Thursday, December 25, 2014

Basics of Technical Analysis, and Understanding Elliott Wave Theory, Part I

(Author's note:  This article was originally published in May 2012.)

In this series, I’m going to attempt to explain a bit about market analysis, with a focus on Elliott Wave Theory.  Later in the series (after we’ve covered the basics), I’ll share some ways to utilize these tools for your own benefit.  A small portion of this has been reprinted from some of my earlier articles, so if it sounds familiar, that's because I plagiarized myself.  My attorney assures me that I am immune from litigation, but I have filed suit against myself anyway, because I can't have people stealing my work! 

Anyway... First, I do want to briefly address fundamental analysis.  My primary focus as a trader involves technical analysis, for reasons I will explain shortly – however, unlike many technical analysts, I do believe that fundamental analysis has value.  I believe it serves as a foundation to interpreting charts across the longer time-frames, and aids in understanding what is possible and likely.

Conversely, some fundamental analysts seem to believe that projecting the market using price charts is some kind of “voodoo.”  I suppose this is understandable; most things we don’t understand carry a certain mystique to them.  It’s important to realize that price charts, all by themselves, contain all the collective knowledge about a stock or index. 

People act on what they know or believe, so it stands to reason that people buy or sell securities based on what they know and believe -- thus(and here’s the critical point about technical analysis) everything known about a given security by all the shareholders collectively is reflected in a price chart.  When an insider makes a trade, it influences the price of that security, and leaves a clue which can be read on the chart.  When a huge hedge fund gains a piece of critical information (usually well ahead of the public) and starts buying or selling a specific stock or commodity, that action leaves its mark on the charts… and so on.   Thus the charts point the way ahead.   

The goal of a fundamental analyst and a technical analyst (one who studies charts) is the same:  they both seek to project the future.  Their methods, while seemingly different, are also quite similar in many respects.  For example, a fundamental analyst might look at Apple and try to project how many iPhones and iWidgets will be sold next quarter, and how that will influence profits, growth, etc.   Then he takes all his research numbers and derives a projection of the company’s outlook -- largely based on what’s happened in the past.  He then plugs that projection into a formula to arrive at a future share price target, which is also based on how things have performed in the past. 

A technical analyst does the same thing, except he looks at the charts directly (which, as we just learned, contain all the knowledge of the collective) and cuts out the middle man.  He seeks patterns which convey information:  When price has moved up by x number of dollars, and then moved down by x percent to create a certain pattern, how has the market usually performed in the past? 

Both forms of analysis are based on past performance and on future probability – they just get there by different means.

The weakness to fundamental analysis is that there are a great many variables which the analyst simply cannot foresee.  Study what happened in 2007-2008 for an example.  Many stocks looked great, and projected earnings looked great, and their futures looked so bright that everyone was wearing shades – but their share prices collapsed anyway, in a spectacular fashion.  In September 2008, did anybody care about how many iWidgets any given company was projected to sell in the fourth quarter of that year? 

Some fundamental analysts saw what was coming back then; others didn’t.  Likewise, some technical analysts saw what was coming (myself included) and others didn’t.  But the probability of a crash was all telegraphed well in advance on the price charts – one didn’t even need to turn on the TV to see it coming ahead of time. 

The big advantage to technical analysis: we technical analysts were able to arrive at actual price-targets for the crash, in real-time, while it unfolded.   Fundamental analysts knew it was “gonna be bad!” but that type of analysis is simply unable to time the market with that degree of accuracy.  This is why the majority of fundamental analysts don’t even try to time the market, except in broad strokes: their system is ill-suited to it.

So, now that we’ve gotten that out of the way, let’s discuss a more detailed form of technical analysis, called Elliott Wave Theory.

On the surface, Elliott Wave is a unique way to understand why the market does what it does, and a detailed tool that allows us to project future price moves by extrapolating the fractals and patterns found on the charts. The theory runs far deeper than that, though.

At its core, Elliott Wave helps us to understand something much more meaningful than markets: it helps us to understand human nature. The patterns formed in the market are, in part, a direct reflection of investor knowledge, and more importantly, investor sentiment.  Like most things in the world, sentiment fluctuates in cycles. 

You can observe the symptoms of this cyclical tendency in the news reports.  One week, you’ll see nothing but happy headlines, as sentiment hits a positive cycle and everyone forgets about all the troubles in the world:

“Rally Takes off as Market Cheers Job Report”

“Stocks Rise as Greece Agrees to Austerity Measures”

“Dow Closes Higher after Bernanke Announces He’s Dying His Beard”  (If you were rooting for that sentence to end without the last two words – shame on you!)

Then a short time later, it’s as if everyone forgot how “good” everything was just a few minutes ago, and suddenly it’s nothing but bad news again:

“Rally Crumbles as Market Boos New Jobs Report, Which Was Pretty Much Exactly the Same as the One They Cheered Last Month”

“Stocks Collapse as Investors Realize They Don’t Actually Know What Austerity Means”

“Dow Suffers Biggest One Day Loss on Record when the Market Realizes It’s Afraid of Snakes”

As I’m sure you’ve seen, even the exact same news item can be received well on one day and poorly on the next – highlighting my point that sentiment is cyclical. In reality, outside of certain “black swan” events, the news doesn’t drive the market directly -- it merely reports what the market did after the fact and attempts to explain it.  Otherwise, good news would always cause the market to go up, and bad news would always cause it to go down.  But as you’ve certainly noticed, it doesn’t work that way.  

The other problem with news is that, even if it was a prime mover for the market, it always arrives too late for you to make use of it.  If you’re dead set on trying to assign a “reason” for what the market did that day, you could simply look at the closing prices to figure out whether sentiment was good or bad (up = good; down = bad), and then make up your own random explanation, just like the news does: “Market Crashes As Investors Realize that Your and You’re Are Actually Two Different Words.”   

Fortunately, we don’t need to pay attention to the lagging-indicator news, because these sentiment cycles often leave clues telegraphing their arrival and departure.  These clues are found in the price patterns.   As we discussed, all the collective knowledge of investors is reflected in the numbers on the charts.   By tapping into that knowledge, Ellliott Wave Theory can, at times, recognize and anticipate the sentiment and cycles in advance.  And since sentiment goes a long way toward driving the price, we can then either:

1.   Anticipate the market’s future price movements before the moves actually occur, or;

2.  Gain a reasonably accurate window into what’s likely to occur if the stock or index crosses a certain price threshold.

The market's price movements are, in the end, a reflection of human nature.  And here’s where things become truly fascinating:

By rule of intrinsic design, human nature must be universally reflected in all human constructs, be they markets, governments, or otherwise.  Once you unveil one universal aspect of human nature, you are often able to locate the same common thread running throughout other human activities. This is one of the fascinating things about Elliott Wave Theory:  it seems to apply to patterns found not only in markets, but in the rise and fall of nations, and even entire civilizations (as well as the ebb and flow of many other things in the natural world). I have studied and applied it for many years, and continue to be in awe of its frequently-uncanny ability to anticipate the future.

It is important to note that Elliott Wave Theory was derived from back-testing.  Back in the 1930’s, R.N. Elliott studied decades of charts at various time frames, and discovered that there were certain patterns  which repeated across all time frames.  These patterns were of a fractal nature; in other words, the patterns on the one-minute chart join together to make up identical larger patterns on the hourly charts, which in turn make up identical larger patterns on the daily charts – and so on.   He developed Elliott Wave Theory as an attempt to quantify and explain these patterns.

In the next chapter, we’ll examine the underlying patterns that form the basis of Elliott Wave Theory.

Part II can be found here.

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