Elliott Wave Trendlines
Technical analysis of trendlines is not new. But it is one of the most basic and popular methods of technical analysis and works very well with Elliott Wave Theory. Generally, prices of any security tend to move in trends. They will continue to move in trends unless acted upon by a strong opposite force. Newton's First Law of Motion suggests "An object at rest tends to stay at rest, and an object in motion tends to stay in motion with the same speed and in the same direction unless acted upon by an unbalanced force." This describes inertia and momentum (where have we heard that word before?). While Newton was really talking about physics, it also applies to market prices and investor sentiment.
Trendlines and Technical Analysis
At any given time a market may be in one of three basic trends: Up, down, or sideways. There will always be corrections made in opposition to a trend, but the basic trend still remains. Technical analysis using trendlines helps to determine these trends so a trader can best predict the future of the security. Trendlines are a basic but powerful aid in helping to determine trends during technical analysis.
Elliott Wave trendlines are drawn at the bottoms of prices during an uptrend, and the tops of prices during a downtrend:
Notice in the graph above, the trendline starts from the beginning of the Elliot wave, and the second point connects through point 2, the bottom of the first correction. Assuming this is a valid uptrend, we see that the price never breaks through the trendline until the abc correction. In general, reversals are indicated by the price breaking through the trendline by at least 3%. We can see that even the correction of wave 4 didn't break the trend. By knowing the structure of an Elliott Wave and using trendlines, we can get a pretty good idea of where the price will reverse, and where the price is headed.
In volatile markets, you might choose to use a different filter for technical analysis than the 3% in the example above. Perhaps when trading tends to be extraordinarily volatile, you might choose to use a filter of 5%, or 10%, or more. That's where experience comes in. Get to know the market. Watch its behavior. Use technical analysis to learn its movements. Then test different things and see what works best with your trading strategy. Technical analysis is an art form.
Lets look closer at the ABC correction:
Our original trendline is in green. Examining the Elliot Wave we can see the wave turning from point 5 to the abc correction, but we aren't sure yet whether it is a reversal, or just a correction. Lets say our stop is 3% below the trendline. Our position would get closed out between the b and c points, but even if we didn't get in on the long position until after point 4, that still shows us a bit of profit. Of course, knowing Elliot Wave Theory, we might be able to predict that after the turn of point 5, then seeing the turn from the wave a correction, we might close our position early for a larger profit.
Also, there is profit to be made from the abc correction as well. We could be very risky and get in on the short position after the turn at green point 5, waiting until the turn at red point c before closing that one. Or we could wait for confirmation of the abc correction by waiting until after the turn at point b of the Elliot Wave before going short. This wouldn't make us as large of a profit, but it is also less risky since the abc correction would be confirmed.
Unfortunately, our profit on the abc short would have been small, because as we see in the graph the market corrected and then carried on with the original uptrend. But, that gives us a new trendline (blue) and new chances to make good trades. If we follow the graph after blue point 2, assuming we go long just after that point, we can see that it trends up quite well, following Elliot wave patterns, allowing us to earn more profit, until the next abc correction.
Trendlines are magnificent technical analysis tools, but not free from error. We must always look to other means of technical analysis to confirm what we think will happen. Even then, we are sometimes wrong. For example, perhaps green point 5 was the securities all time high price. Barring any other factors, it could easily mean the security is overbought. Going long at blue point 2 might be a mistake if the ceiling is near. Or perhaps we see all the technical indicators that the security will continue it's meteoric rise. But then, a news article comes out saying that the company, or commodity, or dollar index, or whatever has crashed and then investors immediately begin closing out their positions. Keep in mind there is always risk. Our goal is to use as many indicators and fundamental and technical analysis as possible to minimize our risk and maximize our reward.
Trendlines have been and will continue to be a highly popular indicator for technical analysis. Trendlines can be quite powerful when used with Elliot Wave Theory.
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