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Building the Wave

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Elliott Wave analysis is based on the work of R. N. Elliott during the 1930s. Elliott believed that the movements of the markets follow given patterns and relationships based on human psychology. Elliott Wave analysis is a complex subject and has been discussed in detail in many books and articles. Here, we will not go into it in detail but will provide an overview so that you can understand (1) why I think Elliott Wave analysis is predictive, and (2) how to make it mechanical so that it can be used to predict the markets.

AN OVERVIEW OF ELLIOTT WAVE ANALYSIS

Elliott Wavetheory is based on the premise that markets will move in ratios and patterns that reflect human nature. The classic Elliott Wave pattern consists of two different types of waves:

  1. A five-wave sequence called an impulse wave.
  2. A three-wave sequence called a corrective wave.

The classic five-wave patterns and the three-wave corrective wave are shown in Figure 13.1. Normally, but not always, the market will move in a corrective wave after a five-wave move in the other direction.

Let's analyze a classic five-wave sequence to the upside. Wave one is usually a weak rally with only a few traders participating. When wave one is over, the market sells off, creating wave two. Wave two ends when the market fails to make new lows and retraces at least 50 percent, but less than 100 percent, of wave one. ...

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