The law of nature: part 2

The market has its law. Were there no law, there could be no centre about which prices could revolve, and therefore, no market Ralph Nelson Elliott Before we dive into the depths of Elliotts ocean of information, it is vital that the paradigm of his findings is well understood. It is crucial that one builds an eye for visuals of the price action as a wave. Trade on stock exchange ensures an environment of perfect competition and henceforth runs a price finding mechanism in itself. Every tick on the exchange reflects investor sentiments and as we all now know that is what essentially drives the market. Elliott believed that the sentiments of not an individual but a crowd on the whole follow patterns and reflect cycles of optimism and pessimism and to an extent could be anticipated; therefore prediction based on these patterns can be relied on for investment decisions. However Elliott clearly states that his principles are to be applied on market instruments that involves mass participation and cannot be influenced by a single or a group of entities. Different from cyclical theories especially economic theories Elliotts waves do not confine in strict periodic constrain but governs completion of wave structure occupied by indigenous characteristics of each wave. It is crucial that these waves follow certain set of rules but rest assured are more of guidelines hence provide flexibility and enhances the power of prediction. Also, that Elliots findings are based on the growth and development of economy and encircle the changing nature of market behaviour. Elliott in his work put forth the structural development of price action in a Five UP Three Down wave pattern as shown in figure. He stated that prices developed in a bull market starting from a low and rises in three IMPULSE moves up that are separated by two CORRECTIVE moves forming a five UP pattern which is followed by a three DOWN correction of the whole pattern. This is the ultimate pathway of price action no matter what market or what instrument we analyse around the globe. In his effort to govern his pattern formation and recognition Elliott gave a set of RULES. Altogether five important rules are as follows.... 1. For every action there is a reaction. Stock market movements in the direction of the main trend are impulse moves. Stock market movements counter to the main trend are corrective moves. An impulse move is always followed by a corrective move. 2. Generally, all impulse moves have five subordinate waves while all corrective moves have three waves. 3. When the main trend is upward, waves 1, 3 and 5 are impulse moves and waves 2 and 4 are corrective moves. When the main trend is downward, the first and third waves become impulse moves, while the second wave becomes a corrective move. 4. The action of the main trend can be taking place over a time frame of anything from a few hours to many years. When the main trend has completed a series of five waves, it reverses and a counter move of three waves is expected.

5. When completed, a move comprising five waves followed by a counter move consisting of three waves is the first cycle movement. This complete cycle movement will represent the first and second waves of a cycle in the time frame of the next higher degree.

As depicted in the figure is the explanation of the progression of the wave pattern. A pattern begins at a bottom where economic environment is worst and raises a question of existence of the economy such as a depression, recession and war and still the prices rise falsifying the question of existence; this impulse move is followed by a correction to wave two which is a severe retest of conditions that are often as bad as they were yet it holds above the bottom. The wave three is the strongest and broadest of all three impulse moves in terms of market breadth and participation, this wave is then corrected by a sudden shock that threatens the growth picture yet the wave 4 maintains above the high of wave one. And finally the progression nears its end to wave five where valuations begin to look overpriced and marks the end of impulse move and a reversal is in store. This is how Robert Prechter explains the pathway of price progression. And quite rightfully so history is the evidence in itself.

Disclaimer: The above article is not intended to influence any sort of investment nor is a recommendation for trading any mentioned stock. it is to be utilized solely as an illustration for educational purpose only.

Shounak Pohankar CFT (Certified Financial Technician) Managing Director, Shounak Pohankar Financial Services Pvt. Ltd. For any queries relating to todays and previous articles write to author on Shounak@shounakpohankar.com. For further information on related topics visit www.shounakpohankar.com