Marrying Elliott Wave Analysis And Technical Indicators
This will be the final installment of a six part series I have recently penned about Elliott Wave analysis. In this installment, we will address how to use technical indicators to assist with our wave count.
I often shake my head when I hear an analyst point to a technical indicator which has reached an oversold reading, and then proclaim we are now going to bottom because this indicator has reached a point of being oversold. Anyone who has any experience in the market using technical indicators knows exactly what I am talking about.
In fact, the great majority of the time, you will see the market continue to sell off despite this indicator having already hit a point of being oversold. But, how can that be?
As I have said many times before, I know of no other analysis methodology which provides better context to understanding the market than Elliott Wave analysis. Back in the 1930’s, R. N. Elliott theorized that markets move through five waves in a primary trend, and three waves in a corrective trend. So, when a five-wave structure is nearing completion, you have the context within the market to be able to prepare for a reversal of the trend.
Within that five-wave structure, the 3rd wave is, technically, the strongest segment of the five-wave structure when we are dealing with equities and equity markets. (Commodities often present with the 5th wave being the strongest).
That means one must first understand that the chart you are focused upon is in a 3rd wave. When that 3rd wave is pointing down, it means the market not only hits the oversold condition, at which time many analysts will prematurely declare a bottom, it usually means that the technical indicator will become embedded within that oversold state. In other words, just because an indicator strikes an oversold state does not mean the market will turn back up. Rather, it may mean the indicator becomes embedded in this state as price continues lower while in the heart of a 3rd wave decline.
We see embedded technicals most commonly within the 3rd wave of the 3rd wave. Remember, because the market is fractal in nature, waves 1, 3 and 5 within Elliott’s five-wave structure are each comprised of five-wave sub-structures. Therefore, the 3rd wave itself also develops as a five-wave structure.
Within the five-wave structure of the 3rd wave, the 3rd wave of this sub-structure is where we see technicals embed. Once the technicals move out of the embedded status, it often signals that we are seeing a 4th wave within that 3rd wave five-wave structure, which sets up the market to drop again in price to lower lows in a 5th wave, but the technical indicator will only see a positive divergence where price strikes a lower low but the indicator does not. This tells me that the market is completing the 5th wave of that 3rd wave down.
Once the market provides us with a first indication of positive divergence, it often means that the market has now completed the 3rd wave down. Thereafter, I would expect a 4th wave “bounce,” which will develop further potential divergence in the technical indicator. That means that when we drop to complete the 5th wave to the downside, the market will exhibit a second positive divergence, which will then signal we are completing the five-wave structure to the downside.
At the end of the day, it means we need to see two positive divergences in a technical indicator to suggest the market is bottoming in 5 waves to the downside, which should then have us ready for a trend change. This type of structure, supported by the technicals as noted above, is often a very strong indication that the market is nearing the point of a strong trend reversal.
And, of course, the same applies when tracking a market or stock rally, but in the opposite manner.
While I have seen comments through the years regarding how Elliott Wave analysis was akin to “voodoo” or “tarot card reading,” I hope that this six-part series has opened your eyes as to how Elliott Wave analysis, coupled with our Fibonacci Pinball method and supported by technical analysis, provides a very objective perspective into tracking market sentiment, which I believe is the true driver of market pricing.