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Wouldn’t it be fantastic if you had the almost clairvoyant ability to predict how a stock’s price would move? If you had such an ability, your success as an investor would be all but given, right? I mean, armed with such an advantage, how could you lose?
Unfortunately, there is no such ability in the world of investing, but the good news is that there’s something almost as good. It’s called “Wave Theory,” and since it was developed, it has had a history of spooky accuracy. Is it perfect? No, but then, what is? And of course, it’s easy for a novice practitioner to misread the signs and get the analysis wrong, so there is more than ample opportunity to make investing missteps, even armed with the awesome power of this method of analysis.
You might be asking yourself then, if it’s so good, why haven’t you heard of it before now (and you probably haven’t). It is one of the best kept secrets in the world of investing, and as with most good secrets, this one is hiding in plain sight. Below, we’ll outline in detail what the theory is, and how you can use it to up your investment game and take your strategies to the next level.
“The Wave Principle” is the brainchild of Ralph Nelson Elliott, who began studying all existing stock market data at the time, way back in the early 1930s. He published his findings in 1938, which laid the foundations of the analytic theory.
While the major thrust of Elliott’s research was geared toward providing better analytic tools for stock market investors, it quickly became apparent that ANY social or crowd-based behavioral trend could be modelled and predicted with startling accuracy using the methods he developed.
At the root of the theory is the assumption that every market decision made by individual investors has two basic, defining characteristics: One, they are informed by meaningful information, and two, those decisions themselves produce meaningful information that can be used to gain some understanding of the future direction of price. Thus, every individual transaction can be seen as both cause and effect, simultaneously. That is to say, if you, as an investor, make the decision to buy a certain stock at a certain price, you exert a small amount of upward price pressure on that stock. I, as another investor whom you may or may not even know, am also watching the market, and see a slight upward movement in the stock price of the company you just made a purchase in. This gets my attention, and may prompt me to do likewise.
Our decisions, although individual (you and I are not colluding in any way) for a chain of events that ultimately create identifiable patterns of behavior. Patterns, of course, are recognizable if you know when, where, and how to look for them, and this is what the Wave Principle is really all about. Identifying patterns of behavior as they emerge, and then using that information to make investment decisions based on the seemingly random actions of a population of investors, each making their own informed decisions about what to buy, when to buy, and when to sell.
During the course of his analysis of the then 75 years of stock market data, Elliott identified 13 separate patterns in the overall movement of stock prices that represented recurring themes in the history of the market. The important thing to understand about these 13 patterns is that their forms are always identical, but the frame of time that they occur in, and their amplitude (the net size of the upward or downward movement) vary. Nonetheless, the patterns are there, and appear reliably through the history of the stock market. We’ll take a closer look at the basic five-wave pattern to help give you a better understanding of exactly what to look for in your own analysis. Before we do that though, let’s go over some of the terms that are commonly used when discussing Wave Principle.
An introduction to the terms
Over the years, discussions of the analysis arising as a consequence of Wave Theory has developed its own language, and it’s important to understand the terms being bandied about by other practitioners as you continue your own research. Some of the terms you’re likely to run across are these:
ACTIONARY WAVE – Also called “trend waves,” these describe waves whose basic direction is in alignment with the larger trend, of which it is a part.
CORRECTIVE WAVE – These are waves that represent a brief “pulling back,” or bucking of the larger trend. If you look at the price of any stock over time, you’ll see a saw-toothed price movement, with upswings and downswings. These downswings are corrective waves that represent a minor interruption in the overall trend (up or down). Because they come in so many variations, they are much more difficult to recognize. Adding to this difficulty is the fact that they can be strung together to create highly complex corrections. For this reason, recognizing a correction, as opposed to the beginnings of a new trend and direction, is one of the most difficult parts of wave theory and analysis, and one of the hardest things to get consistently right.
EXTENSION – An extension merely describes a wave of unusual length. Standard wave theory revolves around a five wave pattern. An extension describes a pattern of more than this, 9, or even 13 sub-waves that describe and define the overall pattern. Note that Elliott’s original analysis confirms that if one of the waves is an extension, the others will be of normal length. That is to say, in a five wave pattern, if the first wave (Wave One) is an extension, then waves three and five will be of normal length.
IMPULSE WAVE – A five-wave pattern with sub-waves (5-3-5-3-5), and no overlap between waves one and four.
MOTIVE WAVES – These are waves that push the market to new heights. They are the opposite of corrective waves that interrupt and retrace prior gains. Motive waves tend to have a five-wave structure, although they can have a combination of multiple five-wave structures. Wave 2 will not retrace all of Wave 1, and Wave 4 will not retrace all of Wave 3. Wave 3 always travels beyond the end of Wave 1. Wave 3 is often (but not always) the longest of the waves in the set (between Waves 1, 3 and 5). Motive waves often find themselves flowing within a “trend channel” which is comprised of two more-or-less parallel lines of a trend. One of the sub-waves (1, 3 or 5) is usually, but again not always, longer (an extension wave) than the others in the series.
ONE HIGHER DEGREE – If a wave is, say, a wave on the ocean, then a wave of “One Higher Degree” would be the tide itself. If you’re looking at a price chart at a sub-wave, then a wave of “One Higher Degree” would be a wave.
OVERLAP – This describes the phenomenon of waves “sharing space.” That is to say, if Wave 4 in a set moves into the territory of Wave 1. By definition, this cannot happen during an Impulse Wave (see above).
SUB-WAVES – are smaller price movements that make up a larger wave, which in turn, makes up a set of waves that define an overall trend in price directionality. Think of sub-waves as being the ripples on the water. On a price chart, these are the jagged, saw-toothed interruptions to the overall trend in the movement of price up or down.
So with those terms in mind, let’s take a look at the anatomy of a wave set:
The Five Wave Pattern - the "Master Template Pattern"
Every other of the 13 waveform patterns Elliott identified in his original research stem from this basic pattern. Consider this to be the master template pattern, from which all the rest are derived. At the root, it answers the question, “what does progress look like?” Elliott’s research indicates that invariably, progress is uneven, and, with fits and starts. These fits and starts, however, are predictive in nature. They always abide by the five wave pattern, although there are variations on the basic theme. Nonetheless, it seems that no progress can actually be made (and never has been, historically) without some occasional contractions and retreats. In looking at the market at the macro level, it can always be said that it, the market, is always somewhere in the midst of a five-wave cycle, and again, every other wave form is derived from this one.
For the sake of simplicity, the five waves in this basic pattern are simply named via numbers, 1-5. In looking at an increase in market price, waves 1, 3, and 5 will be the waves that see the price surging to new heights, while waves 2 and 4 will be the waves that represent the corrections, or short term dips in price that interrupt the overall trend toward higher price. Using the terms we outline above, waves 1, 3, and 5 are impulsive waves. They impel the stock price to new heights and describe the overall direction of the market. Waves 2 and 4 are the short term, corrective interruptions.
Five-wave impulses as described above are always followed by a three wave correction, in which the market (or any individual stock) takes a sustained downward trend, thus completing the cycle in a total of eight waves. So as not to confuse things, we’ll label these corrective waves A, B, and C. In this corrective phase, waves A and C see the market price trending downward, briefly interrupted by a surge in price represented by Wave B.
This basic pattern is repeated throughout the market, for as long as the market has existed. It doesn’t matter if you’re looking at the macro-level trends, or at the micro-level and tracking the price history of an individual stock, the pattern is always there, and is unmistakable. Even if you break down the individual components of a set of waves, you see the same basic pattern repeating again and again. The micro-level models are simply more granular and detailed models showing all the same characteristics of the macro-level ones.
Essentially then, what Elliott uncovered in his research, before anyone knew that such a thing actually existed, was a fractal landscape, which wasn’t truly given voice until 1978. Fractal geometry is a naturally occurring phenomenon in which a repeating pattern is displayed and replicated at every scale, and that’s exactly what we see in Elliott’s research.
Questions of Magnitude (Amplitude)
The above describes the entire history of the movement of price in the stock market, and for every individual stock in the market. Knowing that, and learning how to apply that theoretical framework in your own investing research gives you a powerful advantage when making strategic investment decisions. Knowing where a given stock “is” in its cycle can let you know when (at least in general terms) you might expect the stock price to rise or fall, although of course, markets are much more complex than this simplistic model indicates, and here, we’re talking about the degree of fluctuation. Let’s face it, some price surges are huge and long lasting, while others are relatively short lived, fairly small spikes.
Depending on the amplitude of the wave form pattern, and the overall size of the impulse or correction, investment analysts who use Elliott’s research have named them, based on amplitude. The following are the types of wave form cycles, from largest to smallest:
> Grand Supercycle > Supercycle > Cycle > Primary
> Intermediate > Minor > Minute > Minuette > Subminuette
Again, these describe the degree of change in a larger cycle, or the cycle’s amplitude. Cycle waves are subdivided into primary waves, that are in turn subdivided into intermediate waves, which are in turn subdivided into minor and sub-minor waves, with the exact same pattern being found woven through the whole cloth of the market.
So what does this mean to you?
Knowing that the market is underpinned by clearly identifiable and repeating cycles that date back as far as we have data, and knowing that Elliott’s research confirms what we find in nature (naturally occurring fractal landscapes that repeat at any scale), you can rely on the fact that this is a trend that’s’ going to hold, and knowing that gives you a powerful advantage when conducting your own investment research.
To this day, Pattern Theory is widely used by all the top investment firms in existence, and is widely regarded as an invaluable, eerily accurate predictive tool. It’s not easy to learn, and can take years to master, but once you become adept at reading the impulses and corrections of the market, and once you come to understand where a given stock “is” in its own cycle, you can begin to make winning, profitable investment decisions with an amazing degree of accuracy that will see you generating consistently higher profits than you’ve ever been able to realize before.
There are entire websites devoted exclusively to the study of market patterns, and whole books have been written on the topic. Some of the best, most successful investors in the market’s history have relied heavily on Elliott’s research to drive their decision making process. All that to say that if you’re serious about investing, and are looking for a way to take yourself and your portfolio to the next level, then you need to start getting comfortable with using Wave Analysis before making a buy/sell decision.
The Fibonacci Sequence, Wave Theory and You
At first glance, the two phrases seem to have nothing to do with each other. Most people’s first exposure to the Fibonacci Sequence came from a popular fiction novel written by Dan Brown. Wave Theory, developed by Ralph Nelson Elliott in the 1930’s describes the way stock prices advance and retreat over time. How can these two possibly have anything to do with each other? The relationship is more interesting and complex than you might think. We’ll describe that relationship in more detail just below, and what it means to you in terms of your investment strategy, but first, a bit of background.
What IS The Fibonacci Sequence, Exactly?
Start with the number one. Since it is the only number in your list, add it to itself. 1+1 = 2. Two is the second number in the sequence (1,2). Now, add the last number in the sequence (2) to the number to its immediate left (2+1 = 3). Three is the next number in the sequence. Continue that pattern. 3+2 = 5, 5+3 = 8, etc. Here is the Fibonacci sequence, out to 144. Note that you can do this to infinity: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.
If you already have at least some familiarity with Wave Theory, then you probably noticed something interesting right off the bat. Wave theory revolves around the idea that man’s progress (whether in terms of investments and the movement of stock price, or anything else) is never even. Instead, we find that progress is jagged. A rush forward, followed by a retrenching, followed by another push forward. This is what gives stock prices their sawtoothed appearance over time.
Wave Theory also stipulates that these advances and retreats happen in “sets” of waves. Specifically five waves and three. Intriguing then, that both of those numbers (3, 5) are part of the Fibonacci sequence!
Elliott had not heard of the Fibonacci Sequence when he first developed his theory. Once he did hear about it, he remarked that the Fibonacci Sequence served as the underpinning for his work.
The Golden Ratio
It gets more interesting. You may have also heard of “The Golden Ratio,” which is approximately 1.618033. We find the Golden Ratio appearing everywhere in nature. The position of the petals on flowers are governed by it, as are the position of fruitlets on a pineapple. The branching of trees, tomato plants, and everything else that branches in nature. All of Leonardo Da Vinci’s sketches, drawings and paintings were done with this ratio in mind. In fact, it’s not possible to draw an accurate rendering of the human form without paying homage to this ratio. Even the lineage of bees is governed by the Golden Ratio. Intriguing then, that if you divide any number in the Fibonacci Sequence by the number to its left, you get a number close to the Golden Ratio. The farther up the sequence you go before making the division, the closer to the Golden Ratio you get. You can even construct a mathematical spiral using the Fibonacci Sequence that looks eerily similar to the spiral you get when you use the Golden Ratio to create one.
All of this is very interesting, but at this point you might be wondering what this has to do with investing in general, and Wave Theory in particular. Let us begin by saying that human behaviors (any human behaviors) are governed by nature in the same way that the petals of a flower, the branching of a tree, or bees are. We can no more escape that truth than we can avoid breathing. It’s just an elemental fact of humans as a species. As such, we find our own behaviors expressed in terms of the Golden Ratio as well, which of course, is closely approximated by the Fibonacci Sequence, which underpins the whole of Wave Theory.
For this reason, Wave Theorists have reached the inescapable conclusion (and proved it, over time) that price advances and retreats often (but not always) correct in the form of Fibonacci ratios. Note here that they key word in the phrase is “often.” Markets are influenced by a number of exogenous factors, and as such, these factors are occasionally great enough to mask or mar what would otherwise be a Fibonacci correction, but it is visible often enough to be an unmistakable trend.
Because of the presence of the word “often,” it is not advisable to use your newfound knowledge of the Fibonacci Sequence and ratios exclusively to determine the amplitude of Elliott Waves, but bearing this information in mind, you can often predict with uncanny accuracy, the height of a surge, or the depth of a correction, simply by examining the preceding waves. Using this information, in conjunction with a careful analysis of exogenous factors that may be influencing the current price movement will make your analysis even stronger.
The point of all of this, at least as it relates to investing, of course, is to help you make better investment decisions and by doing so, increase your profits per trade. How powerful an advantage is it, if you can say with a high degree of certainty, for example, that the current drop in price is merely a corrective wave and a precursor to a renewed surge in the value of a given stock you’re investing in? Where many investors would panic and sell the moment the price began to drop, you would double down, and reap an enormous windfall when the price surged again, exactly as you predicted it would.
This is the power of Wave Theory, and one of the key ways that knowledge of its relationship to the Fibonacci Sequence and Golden Ratio can help your overall investing strategy. With deep study, you can come to a basic understanding of these three things (Wave Theory, Fibonacci, Golden Ratio) in a matter of days, but learning the fine art of applying them to your overall investing strategy can, and probably will take a lifetime. It is rich and complex, and the more deeply you peer into its mysteries, the more wondrous they become. Indeed, it has been said (and Wave Theory used) to describe, define, and predict a wide range of human behaviors, not just stock prices. Armed with a good understanding of wave theory, you can become almost supernaturally good at predicting almost any human behavior.
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