Elliott Wave Channel Analysis
Technical analysis of channels is most commonly seen in actively traded securities with a large number of outstanding shares. Basically, high volume trading with high liquidity. The channel is a common and important indicator for technical analysis and works well with Elliott wave theory. Channel Analysis is based on Trendline analysis.
As Elliott developed his wave theory, the trend channel played an important role. In his first book The Wave Principle, Elliot wrote "To properly observe a market's movements, and hence to segregate the individual waves of such a movement, it is necessary that the movement, as it progresses, be channeled between parallel lines."
Channel Analysis is basically two trendlines, where one trendline is developed along the valleys of a security and another trendline is developed along the peaks of a security. The channel lines are parallel to each other. Prices bound by trend channels follow the Rule of Alternation where a move that meets the bottom channel line is likely to reverse and when a move meets the upper channel line will also reverse, in a repeating pattern.
Constructing a Trend Channel
We must wait for the first two waves in an impulse move to be complete before drawing a channel. The first two waves will define our channel therefore wave 3 will already have begun before we draw the trend channel lines.
First we start by drawing the base line starting at point 0 (the beginning of wave 1) and extending through point 2 (the end of wave 2). This line establishes the lower limits of the channel. Then we draw a line parallel to the first, where the line uses point 1 (the end of the first wave) as a reference. This line establishes the upper limits of the trend channel. Both channel lines are shown in the graph below with green lines:
Channels and Technical Analysis
Technical analysis can be used on the channels to predict price movement. Assuming that normal market behavior continues, wave 3 will likely be very similar to wave 1. How we do this is to draw a line from the origin to point 1. Using that as a reference, we draw a parallel line from point 2 in the direction of the trend. Where the new line (shown above in blue from point 2) crosses the upper channel, we can reasonably assume the current trend of wave 3 will reach that point. Possibly even correcting with wave 4 at that point:
Wave 3 moved as expected, but at the upper trend line didn't do a full correction. It was more of a stall, possibly due to the resistance shown by the upper channel line. As we discussed earlier, wave 3 is usually the longest of the impulse waves, though not always, and never the shortest. So wave 3 did track the way we expected, and it is also normal to see it break through the upper channel line before wave 3 is finished. Seeing the graph above, our technical analysis of the Elliot wave trend channel lines was fairly accurate. Wave 3 did extend past the upper trend channel line, and wave 4 completed by correcting back into the channel. Elliot wave theory is fascinating, isn't it?
Now we should work on predicting wave 5. We'd like to know where our target price would be. There are two methods for doing this. The first is to continue to use the same trend channel that we have been using. However, many traders will now use the new references generated between points 2 and 4. Notice above that wave 4 didn't quite move to the bottom of the trend channel as we had expected. That's okay. All it means is that the Bears weren't as strong in this case, and after a short sell off, the Bulls started pushing the market again. Now we might even expect a bit of a faster rise in price, so we will draw a new channel with price predictions based on points 2 and 4:
In the graph above, we've drawn new Elliot wave trend channel lines, and also new prediction lines using technical analysis of the current waves. According to Elliott, wave 5 should be similar to wave 1 with regards to price and time. Thus, as we draw our hypothetical wave 5, we connect point 4 to the upper channel line by drawing a line parallel to wave 1. This indicates the probable move of wave 5. So now we have our wave 5 prediction. Lets see how close we were:
As we can see, wave 5 progressed a little more slowly than we predicted. However, it remained in the channel and the price peak at point 5 was very near the upper channel line. After wave 5, the security moves into an abc correction. If we were using the lower channel line as our stop for our long position, we would have been stopped out somewhere between the b and c area of the corrective phase. Remember, even though the price dipped below the lower trend channel line several days after point 4, we probably wouldn't have been stopped out since we set our stops with at least a 3% variance. And the price didn't drop below the trend line by more than 3% until the abc correction. Using trend channel technical analysis on this Elliot wave would have been quite profitable in this instance. Not every trade will work out as well as this one did, but you can see how powerful this simple technique can be. Keep in mind you should always use as many indicators for market behavior as possible, and never rely on just one.
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