By Editorial Staff

The following article is an excerpt from Elliott Wave International’s Trader’s Classroom Collection.

Every trader, every analyst and every technician has favorite techniques to use when trading. But where traditional technical studies fall short, the Wave Principle kicks in to show high probability price targets and, just as importantly, how to distinguish high probability trade setups from the ones that traders should ignore.

Where Technical Studies Fall Short
There are three categories of technical studies: trend-following indicators, oscillators and sentiment indicators. Trend-following indicators include moving averages, Moving Average Convergence-Divergence (MACD) and Directional Movement Index (ADX). A few of the more popular oscillators many traders use today are Stochastics, Rate-of-Change and the Commodity Channel Index (CCI). Sentiment indicators include Put-Call ratios and Commitment of Traders report data.

Technical studies like these do a good job of illuminating the way for traders, yet they each fall short for one major reason: they limit the scope of a trader’s understanding of current price action and how it relates to the overall picture of a market. For example, let’s say the MACD reading in XYZ stock is positive, indicating the trend is up. That’s useful information, but wouldn’t it be more useful if it could also help to answer these questions: Is this a new trend or an old trend? If the trend is up, how far will it go? Most technical studies simply don’t reveal pertinent information such as the maturity of a trend and a definable price target — but the Wave Principle does.

How Does the Wave Principle Improve Trading?
Here are five ways the Wave Principle improves trading:

1. Identifies Trend – The Wave Principle identifies the direction of the dominant trend. A five-wave advance identifies the overall trend as up. Conversely, a five-wave decline determines that the larger trend is down. Why is this information important? Because it is easier to trade in the direction of the overriding trend, since it is the path of least resistance and undoubtedly explains the saying, “the trend is your friend.” Simply put, the probability of a successful commodity trade is much greater if a trader is long Soybeans when the other grains are rallying.

2. Identifies Countertrend – The Wave Principle also identifies countertrend moves. The three-wave pattern is a corrective response to the preceding impulse wave. Knowing that a recent move in price is merely a correction within a larger trending market is especially important for traders, because corrections are opportunities for traders to position themselves in the direction of the larger trend of a market.

3. Determines Maturity of a Trend – As Elliott observed, wave patterns form larger and smaller versions of themselves. This repetition in form means that price activity is fractal, as illustrated in Figure 1. Wave (1) subdivides into five small waves, yet is part of a larger five-wave pattern. How is this information useful? It helps traders recognize the maturity of a trend. If prices are advancing in wave 5 of a five-wave advance for example, and wave 5 has already completed three or four smaller waves, a trader knows this is not the time to add long positions. Instead, it may be time to take profits or at least to raise protective stops.

Since the Wave Principle identifies trend, countertrend, and the maturity of a trend, it’s no surprise that the Wave Principle also signals the return of the dominant trend. Once a countertrend move unfolds in three waves (A-B-C), this structure can signal the point where the dominant trend has resumed, namely, once price action exceeds the extreme of wave B. Knowing precisely when a trend has resumed brings an added benefit: It increases the probability of a successful trade, which is further enhanced when accompanied by traditional technical studies.

Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

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By Editorial Staff

Investor expectations are decidely bullish right now, and many people expect an economic turnaround this year. What do the underlying economic conditions suggest? The Chinese mall “The Place” demonstrates the contrast between investor hope and economic reality.

The following is an excerpt from the February issue of Global Market Perspective. For a limited time, you can visit Elliott Wave International to download the rest of the 100+ page issue free.

• Bullish expectations (shown by the top three panels) may not be quite as extreme as they were in 2007, but adjusted for underlying economic conditions (bottom panels), the current psychology probably ranks right up there with the most complacent outlook in history. The charts of housing, consumer credit and unemployment show the systemically sluggish state of the economy. We know that fundamentals always lag psychological trends, but the lag is generally only a matter of months. It’s been nearly 11 months since the outset of the Primary wave 2 rally; by these critical economic measures the rebound is barely registering.The wide disparity between the hope of investor expectations and the reality of economic strength shows that the great bear market — already ten years old — remains in its early stages. As the next legdown matures, hope will turn to despair, and it will become impossible to ignore the persistence of the economic contraction.

The same chasm between fundamental performance and stock market expectations is visible in other parts of the world. In China, for instance, ground reports reveal how out-of-whack financial
expectations are with street-level demand. A blog called The Peking Duck described Beijing’s “stunningly dysfunctional, catastrophic mall, The Place. Fifty percent of the eateries in the basement were boarded up. The cheap food court, too, was gone, covered up with ugly blue boarding, making the basement especially grim and dreary. There is simply too much stuff, too many stores and no buyers.” The world’s largest mall in southern China is completely empty. Most investors do not see past the performance of the Shenzhen or Shanghai stock indexes, just as most of the buying and selling of U.S. stock indexes remains detached from the real economy. We see lots of hope but no change in the reality.

Elliott Wave International (EWI) is the world’s largest market forecasting firm. EWI’s 20-plus analysts provide around-the-clock forecasts of every major market in the world via the internet and proprietary web systems like Reuters and Bloomberg. EWI’s educational services include conferences, workshops, webinars, video tapes, special reports, books and one of the internet’s richest free content programs, Club EWI.

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