement is some sort of retrace of that movement. We know that price ebbs & flows, it never proceeds to where it is going in a straight line - instead, it moves, and then pauses or retraces some of that movement prior to continuing the impulsive move in the form of the next wave.
2 - Impulsive moves consist of a 5 wave pattern, whereby waves 1,3,5 are in the same primary direction, while waves 2 & 4 retrace some of waves 1 & 3.
Lets take a look at a example of a Impulsive Wave:
Sorry if I am stating the obvious here, but there are 3 key attributes to wave structure that we want to take note of.
1 - Waves 2&4 that are "retracing" the impulsive movement do not go below the low of the preceding wave. So yes, they do give back some ground, however they make a "higher low" as price stair-steps higher. (or lower if it's a Down Impulsive move)
2 - The Wave 4 low is above the Wave 2 low.
3 - The Wave 3 high is higher then the Wave 1 high, and Wave 5 is higher than wave 3.
In other words, this is describing a price movement having a series of higher highs and higher lows for a "advancing movement", or the inverse being a series lower lows and lower highs for a "declining movement". - There you have it, a 5 Wave Impulsive Movement.
Now lets look at a Corrective wave structure which is a 3 wave pattern or "A,B,C" retrace of an impulsive movement.
For a Corrective move we see the following:
1 - A 3 wave pattern running contrary to the Primary Movement.
2 - We see the B wave high, lower than the A wave high.
3 - We see the C wave low below the A wave low.
4 - Price then resumes the primary trend after the correction, which is confirmed after it "takes out" or surpasses the high of the corrective pattern.
There are many specific rules and nuances to Elliot Wave Theory - The thing that we have found however is that it is only in hindsight that each wave becomes clear.
For Example a "ABC" correction can either be: 1) The first 3 waves of a 5 Wave impulsive move in the opposite direction of the preceding impulsive move, or 2) It may actually be a ABC correction, in which the impulsive sequence will continue. This ambiguity is only settled when price either: A) Takes out the "C" Wave low in which case it is no longer a 3 Wave corrective move, but rather something else, or B) Takes out the B Wave high on its way to new highs in which case the evidence points to the continuation of the trend.
In the real world prices tend to whipsaw back and forth repeatedly " Head-faking" either wave count. In this scenario Elliot Wave Practitioners find themselves constantly adjusting their wave count, just as chartists drawing a trend line connecting lows or highs find themselves re-drawing those lines every time price violates them, only to continue moving in the preceding direction.
The point we are making here is that any chart analysis only becomes clear in hindsight - It is never in and of itself predictive of future price movement. Therefore it is silly to follow any Technical discipline dogmatically, because as we know Price will gyrate randomly and violently, & is just as likely to prove your forecasting tools incorrect as correct.
Does this diminish the value of Wave theory though? We argue no.
Understanding wave structure and where price currently resides within a wave structure is valuable information, particularly when we combine this with a myriad of other indicators that are pointing to a certain direction in a state of Unity. Dogmatically arguing whether price is a B wave corrective high vs a 1 wave impulsive high is of little value to us however, as we have learned through experience that we don't have to predict the next price move in order to make money.
What you will see from our Trading team is that when we are stalking price and waiting for the right opportunity to act , we will look to formulate a wave count to see where a major important low or high level may be. As we have stated previously, these pivot points tend to provide a kinetic energy to a price move, and we are very interested where the many thousands of wave technicians may be liable to act. Particularly on a long term or weekly chart time frame.
Remember that for each trade, we have a fundamental catalyst, we have some sort of extreme Price or Positioning that is due to mean revert, we have our Odds tables confirming we are trading with a statistical edge, etc etc - So Wave theory is simply another piece to that puzzle.
Any time price is moving, we know it will retrace some of that move at some point in time. Just as the tide moves in and out, so does price.
This observation of price behavior was clearly articulated over 130 years ago by students of the market such as Charles H Dow and William Peter Hamilton. Dow was one of the founders of the Dow Jones & Co, in addition to publishing a somewhat well known Rag called the Wall St Journal. Hamilton was editor of that newspaper for 20 years until his death in 1929. Hamilton is immortalized for writing about the "Stock Market Barometer" or Dow Theory, which at it's basic tenet states that only when both the Industrials and Transports both confirm movement (Seeking Unity across indicators even 130 years ago!) is a Primary Movement confirmed.
In reading their works as well as one of Dow Theories most famous practitioners, Robert Rhea, we not only learned about Primary and Secondary movements (or waves) but we also learned about wave structure - and so I will quote Mr.Rhea so that you will learn as well:
A secondary reaction is considered to be an important decline in a bull market or advance in a bear market, during which intervals the price movement generally retraces from 33% -66% of the primary price change since the termination of the last preceding secondary reaction. These reactions are frequently erroneously assumed to represent a change of primary trend, because the first stage of a movement must always coincide with a movement which might have proved to be a secondary reaction to a primary movement in the opposite direction.
So as the man explains, price reactions retrace one to two thirds of the preceding movement, and wave counts at turn points can be confusing because at the turn they look exactly the same. Not to put words in his mouth, but it sounds to us like a coin flip!
A common charting application for measuring retracement is the Fibonacci Retracement Lines. You draw a line connecting highs and lows of a given price movement and the Chart function will show you 5 retracement lines of 23.6%, 38.2%, 50%, 61.8% and 76.4%. As you can see this range of numbers ties in nicely to Dow Theory concept of 1/3 to 2/3 retracement of primary moves. Lets take a look at a Fib retracement of a Primary move on a weekly Soybeans Chart:
You can see that Beans ran from 872 to 1225 in a near vertical blast-off. Once there is a sign of termination of that move, such as a lower high as well as lower close on the chart, you draw in your Fib lines. At the highs one could have expected a 50% retrace to 1047, but this one was even sharper going below the 61.8% level. You can do 2 things with this information:
1 - If your other signals are still bullish on beans then you can wait for a rally back through the 61.8% fib level & re-establish your longs. If you did, you could have participated in the rally back to the 38.2% Fib level of 1088 or a 80cent move (worth 4k for those of you counting)
2 - If your signals were bearish beans, then the very deep retrace of the primary movement would have been another signal reinforcing the bearish view. Because we know we are wrong half the time, we don't stick around when wrong so you could have used the 61.8% Fib level as your exit point on the short, and look to re-establish once price weakness begins to manifest itself.
This is the type of flexible, open minded Technical Analysis you will be seeing from us in our blog and research reports. This mental flexibility keeps us out of trouble when wrong, but allows us to participate when correct.
Once again, we have to highlight that we are not dogmatic followers of any indicator, and that goes for Fib numbers. How 3PC uses them as follows:
- We are constantly stalking price, and we know reactions tend to be sharper and quicker than the primary movements - As such, we want in on those! We'll draw the Fib lines to give us an indication of where price can retrace to, and will then wait for our signals to trigger action. Typically as we are waiting we constantly have to adjust and redraw the Fib lines, because you never know when the actual end to a price movement is!
- As price is retracing a prior movement, we know that in order for a trend to remain in tact, that the preceding low should not be violated - As such the Fib lines help us to determine the strength or weakness of a price movement. If retrace levels are only hitting 25-50% then there is power behind the move. If price is retracing 50-75% then we know that there is much uncertainty as much of the price move cannot be sustained. If price retraces over 75%, then you should be on red alert as a potential change in trend is at hand - this deep a retrace puts at risk the "higher Highs & higher lows" requirement or vice versa for a bear movement.
- We use the Fib levels across many different time frames, because just as waves overlap, so does time - And what is happening on a 60minute chart can tip us off to what will happen next on a daily chart.
The concepts here are very basic, yet invaluable tools for you as a trader. Always remember that price acts, and then reacts. This gives you numerous opportunities to get in on a primary move, or catch a retracement of that move for a profit.
While we are not strict disciples of any Technical method, the concept of Wave counts and price retracement levels has helped make us way too much money to ignore. Stay flexible in thought and open to the 50% possibility that price is doing something else than what your technical analysis has led you to believe. Provided you do so, you will be quick to exit when wrong, and will be in the hand to capitalize when you are right.