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Which Works Best -- GPS or Road Map?

Trading with Elliott Wave Analysis


By Jim Martens

Some of the best stories about global positioning systems (GPS's) are the weird detours
they sometimes recommend to drivers. Just like some of the weird detours that financial
markets can make you take when you think they would be better off going in a straight
line either up or down, depending on how you've positioned your trades.

Not long ago, while taking a trip with my family through Great Smoky Mountains
National Park on the way to Gatlinburg, Tenn., I decided to use my GPS to drive around
the park's western boundary. We wanted to visit Fontana Dam and Cades Cove to see the
wildlife. We’d do the go-carts, miniature golf and rides the following day.

From Fontana Dam, my old-fashioned map made it look like it would take the better part
of the day to drive around the park to Gatlinburg and then head into Cades Cove from the
north. But my new GPS unit suggested that Cades Cove was less than 20 miles away. I
could have kissed it – my GPS was going to save me hours of travel time! Or so I
thought. Little did I know until I got there that the road my GPS suggested for the final
few miles was only the remnant of an old wagon trail – and it was a one-way wagon trail,
going the wrong way. I had to backtrack and take the much longer path my paper map
suggested.

What’s the moral of the story? Sometimes the new-fangled gadget is not much of an
improvement over what it’s designed to replace. Although my GPS unit is great when it
comes to identifying the quickest and most efficient route from point A to point B, it
sometimes fails to take into account some of those necessary nuances, such as whether a
street is one way or whether it might be impassable at times. Every so often, the old-
fashioned way of doing things is still the best way.

I believe that’s true when it comes to analyzing markets, too. The method I employ every
day has been around since the 1930s, and it works as well as, if not better than, any new-
fangled technical analysis method for which you must buy some expensive computer
software. My method is a form of technical analysis based on the Elliott Wave Principle,
which Ralph N. Elliott worked out via hundreds of hand-drawn charts, well before the
dawn of charting software. If you like those GPS units that talk you through every turn,
you can almost imagine Ralph's voice explaining where to turn as you follow a market.
Those directions – the road map he drew for tradable markets – have withstood the test of
time.

As I found during my trip, detours are a fact of life. They are also a part of market trends.
For instance, a bull market shows periods of “punctuated growth” – that is, periods of
alternating growth and non-growth, or even decline. The patterns then build on
themselves to form similar designs at a larger size, and then again at an even larger size.

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You’ve probably heard of this idea of repeating patterns on increasing and decreasing
levels of scale. This emerging science, which is called “fractal geometry,” is a branch of
chaos theory. And it is precisely the model identified by R. N. Elliott more than 60 years
ago.

A Quick Road Map of Wave Analysis

For this overview of wave analysis, I have borrowed from the “Cliffs Notes” version that
we provide for free to anyone interested in learning about wave analysis. It's called
Discovering How To Use the Elliott Wave Principle. (For your own copy, please go to
www.elliottwave.com/wave/discovering .)

Elliott’s road map, or basic wave pattern, consists of “impulsive waves” and “corrective
waves.” An impulsive wave is composed of five subwaves and moves in the same
direction as the larger trend – or the wave's next larger size. A corrective wave is divided
into three subwaves, and it moves against the trend of the next larger degree. As you can
see in Figure 1, there are plenty of right and left turns – or up and down moves on a price
chart.

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Figure 1 reveals the general roadmap that markets follow during bull markets. Notice the
building-block process. The completion of an initial impulsive wave (waves 1-5, up-
down-up-down-up) sets the stage for a corrective phase (waves A-B-C, down-up-down).
Combined, those waves represent the first two legs of a larger “degree” advance. In this
illustration, waves 1, 2, 3, 4 and 5 together complete a larger impulsive wave, labeled as
wave (1).

A five-wave rally from a significant low tells us that the movement at the next larger
degree of trend is also upward. It also warns us to expect a three-wave correction – in this
case, a downtrend. That correction, wave (2), is followed by waves (3), (4) and (5) to
complete an impulsive sequence of the next larger degree. At that point, again, a three-
wave correction of the same degree occurs.

Note that, regardless of the size of the wave, each impulsive wave peak leads to the same
result – a correction.

If we isolate the corrective waves, the subwaves A and C move in the direction of the
larger trend and usually unfold in an impulsive manner. Referring to Figure 1, the (A)-
(B)-(C) decline that follows the (1)-to-(5) sequence illustrates this structure. Waves
labeled with a B, however, are corrective waves; they move opposite to the trend of the
next larger degree. In this case, they move upward against the downtrend. Notice that
these corrective waves are themselves made up of three subwaves.

Reading the Wave Analysis Map

So now that you have a wave road map in hand, let's talk about how to apply it to the
actual terrain of financial markets. When I look at a price chart for the first time, my first
task is to identify any completed five-wave and three-wave structures. Once I do that,
then I can interpret where the market is along the pre-defined path and, from there, where
it’s likely to go.

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Say we’re studying a market that has reached the point shown in Figure 2. So far we’ve
seen a five-wave move up, followed by a three-wave move down.

But this is not the only possible interpretation. It's sort of like having a GPS that tells you
that you've arrived, when you've actually got miles to go. In this example, it is also
possible that wave (2) hasn’t ended yet; it could develop into a more complex three-wave
structure before wave (3) gets under way. Another possibility is that the waves labeled
(1) and (2) are actually waves (A) and (B) of a developing three-wave upward correction
within a larger impulsive downtrend, as shown in the “Alternate” interpretation at the
bottom of the chart. According to each of these interpretations, though, the next imminent
movement is likely to be upward. That tells you more than most technical analysis
systems do.

Alternate counts are an essential part of using the Wave Principle. They are neither “bad”
nor “rejected” wave interpretations. Rather, they are valid interpretations that are given a
lower probability while the count works itself out. If the market doesn’t follow the
original preferred scenario, the top alternate usually becomes the preferred count.

I consider alternate counts to be similar to detours – just a different way for the market to
get to where it’s going. How many times do you actually go from point A to point B non-

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stop in your travels? Admit it, you have to stop to grab a bite to eat or ask for directions
once you realize you’re lost. After consulting the map, you get back on track toward your
intended destination. The new path represents an alternate count.

This seeming ambiguity about a wave structure illustrates an important point about the
Wave Principle that, in my opinion, is often misunderstood. The Wave Principle does not
provide certainty about any one market outcome. Instead, it gives you an objective means
of determining the probability of a future direction for the market. At any time, two or
more valid wave interpretations usually exist. Unlike actual physical roads that exist,
price movements in financial markets are always changing, and the best you can do is be
somewhat confident of whether they are moving up or down. That's the kind of
confidence that the Wave Principle provides.

Think of Investing as a Trip

Here's my advice: View the Wave Principle as your road map to the market and your
investment idea as a trip. You start the trip with a specific plan in mind, but conditions
along the way may force you to alter course. Alternate counts are simply side roads that
sometimes end up being the best path.

Elliott’s highly specific rules keep the number of valid interpretations to a minimum. The
analyst usually considers the “preferred count” to be the one that satisfies the largest
number of guidelines. The top “alternate” is the one that satisfies the next largest number
of guidelines, and so on.

There are only three hard-and-fast rules with the Wave Principle:
• Wave two cannot retrace more than 100% of wave one.
• Typically wave four does not end within the price territory of wave one but may
do so from time to time in highly leveraged markets.
• Wave three is never the shortest wave of an impulse.

Elliott’s rules give specific “make-or-break” levels for a given interpretation. In Figure 2,
for example, if the move labeled (2) continues below the level of the beginning of wave
(1), then the originally preferred interpretation would be instantly invalidated. By
eliminating subjectivity, the rules help you firm up your investment strategy – and reduce
your risk.

“Are We There Yet?”

You’ve heard that irritating question, "Are we there yet?," from the back seat just about a
million times. Every map has a scale, and it’s the scale that helps me determine how
many miles I have to travel before I reach my destination. When using the Wave
Principle, Fibonacci relationships are the scale.

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Many investors today know that Fibonacci ratios are used for market forecasting. But few
realize that Fibonacci analysis of the markets was pioneered by R.N. Elliott. The use of
Fibonacci ratios requires a valid Elliott wave interpretation as a starting point.
Unfortunately, many non-Elliott analysts try to find Fibonacci proportions between
market moves that are not related to each other in any way. This has made the approach
appear to be far less valuable than it is.

Elliott wave analysis has two chief insights concerning Fibonacci relationships within
waves. First, corrective waves tend to retrace prior impulse waves of the same degree in
Fibonacci proportion. For example, wave (2) in Figure 2 retraces 38% of wave (1). That’s
a common relationship. Other frequent wave relationships are 50% and 62%. Second,
impulse waves of the same degree within a larger impulse sequence tend to be related to
one another in Fibonacci proportion. For example, common relationships include wave
three traveling 1.62 times the distance traveled by wave one of the same degree. When
that occurs, wave five often tends toward equality with wave one of the same degree.

Planning the Trip

Just as I sit down and plan my trips before shoving off, I rely on wave interpretations and
Fibonacci relationships to help establish investment strategies and reduce risk exposure
when I analyze the markets for our clients. Investors use these same wave analysis
methods to help decide where to get into a market, where to get out and at what point to
give up on a strategy. The Wave Principle lets you identify the highest probability
direction for the market, as you also adopt an optimum position to take advantage of it –
all while protecting yourself against lower probability outcomes. You couldn't ask more
from your own GPS.

By the way, we did make it to Cades Cove on our way back across Smoky Mountain
National Park. I turned off my GPS and consulted my map. The old tried and true worked
like a charm.

Jim Martens is the senior currency analyst at Elliott Wave International (EWI). He
worked as an analyst with floor brokers before joining EWI in 1993, where he covered
commodities and oversaw currency analysis. After a stint with Nexus Capital Ltd., a
Soros-affiliated hedge fund, he is back with EWI, covering dollar rates and major cross
rates in EWI's International Currency Outlook. For more information, please visit
www.elliottwave.com.