by John Lansing | April 21, 2009 7:44 pm
It has been more than 60 years since the breakthrough discovery of the Elliot Wave, and I find it to be the most relevant tool for my technical analysis today.
R.N. Elliott, a modest genius near the end of his life, began to study price movements in the financial markets. He observed that certain patterns of human behavior repeat themselves and, with the few years he had left, Elliott offered proof of his discovery by making astonishingly accurate stock market forecasts.
What appears random and unrelated, Elliott said, will actually trace out a recognizable pattern once you learn what to look for. Elliott called his discovery “the Wave Principle,” and the implications were huge. He identified the common link that drives the trends in human affairs, from financial markets to fashion, from politics to popular culture.
The basic principle behind the Elliot Wave is that the price of any given security in a free market will travel in a pre-determined, wave-like advance and recessions in a semi-cyclical fashion.
Essentially, his theory maintains that price of an actively traded security will move in wave-like motions that alternate, typically, between three steps forward for every two steps backward.
These steps, or parts of the wave, are called either “impulsive waves,” which are ascending in tandem with a rising trend or falling in a falling trend, or “corrective waves,” which fall counter to a rising trend or rise in a downward trend.
Using the idea of Elliot Waves, which are comprised of three steps forward and two steps back, we find triangles, which are overlapping five-wave affairs. They appear to reflect a balance of forces, causing a sideways movement that is usually associated with decreasing volume and volatility.
Triangles fall into four main categories: ascending, descending, contracting (or symmetrical) and expanding (or reverse symmetrical).
Let’s look at each type of triangle a little more closely.
You may also hear this called an ascending right triangle. It’s a bullish indicator.
Technically speaking, what happens is that an ascending triangle is a rally to a new high, followed by a pullback to an intermediate support level, then a second rally to test the first peak, followed by a second decline to a level higher than the intermediate-term support level and, finally, a rally to fresh new highs on strong volume.
A descending triangle is a decline to a new low on news that’s followed by a rally to an intermediate resistance level, then a second decline to test the recent low, followed by a second rally toward (but not through) intermediate resistance. Then, finally, there’s a decline to new lows on strong volume.
This happens when the Street becomes extremely bearish and, subsequently, a stock looks like it’s done for.
But, as a new low is created, buyers — often the smart money — suddenly pile in.
Most analysts consider descending triangles to be the most reliable of all chart patterns because it’s easy to define the supply-and-demand relationship.
A symmetrical triangle shows a rally to a relative new high, a pullback to an intermediate-term support level, a second rally that doesn’t exceed the recent high, then a second decline that falls short of the intermediate-term support level and, finally, a breakout on strong volume above the trendlines created by linking the new high and the secondary high.
This, like most consolidating patterns, is due to traders’ indecision. It occurs when traders’ uncertainty leads them to do nothing.
Also known as a broadening top, an expanding triangle or a megaphone top, the reverse symmetrical triangle is a bearish indicator, and the technical implications are usually extreme.
It is a rally to a new high, weakness to an intermediate support level. Then it’s a second rally to a higher high on increased volume and a decline through the intermediate support level. And, finally, there’s a third rally to a higher high on strong volume, followed by an eventual collapse.
Again, this pattern develops because of indecision and extreme volatility.
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