This Analysis Will Change The Way You Invest Forever - Part 6

by: Avi Gilburt

Oversold or overbought technical conditions are not always what they seem.

We use technical indicators to help us identify the correct Elliott Wave count.

When used together, Elliott Wave and technicals can identify turning points in the market.

Marrying Elliott Wave Analysis And Technical Indicators

This will be the final installment of a six part series I have recently penned on Seeking Alpha 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 1930s, 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 third 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 fifth wave being the strongest).

That means one must first understand that the chart you are focused upon is in a third wave. When that third 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 third wave decline.

We see embedded technicals most commonly within the third wave of the third 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 third wave itself also develops as a five-wave structure.

Within the five-wave structure of the third wave, the third 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 fourth wave within that third wave five-wave structure, which sets up the market to drop again in price to lower lows in a fifth 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 fifth wave of that third wave down.

Once the market provides us with a first indication of positive divergence, it often means that the market has now completed the third wave down. Thereafter, I would expect a fourth wave “bounce,” which will develop further potential divergence in the technical indicator. That means that when we drop to complete the fifth 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 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.

For those interested, here are Part 1, Part 2, Part 3, Part 4, and Part 5.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.