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Counting The Waves

04/30/10 10:09:04 AM
by Alan R. Northam

The whole purpose of technical analysis is to predict future prices. There are many technical analysis tools that the trader can use for this purpose, of which counting the Elliott wave is one.

Security:   XLU
Position:   N/A

 Technical analysis is all about looking at past price data of an individual stock or market with the purpose of predicting its future price. By making this prediction, the trader learns in what direction to take, whether it be long or short, and be able to predict a future price target at which to take profits. While there are many technical tools that can be used for this purpose, I have chosen to use the Elliott waves to analyze the future direction of the Utilities SPDR exchange traded fund (ETF)(XLU). FIGURE 1: XLU, WEEKLY Graphic provided by: AmiBroker.com. Counting the Elliott waves can sometimes be daunting, as there are so many waves to count that this often seems impossible to do. To try to simplify this task, I offer the follow procedure. First of all, try to identify the larger waves as I have shown on Figure 1 in red and green. Don't worry about counting the smaller waves contained within each of the larger waves. Note that I have identified five red waves. Wave 1 is identified as the bar with the lowest low price. Wave 2 is identified as the bar with the highest price. Wave 3 is the lowest price, and wave 4 the highest price, and again wave 5 is identified as the price bar with the lowest price. Note that the low of wave 1 and the high of wave 4 do not overlap in price. These five waves are identified as an impulse wave. An impulse wave is identified by five nonoverlapping waves. Impulse waves define the direction of the overall trend. From this information we know that the trend is downward. Following the completion of a downward rally, the market will undergo a market correction. Following the completion of an impulse wave, again the market will undergo a market correction. Market corrections are identified by waves that overlap each other. Note that I have identified 19 green waves. Also note that everyone of these waves overlap. By this I mean that the valley of one wave overlaps the peak of a previous wave. This is the characteristic of a corrective wave structure. Another characteristic is that market corrections do not make much progress in their rally attempt and often run out of gas around the price level of the previous wave 4. I have identified this level with a dotted red horizontal line. Another characteristic is that they can have many waves. One characteristic of a corrective wave structure is that the correction will always end once the wave count completes a sequence of waves as follows: 3,7,11,15,19. Note that each number is increased by four. Currently. I have counted 19 waves and so the corrective wave structure has satisfied the Elliott wave count for its completion. However, if another wave is formed, then the correction will carry on for four more waves before it can start to correct again. Unfortunately, this can go on for ever. Since market corrections can continue to extend, it is hard to determine when it will end based upon counting the Elliott waves. To this end I employ some traditional technical analysis tools. Note that I have drawn a downsloping trendline off the first two peaks. This trendline acts as resistance. In addition, since this trendline has not been violated for almost two years, it represents a very strong line of resistance. Therefore, we should expect that XLU will bounce off this trendline and move lower. This trendline is forecasting when we should expect the market correction to end and the resumption of the downtrend to begin. I have also shown a line of support off the low of corrective waves 14 and 16. This trendline acts as a line of support. A violation of this support line will also signal the resumption of the downtrend. In conclusion, the Elliott wave count shows that the main trend of XLU is down. It also shows that XLU has been in a market correction since early 2009. The traditional technical analysis tools further suggest that the market correction is now close to being complete. Once wave 19 is complete, the corrective wave structure will have satisfied the Elliott wave theory for its completion. As such, we should should be expecting the market correction for XLU to be completed in the very near future. A breakdown below support will signal the resumption of the downtrend. However, a violation of the downsloping red trendline will signal that the market correction is yet extending.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

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