Raph Nelson Elliott discovered in the 1920’s that stock markets do not behave, as many thought, in chaos but in harmony. Why? It is difficult to state but most probably due to investors emotions and psychological influence. All this points to the fact that due to the eruption of our emotions on markets, the market itself could be interpreted as a living organism with harmonic movements, whether in shape, proportion or even time.
Basically, Elliott stated that market swings whether in an increase trend or decrease trend moved in repetitive movements which he called waves. In his typical wave structure market movement was made up of five waves in the direction of the trend and three waves forming a corrective movement.
Basically, Elliott stated that market swings whether in an increase trend or decrease trend moved in repetitive movements which he called waves. In his typical wave structure market movement was made up of five waves in the direction of the trend and three waves forming a corrective movement.
There are many rules regarding the structure of the waves and the following are some of the most significant:
- Wave 2 cannot break the bottom of wave 1 in an increase trend and cannot break the top of wave 1 in a decrease trend.
- Wave 3 cannot be shortest in term of length and time, in comparison to waves 1 and 3.
- Wave 4 cannot break the top of wave 1 in an increase trend and cannot break the bottom of wave 1 in a decrease trend.
- Wave 4 cannot be longer than wave 2.
Example:
- Rule one is not broken as wave 2 represents 78.6% of wave 1.
- Rule two is not broken as wave 3 is the longest of all waves in the direction of the decrease trend.
- Rule three is not broken as the bottom of wave 1 is not broken by the top of wave 4.
- Rule four is not broken as wave 4 represents 78.6% of wave 2.
As seen on the USACAD market this decrease was followed by corrective movement ABC.
Conclusion:
Many believe that the Elliott Wave Theory can only be used on structures that have already been formed and that it is very unlikely to use this tool in real time investments. I believe that this is not true. Many great traders like Ed Seykota, Bryce Gilmore and Robert Miner make use of this tool with great success. It is not easy to specify where in the five wave structure the current market movement is and this could lead to many losing transactions due to the fact that investors may believe that they are in one specific wave whilst being in another. Personally, I do not seek which wave I am currently encountering but I do analyze markets and trade on the basis of many of Elliott’s rules assigned to specific structures with strong concentration on corrective movements and their possible end. If you are able to recognize when a correction has ended then you may be on the right track to making money. Why? Because after every correction a new top or bottom could follow, enabling investors to assign a minimum reach of market movement. When trading a minimum reach or in other words the investors trade target is very significant because this decreases the effect of destructive emotions such as the fear of loss or the greed to earn more.
Price Patterns
Double Top
This price pattern is also known as formation "M" due to its shape. It is made up of two tops where the second top should not be higher than the first one. A perfect "M" is where both tops are exactly on the same level, but these types of situations cannot be always found. Most often this pattern is formed, where the second top is lower than the first, though the difference between the two tops should not exceed 10% counting from the support break (green horizontal line in example below). Before explaining how you could make money on this pattern, let’s take a look at the shape itself.
In this pattern the market forms one top and later forms a corrective movement, after which another top is formed. On the minimum of the bottom formed (correction), we should draw a horizontal line which will be called the support break. If the market breaks the support break then we could open a short position. What is interesting in this price pattern is that we can actually expect how far the market can go after breaking the support break. After breaking the support break the market should decrease by the distance counting from the first top to the support break itself.
Price Patterns
Double Bottom
This price pattern is also known as formation "W" due to its shape. It is made up of two bottoms where the second bottom should not be lower than the first one. A perfect "W" is where both bottoms are exactly on the same level, but like in the previous patter, it is not always easy to find a perfect "W". Most often this pattern is formed, where the second bottom is higher than the first, though the difference between the two bottoms should not exceed 10% counting from the resistance break (green horizontal line in example below).
In this pattern the market forms one bottom and later forms a corrective movement, after which another bottom is formed. On the maximum of the top formed (correction), we should draw a horizontal line which will be called the resistance break. If the market breaks the resistance break then we could open a long position. In this price pattern we can obviously also expect how far the market will increase. This distance is counted as follows:
X (distance) = Bottom 1 – Resistance Break
More Examples:
An interesting fact in double tops and bottoms is that when making a prognosis to where the market may move to, we automatically find a significant level of resistance or support for the next few weeks and sometimes even months. So keep in mind that the eventual range of both formations could be relevant information for making decisions in the future.
Conclusion:
Double tops and bottoms are not only easy to find, but they are also very effective. Many investors stray away from them stating that they are just too simple to make money on. That is only half true. They are simple but as mentioned before, they are also very effective if managed well. Managing your transactions is very important, sometimes even more important then the position you choose to take. More about capital management will still be mentioned in further materials where we will once more come back to double bottoms and tops and explain how to open a position well and not worry what the market does.