Why Playing the Markets Is Different from Other Businesses

 A portfolio or trading account at a broker should be run just as any other business. Operating principles should be established, goals should be set, plans should be followed, and the risks and rewards from potential transactions ascertained. We have already discussed that the perceived cost of entry into the investment business is far lower than any other business and that this encourages the inexperienced to try their hand. People who would never take a plunge in a business in the "real" economy are often willing to commit a large proportion of their net worth to the markets. This is due not only to the ease of entry and the view that playing the markets is relatively simple but also to the fact that markets are very liquid.

Let's compare the ease of buying and selling a stock or bond with that of buying and selling any other business. For example, you might purchase a small retail store and then find that running the business is not as easy as you had thought. Perhaps the hours are inconvenient, personnel problems are more difficult than you had originally estimated, and the tangle of government regulations becomes a burden. For whatever reason, getting out is not as easy as getting in. Retail stores are not that liquid, and no buyers are waiting with cash in hand. If there are, you may not like the bid and decide to wait for another one. You will probably have to pay a substantial commission to a business broker, normally 10% of the price. All these considerations add up to the fact that most businesses take time and money to liquidate.

On the other hand, in a financial market there is always a bid-and-ask, meaning that our asset can be readily priced. This liquidity is a powerful reason investing in the market is far more attractive than investing in any other business.

Unfortunately, this readily available pricing mechanism also has its downside. Every time you look at price quotes in the paper or call your broker, you know exactly how much your investment is worth. You can watch it when the price goes up, which will make you happy; and you can follow it when it goes down, which will depress you. This constant access to the pricing mechanism draws you into the market emotionally. Since it is very easy and relatively inexpensive to liquidate the position when your "business" temporarily hits the skids, the temptation is to do just that. So you sell. The odds are strong that you are responding emotionally to the fluctuation in the price rather than the change in the underlying market conditions.

On the other hand, consider the example of a person who buys a manufacturing business for which there is no easily available pricing mechanism. Initially, he may find that things go well. The cost-cutting measures that he takes immediately increase his cash flow. He uses the savings as capital to invest in more plant capacity and equipment to spur future growth. After awhile, though, he runs into problems; sales slow down and the economy looks weak. Our entrepreneur may decide to sell his business, but he is less likely to do so because he cannot find a suitable buyer. Eventually, he no longer experiences the urge to sell and hangs on until retirement several years later. When he finally liquidates the business after 15 years, he finds that it has appreciated in value to a considerable extent and he now has a wonderful nest egg. In this example, the business owner concentrated on running his business. He was not constantly looking to see how much it was worth each day for the principal reason that he couldn't. The nature of his business was such that it forced him to be patient. He could, of course, have sold it any time during those 15 years, but the costs and difficulties involved in selling were strong enough to keep him from taking that step.

Investing in the stock market, on the other hand, is much different. There, the constant price fluctuations, the market's addictive response to news, and its emphasis on short-term performance drag us in by our emotions, causing us to make hasty and ill-considered decisions. The liquidity and pricing mechanism that make it easy to enter the financial markets have their downside: They literally try our patience. We have a tendency to think that to be successful we need to have constant access to prices and other information. As we have seen in previous chapters, too much access actually works against our best interests.

* From Investment Psychology Explained

Mastering Fear and Greed

 


The target of objectivity or mental balance lies approximately in the middle between the two destructive mental forces of fear and greed. Fear is a complex emotion taking many forms such as worry, fright, alarm, and panic. When fear is given free rein, it typically combines with other negative emotions such as hatred, hostility, anger, and revenge, thereby attaining even greater destructive power.

Aspects of Fear

In the final analysis, fear among investors shows itself in two forms: fear of losing and fear of missing out. In his book How I Helped More Than 10,000 Investors to Profit in Stocks, George Schaefer, the great Dow theorist, describes several aspects of fear and the varying effects they have on the psyche of investors: A Threat to National Security Triggers Fear. Any threat of war, declared or rumored, dampens stock prices. The outbreak of war is usually treated as an excuse for a rally, hence the expression: "Buy on the sound of cannon, sell on the sound of trumpets." This maxim is derived from the fact that the outbreak of war can usually be anticipated. Consequently, the possibility is quickly discounted by the stock market, and, therefore, the market, with a sigh of relief, begins to rally when hostilities begin. As it becomes more and more obvious that victory is assured, the event is factored into the price structure and is fully discounted by the time victory is finally achieved. "The sound of trumpets" becomes, therefore, a signal to sell. Only if the war goes badly are prices pushed lower as more fear grips investors.

All People Fear Losing Money. This form of fear affects rich and poor alike. The more you have the more you can lose, and therefore the greater the potential for fear in any given individual. Worrisome News Stimulates Fear. Any news that threatens our economic well-being will bring on fear. The more serious the situation, the more pronounced is the potential for a selling panic.

A Fearful Mass Psychology Is Contagious. Fear breeds more fear. The more people around us who are selling in response to bad news, the more believable the story becomes, and the more realistic the situation appears. As a result, it becomes very difficult to distance ourselves from the beliefs and fears of the crowd, so we also are motivated to sell. By contrast, if the same breaking news story received less prominence, we would not be drawn into this mass psychological trap and would be less likely to make the wrong decision.

Fear of a Never-Ending Bear Market Is a Persistent Myth. Once a sizable downtrend has gotten underway, the dread that it will never end becomes deeply entrenched in the minds of investors. Almost all equity bull markets are preceded by declining interest rates and an easy-money policy that sow the seeds for the next recovery. This trend would be obvious to any rational person who is able to think independently. However, the sight of sharply declining prices in the face of such an improving background reinforces the fear that "this time it will be different" and that the decline will never end.

Individuals Retain All Their Past Fears. Once you have had a bad experience in the market, you will always fear a similar recurrence, whether consciously or subconsciously, or both. If you have made an investment that resulted in devastating losses, you will be much more nervous the next time you venture into the market. As a result, your judgment will be adversely affected by even the slightest, often imagined, hint of trouble. That intimation will encourage you to sell so that you can avoid the psychological pain of losing yet again.

This phenomenon also affects the investment community as a whole. Prior to 1929, the collective psyche lived in dread of another "Black Friday." In 1869, a group of speculators tried to corner the gold market. When the gold price plummeted, they were forced to liquidate. This resulted in margin calls, the effect of which also spilled over into the stock market causing a terrible crash. Even though few of today's investors experienced the "Black Thursday" crash of 1929, this event still casts a shadow over the minds of most investors. As a consequence, even the mere hint of such a recurrence is enough to send investors scurrying.

The Fear of Losing Out. This was not one of Schaefer's classifications of fear, but it is a very powerful one, nonetheless. This phenomenon often occurs after a sharp price rise. Portfolio managers are often measured on a relative basis either against the market itself or against a universe of their peers. If they are underinvested as a sharp rally begins, the perception of missing out on a price move and of subsequent underperformance is so great that the fear of missing the boat forces them to get in. This form of fear can also affect individuals. Often, an investor will judge, quite correctly, that a major bull market in a specific financial asset is about to get underway. Then when the big move develops, he does not participate for some reason. It might be because he was waiting for lower prices, or more likely because he had already got in but had then been psyched out due to some unexpected bad news. Regardless of the reason, such "sold out bulls" suddenly feel left out and feel compelled to get back into the market. Ironically, this usually occurs somewhere close to the top. Consequently, the strong belief in the bull market case coupled with the contagion of seeing prices explode results in the feeling of being left out.

I have found personally that this fear of missing the boat is frequently coupled with anger, which may be triggered by a minor mishap that compounds my frustration. These mistakes typically take the form of an unfortunate execution, a bad fill, a lost order, and so on. Inevitably, I have found this burst of emotion to be associated with a major, often dramatic turning point in the market. This experience tells me two things. First, I have obviously lost my sense of objectivity as the need to participate at all costs overrides every other emotion. My decision is therefore likely to be wrong. Second, the very nature of the situation-a lengthy period of rising prices culminating in total frustrationsymbolizes an overextended market. It is reasonable to expect that others are also affected by the same sense of frustration, which implies that all the buying potential has already been realized.

When you find yourself in this kind of situation it is almost always wise to stand aside. A client once said to me, "There is always another train." By this, he meant that even if you do miss the current opportunity, however wonderful it may appear, patience and discipline will always reward you with another. If you ever find yourself in this predicament, overcome the fear of missing out and look for the next "train."

Fear, in effect, causes us to act in a vacuum. It is such an overpowering emotion that we forget about the alternatives, temporarily losing the perception that we do have other choices. Fear of losing can also take other forms. For instance, occasionally we play mental games by refusing to acknowledge the existence of ominous developments. This could take the form of concentrating on the good news, because we want the market to rally, and downplaying the bad news, although the latter may be more significant. Needless to say, this kind of denial can lead to some devastating losses.

Alternately, an investor may get into the market in the belief that prices are headed significantly higher, say by 30%, over the course of the next year. After a couple of weeks, the stock may have already advanced 15%. It then undergoes a minor correction that has absolutely no relevance so far as the long-term potential is concerned. Nevertheless, the investor's fear of losing comes to the surface as he mentally relives experiences of previous setbacks.

The reasoning may be, "Why don't I get out now? The short-term correction that is likely to take place may well push the price below my entry point and I will be forced to take another loss. Far better if I liquidate and get back in when it goes lower." He has diverted his focus from what the market can give
him to what it can take away. Getting out would be quite in order if his assessment of conditions had changed, but if the appraisal is based purely on a change in perceptions unaccompanied by an alteration in the external environment, liquidation would not make sense. One way of solving this dilemma would be to take profits on part of the position. This would relieve some of the pressure but would also leave him free to participate in the next stage of the rally.

A more permanent and viable solution is first to recognize that you have a problem in this area. Next, establish a plan that sets realistic goals ahead of time and also permits the taking of partial profits under certain predetermined conditions. This approach would stand a far greater chance of being successful than knee-jerk trading or investment decisions caused by character weakness. If this type of planning went into every trading or investment decision it would eventually become a habit. The fear of losing would then be replaced by a far more healthy fear of not following the plan.

New Elliott Wave Analysis Method


This Method Will Change The Way You Trade Forever  
Avi Gilburt, The Market Pinball Wizard


 

Chapter 1

  • Providing an overview of my analysis methodology.
  • Background on Elliott Wave analysis.
  • Recent experiments support the basis for Elliott Wave.

In 2011, I began writing for Seeking Alpha, and quickly encountered a major challenge. I realized that writing about technical analysis on a fundamental analysis website was not going to be easy.

While those that initially read my articles were quite skeptical (and that is probably being kind), as Seeking Alpha readers began to see the accuracy in my analysis, I started to gain a following. It was not long until I was the number one followed metals analyst on Seeking Alpha, and have basically remained in that position for the great majority of the seven years I have been writing on Seeking Alpha.

Lately, one of the commenters to an article I wrote suggested that we peel back the curtain regarding my analysis methodology:

“You have a large following on SA and in my view are the definitive TA expert on SA, so please consider the following: Offering a weekly SA post on TA Basics (101 if you will) in an effort to introduce more to at least gaining an understanding of TA and how they might benefit from it.”

So, after getting buy-in from the editors at Seeking Alpha, I have begun this new series of articles which will give you a bit more insight into the technical analysis methodologies I use.

In the first several articles in this series, I am simply going to provide you an overview of Elliott Wave analysis and why it can assist you in rising above the herd, which often seem to be chasing their tails. After the introductory articles, I will begin discussing Elliott Wave analysis in more detail, and then explain how we use Fibonacci Pinball – a method we developed – to place a more objective structure around standard Elliott Wave analysis. I will then explain how we use standard technical analysis to assist us in coming up with a higher probability wave count.

So, if you are interested in a methodology which will open your minds and eyes as to how markets really work, then let’s move right into the overview.

Back in the 1930’s, an accountant named Ralph Nelson Elliott identified behavioral patterns within the stock market which represented the larger collective behavioral patterns of society en masse. And, in 1940, Elliott publicly tied the movements of human behavior to the natural law represented through Fibonacci mathematics.

Elliott understood that financial markets provide us with a representation of the overall mood or psychology of the masses. And, he also understood that markets are fractal in nature. That means they are variably self-similar at different degrees of trend.

Most specifically, Elliott theorized that public sentiment and mass psychology move in 5 waves within a primary trend, and 3 waves within a counter-trend. Once a 5 wave move in public sentiment has completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply the natural cycle within the human psyche, and not the operative effect of some form of “news.”


This mass form of progression and regression seems to be hardwired deep within the psyche of all living creatures, and that is what we have come to know today as the “herding principle,” which gives this theory its ultimate power.

And, over the last 30 years, many social experiments have been conducted throughout the world which have provided scientific support to Elliott’s theories presented almost a century ago.

In a paper entitled “Large Financial Crashes,” published in 1997 in Physica A., a publication of the European Physical Society, the authors, within their conclusions, present a nice summation for the overall herding phenomena within financial markets:

“Stock markets are fascinating structures with analogies to what is arguably the most complex dynamical system found in natural sciences, i.e., the human mind. Instead of the usual interpretation of the Efficient Market Hypothesis in which traders extract and incorporate consciously (by their action) all information contained in market prices, we propose that the market as a whole can exhibit an “emergent” behavior not shared by any of its constituents. In other words, we have in mind the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scales have no idea of. This process has been discussed in biology for instance in the animal populations such as ant colonies or in connection with the emergence of consciousness.”

As Elliott stated:

“The causes of these cyclical changes seem clearly to have their origin in the immutable natural law that governs all things, including the various moods of human behavior. Causes, therefore, tend to become relatively unimportant in the long term progress of the cycle. This fundamental law cannot be subverted or set aside by statutes or restrictions. Current news and political developments are of only incidental importance, soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.”

Next, I will focus on the last sentence in Elliott’s quote above using real market examples, along with studies performed over the last 20 years. And, once I have presented the theoretical basis for Elliott Wave analysis, I will then present articles breaking down how we perform the analysis.



Chapter 2

  • There are too many fallacies about what moves markets.
  • This is why mass psychology is an important focus for markets.
  • This why individual psychology is important to focus upon as well.

After writing publicly for over seven years now, the most common comment I have seen to my articles suggests that once a major news or fundamental event occurs it would completely invalidate my wave count, as the market will certainly move based upon the substance of that news or fundamental event.

When I challenge these commenters to provide me just one event in recent history that proves the market changed direction based upon a news or fundamental event, the most common example provided is the 9/11 event of 2001. So, before I move into why these commenters are wrong, let’s take a moment to perform a simple exercise.

Since most everyone views the 9/11 event as the most significant event of our modern times, I am sure everyone would have no problem picking out on a chart where this occurred. I mean, if the most significant event of our time had an equally impactful effect upon our markets, as almost everyone assumes it did, then it should be quite easy to pick it out on the chart.

Now, if you think you have identified the obvious point on this chart where the most significant event of the last 70 years occurred, let’s see if you are right?


I am quite certain that most of you probably thought that it occurred near the highs of this chart, and caused the entire decline evident on the chart. But, as you can see, we were already in a multi-year decline when 9/11 occurred, and we were closer to a bottoming in the market than a top. Moreover, take note that there were even larger drops seen during this downtrend than the one "begun" on Sept. 11th.

In fact, the market bottomed the week after the 9/11 event, and then rallied to a level 10% higher than where we were right before 9/11. Maybe we can actually say that 9/11 caused the selling capitulation we often see at a bottom to the market, and then caused a 20% rally? Well, the facts support such a conclusion, even though the predominant presumptions about how major news events affect the market do not.

So, in this second installment of our series, I am going to explain why Elliott Wave analysis will keep you on the right side of the market despite the fact that many of you believe that the news of the day, or some event, will override the wave count.

If you have not figured it out yet, there has been no instance where a major world or fundamental event changed the larger degree wave count or trend of our stock market. (And, please do not post in the comment section “what happens if an asteroid hits the earth and destroys half the planet).

In a 1988 study conducted by Cutler, Poterba, and Summers entitled “What Moves Stock Prices,” they reviewed stock market price action after major economic or other type of news (including major political events) in order to develop a model through which one would be able to predict market moves RETROSPECTIVELY. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.

However, the study concluded that “[m]acroeconomic news bearing on fundamental values explains only about one fifth of the movement in stock market prices.” In fact, they even noted that “many of the largest market movements in recent years have occurred on days when there were no major news events.” They also concluded that “[t]here is surprisingly small effect [from] big news [of] political developments . . . and international events.”

In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news. Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.


In 2008, another study was conducted, in which they reviewed more than 90,000 news items relevant to hundreds of stocks over a two-year period. They concluded that large movements in the stocks were NOT linked to any news items:

“Most such jumps weren’t directly associated with any news at all, and most news items didn’t cause any jumps.”

And, just over the last several years alone, how many of you were following the news events such as Brexit, North Korea, terrorist attacks, cessation of QE, record hurricane damage in Houston, Florida, and Puerto Rico, Syrian missile attack, interest rates rising, Crimea, quantitative tightening, Trump, etc., and expected the market to crash on just one of these events? Yet, even taken cumulatively, the market continued to rally over 40% during the last several years. Do you still want to assume that geopolitical events or news will drive our markets?

In 1941, Elliott stated, regarding the financial markets, that “[t]hese [Fibonacci] ratios and series have been controlling and limited the extent and duration of price trends, irrespective of wars, politics, production indices, the supply of money, general purchasing power, and other generally accepted methods of determining stock values.” As you can see, the more research conducted into this subject, the more support we find to Elliott’s theories set out almost 100 years ago.

In moving onto studies conducted on individuals rather than stock market history, these will likely be of great interest to those who are seeking the truth about the human thought process.

In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”

One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi.


In a different study conducted at the School of Social Sciences at the University of California, they came to the conclusion that “We may suppose that in a human being, there is a special algorithm for working with codes independent of particular objects.” Specifically, when subjects were asked to sort indistinguishable objects into two piles, their decision making within that process divided the objects into a 62/38 ratio. In other words, these individuals exhibited a Fibonacci tendency in their personal decision making.

Therefore, the more research that is being done into this issue, the more evidence we are uncovering that behavior and decision making within a herd and on an individual basis displays mathematically driven distributions based on Phi, which do not seem to be affected by exogenous events.

This basically means that mass decision making will move forward and move backward based upon mathematical relationships within their movements, and not based upon outside stimuli. This is the same mathematical basis with which nature is governed, as Elliott stated back in 1941.

So, by now, I am hoping we can all move past perspectives that news, fundamentals, or geopolitics controls our market. If you are still with me after this week’s installment, then you can look forward to next week’s installment which will give you a background into who Leornardo Fibonacci was, and why his discovery is so important to us when analyzing the stock market.



Chapter 3

  • Who was Leonardo Bigollo?
  • Why does he matter to us?
  • How studies are supporting Phi in decision making.

Who Was Leonardo Bigollo and Why Does He Matter To Us?


After the fall of the Roman Empire in 476 C.E., much of European advancement in mathematics and philosophy was either lost or simply remained stagnant. Although there is a difference of opinion among historians regarding the classification of the period after the fall of the Roman Empire, this period became commonly known as the Dark Ages. Among recent historians, the Dark Ages lasted until around the 10th century.

Around 1170 C.E., Leonardo Pisano Bigollo, or more commonly known as Leonardo Fibonacci, was born to Gugliemo Bonnacci, a wealthy Italian business man. To give you some reference during which times Fibonacci lived, the Leaning Tower of Pisa was being constructed at the time.

While Leonardo was still quite young, his father was appointed as an official at a port east of Algiers in North Africa. It was not long until Leonardo was traveling with his father through the Mediterranean.

It was during this period of time that Leonardo learned about the Hindu-Arabic numeral system, and recognized that these numerals were simpler and more efficient than the Roman numerals being used in Europe at the time.

It was not long thereafter that he published his famous book Liber Abacci (Book of Calculation). This book was a key turning point in European mathematics, as it introduced the European community to one of the greatest mathematical discoveries of all time, namely, the decimal system, in addition to the numeric system which we still use to this day. This was considered to be the most important advancement in mathematics since the start of the Dark Ages.

Also included in his major work Liber Abacci, Fibonacci worked through a mathematical problem which led him to the discovery of what we call today the Fibonacci sequence, which is based upon Phi, or the Golden Ratio. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.

Within this sequence, each higher number is the sum of the prior two numbers, and the ratio of any two consecutive numbers approximates 1.618 or its inverse, .618. The higher you move through the sequence, the closer you move towards the 1.618/.618 relationship.

This .618 number has been referred to as the "Golden Mean" throughout history. We also refer to this number as Phi.

Phi is a number which exhibits many unusual mathematical properties, and is also the solution to a quadratic equation. These concepts have been understood by Plato, Pythagoras, Da Vinci, Kepler, Bernoulli, and Newton.

Historic structures have been built by architects of famous Greek structures, such as the Parthenon, based upon the concept of Phi, and even as far back as the architects of the Great Pyramid of Giza in Egypt, who recorded their knowledge of Phi as the building block for all man nearly 5,000 years ago.

What makes Phi even more unusual is that it can be derived in many ways and is exhibited in relationships throughout the universe, such as proportions within the human body, plants, DNA, the solar system, music, population growth, and, yes, the stock market. Phi is the one underlying constant throughout all of nature and governs the laws within nature. In fact, the greatest minds of history, such as Pathagorus, Plato, and Kepler, all felt that Phi was the key to the secrets of the universe.

As an example of how Phi is the building block within the human body, in the 1960’s, Drs. E.R. Weibel and D.M. Gomez dissected the architecture of the human lung and discovered a Phi-based relationship in the formation within the bronchial tree. Others have discovered that the diameter of the bronchial tubes decreases in the same proportion.

Another example is when Eugene Stanley of Boston University, along with researchers from MIT and Harvard discovered that the physiology of neurons in the central nervous system also exhibit Phi-based relationships.

Further examples include the fact that the naval in the human body divides the average adult body into Phi-based proportions, the neck divides the distance from the naval to the head into a Phi-based proportion, the heart muscles in the left ventricle are made up of a series of spirals that repeatedly contract to a point that is approximately .618 of the long axes from the aortic valve to the apex, and so on.

In fact, Leonardo Da Vinci depicted the general external Fibonacci relationships within the body of man in one of his most popular drawings entitled “Vitruvian Man."

In 1941, Elliott stated, regarding the financial markets, that ““[t]hese [Fibonacci] ratios and series have been controlling and limited the extent and duration of price trends, irrespective of wars, politics, production indices, the supply of money, general purchasing power, and other generally accepted methods of determining stock values.”

In recent times, we have seen evidence that Phi even governs man’s decision making. As discussed in my last article, social experiments have been conducted which resulted in price patterns, based upon a mathematical standard, that mirror those found in the stock market.

In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”

One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi.

In a different study conducted by psychologist Vladimir Lefebvre of the School of Social Sciences at the University of California, Dr. Lefebvre came to the conclusion that “We may suppose that in a human being, there is a special algorithm for working with codes independent of particular objects.” Specifically, when his subjects were asked to sort indistinguishable objects into two piles, their decision making within that process divided the objects into a 62/38 ratio. In other words, these individuals exhibited a Fibonacci tendency in their personal decision making.

Therefore, there is significant evidence that behavior and decision making within a herd and on an individual basis displays mathematically driven distributions based on Phi.

This basically means that mass decision making will move forward and move backward based upon mathematical relationships within their movements. This is the same mathematical basis with which nature is governed. The same laws that were set in place for nature also govern man’s decision making en masse, and on an individual basis.

The Elliott Wave theory is also based upon Phi, as Elliott Wave postulates that markets move in 5 steps forward, and three steps back (a Phi relationship). Phi, when used appropriately in conjunction with Elliott Wave, can be an incredibly predictive market tool. The internal wave structure within an Elliott Wave analysis must display relationships based upon Phi in order to be able to appropriately predict the next move within a market with any form of accuracy. In fact, after you identify the appropriate Elliott Wave pattern within a market, you are often able to then identify the next move of the market with shocking accuracy based upon a Phi-based target.

Now we know that movements in markets occur within waves, as discovered by R.N. Elliott, and we know that decision making and changes in trend are governed by Fibonacci mathematics and the properties of Phi. So, how do we apply this to our own trading to generate profits?

Stay tuned for next chapter when we begin to move into the meat of Elliott Wave analysis, followed by our own discovery we call “Fibonacci Pinball.” This is the meat of what we are working our way up towards. This should give you much greater insight into where we are within a trend so that you can align your portfolios to match the trend, as well as the maturity of the trend.



Chapter 4

  • Let's review the 5-wave Elliott Wave structure.
  • How we use Fibonacci extensions and retracements with Elliott Wave analysis.
  • What are some of the pitfalls when using Elliott Wave analysis?


As I have mentioned in prior chapter, Elliott theorized that public sentiment and mass psychology move in 5 waves within a primary trend and 3 waves within a counter-trend. Once a 5 wave move in public sentiment has completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply the natural cycle within the human psyche and not the operative effect of some form of "news."

And, in 1940, Elliott publicly tied the movements of human behavior to the natural law represented through Fibonacci mathematics. Therefore, these primary trends and counter-trend movements in the market generally adhere to standard Fibonacci extensions and retracements.

A move in the direction of the trend is considered a "motive" move (or, as I often refer to it as an "impulsive move") and will constitute 5 waves in the primary trend direction. A counter-trend move is considered a "corrective" move and constitutes 3 waves, which are counter to the primary trend direction.

Within the impulsive 5-wave move, waves 1, 3, and 5 move in the direction of the primary trend, and waves 2 and 4 will be counter-trends in the opposite direction.

Since the market is "fractal" in nature, it means that these movements are variably self-similar at different degrees of trend. In other words, these impulsive and corrective movements of the market are occurring at all degrees and in all time frames. That means that the smaller components, or sub-waves, have the same basic shape, form, and pattern as the larger components. So, waves 1, 3, and 5 all have to develop as 5-wave structures.

While this may have begun to sound more complex, I do want to note that the main rules of Elliott Wave analysis are really quite simple. First, wave 2 can never retrace beyond the start of wave 1. Second, wave 3 cannot be the shortest wave. In its simplest form, these are the main rules which you cannot break for a valid Elliott Wave structure. The rest of the analysis is based upon guidelines. And, yes, there are too many to list here.

For anyone who is really interested in developing a working knowledge of Elliott Wave analysis, I would first suggest you read the "bible," entitled The Elliott Wave Principle, written by Frost & Prechter. After you read that book several times, I would suggest you review the detailed webinars that Garrett Patten has developed at Elliottwavetrader.

Let's now move onto the most common retracement percentages we see for a 2nd wave. While the most common retracement level is the .618 retracement of wave 1, we can also see retracements as shallow as .382 or as deep as .764. But, remember, a wave structure is not invalidated until wave 2 retraces more than 100% of wave 1. However, the sub-wave structure of that retracement will often provide early warning signs as to whether this will occur.

As for the Fibonacci targets for the other waves, third waves most commonly target the 1.382 or 1.618 Fibonacci extension of waves 1 and 2. Fourth waves often retrace .382 of the size of wave 3. And, fifth waves are often equal in size to the first wave. These are just some of the simple guidelines we follow when applying Elliott Wave analysis. And, next week, we will go into how we frame this standard analysis into a more objective format using Fibonacci Pinball.

As I said in my last article, Phi, when used appropriately in conjunction with Elliott Wave, can be an incredibly powerful predictive market tool. But, the internal wave structure within an Elliott Wave analysis must display relationships based upon Phi in order to be able to appropriately predict the next move within a market with any form of accuracy. In fact, after you identify the appropriate Elliott Wave pattern within a market, you are often able to then identify the next move of the market with shocking accuracy based upon a Phi-based target.

However, one of the practices which cause people to feel that Elliott Wave analysis just does not work is that they engage in something I refer to as "wave slapping." So, I want to take a moment to provide a warning to all of you who will now open your charts and try to find a 5 wave move. You see, many will take their rudimentary understanding of Elliott Wave and just "count" how many waves they see going up or down, and then place their labels for the Elliott Wave structure based upon that "look." I want to be very clear: This is not Elliott Wave analysis! Yet, this is likely the most common use I have seen of Elliott's 5-wave model.

Remember what we noted at the start of this exercise:

“Since the market is "fractal" in nature, it means that these movements are variably self-similar at different degrees of trend. In other words, these impulsive and corrective movements of the market are occurring at all degrees and in all time frames. That means that the smaller components, or sub-waves, have the same basic shape, form, and pattern as the larger components.”

So, if your intention is to come up with an accurate Elliott Wave analysis, you will need to accurately count all the sub-waves within the structures you are labeling to make sure they adhere to the appropriate Elliott Wave structures. This takes a lot of detailed work. Without this detailed work, the chances that you will be accurate in your assessment of market direction will be reduced to the point of guessing. And that is why "wave slappers" give Elliott Wave a bad name, as they provide nothing more than guesswork. Moreover, when their expectations are not met, they throw their hands up in the air and claim that Elliott Wave simply does not work.

Even those analysts who attempt to apply Fibonacci ratios to their wave counts can also find themselves classified as "wave slappers." I have seen too many wave counts that are akin to scratching your right ear with your left hand by going over the top of your head. In other words, too many of these analysts are simply attempting to fit their Elliott Wave count to a fundamental perspective they maintain. So, their analysis is not based upon an objective reading of what the market is presenting before them. Rather, they are forcing a wave count to fit their fundamental perspective. This is another reason many analysts give Elliott Wave a bad name, and even some very famous practitioners have been quite guilty of this error.

Also, I do not want you to assume that once you master Elliott Wave analysis, you will be able to determine every market movement the market provides. Elliott Wave analysis deals in probabilities within a non-linear environment. That means that there are certainly times we will not be able to accurately identify the next move in the market. In fact, those that follow us have noted that we are right about 70% of the time. That means we will inevitably be wrong 30% of the time. But, one of the main strengths of Elliott Wave analysis (if you utilize our Fibonacci Pinball method) is it provides an objective perspective to know when your wave count is wrong early enough so that you can stop out of a wrong position and then align your positioning with the appropriate trend.

Lastly, while many of you have derided me through the years for not taking into account fundamentals in my analysis, I hope you can now understand that my purpose is to be able to approach the market without a bias having been formed. For those that have bought into a "story" with regard to how markets should move, such as most of the market who have been bearish and not believing the stock market can continue to rally over these last several years, believing in the common bearish stories would have you approach your analysis with a bearish bias. Yet, ignoring those fundamentals has allowed me to view the markets from an objective perspective and has kept us on the correct side of the market for many years. This is most true at the market extremes, when everyone is so certain about the continuation of the trend, just as the trend is about to turn.

So, I hope I have offered you some insight into the basics of Elliott Wave analysis this week. Next week, I will show you how our Fibonacci Pinball method works, and why it frames the standard Elliott Wave analysis within a much more objective framework. I will also show you how we use it for entries and exits for the various stocks and indices we track.



Chapter 5

  • How we use the fractal nature of the market to our benefit.
  • An outline of Fibonacci Pinball.
  • We then explain how we trade Fibonacci Pinball.

In my last chapter, I presented the basics of Elliott Wave analysis. And those who have spent time working with me have learned that this is based upon a logical progression of if-then propositions. In fact, one of the recent feedback posts I received regarding my Market Pinball Wizard service provides a very clear assessment of what we are all about:

“It’s not about right or wrong. It’s that Avi Gilburt is logical. His model works for me and I can follow it.”

You see, based upon the structure of the market action, we gain insight into where it will move next, in a probabilistic sense. Moreover, if the market begins to move in a manner that is inconsistent with that structure, then it provides us with early warning signs so we can stop out and readjust our positions.

In this chapter, I will try to explain how we do this through the use of the Fibonacci Pinball method we developed.

I am going to start by repeating some of the lessons we learned in the prior articles, upon which we will now build:

“Since the market is “fractal” in nature, it means that these movements are variably self-similar at different degrees of trend. In other words, these impulsive and corrective movements of the market are occurring at all degrees and in all time frames. That means that the smaller components, or sub-waves, have the same basic shape, form, and pattern as the larger components . . . So, waves 1, 3 and 5 all have to develop as 5-wave structures. . .

As I said in my last article, Phi, when used appropriately in conjunction with Elliott Wave, can be an incredibly powerful predictive market tool. But, the internal wave structure within an Elliott Wave analysis must display relationships based upon Phi in order to be able to appropriately predict the next move within a market with any form of accuracy. In fact, after you identify the appropriate Elliott Wave pattern within a market, you are often able to then identify the next move of the market with shocking accuracy based upon a Phi-based target.”


First, we will start with the assumption that you are tracking a market or stock that you view as “bottoming.” And, if you are using Elliott Wave analysis, you recognize it is coming to the completion of a 5-wave c-wave structure, which means you are on alert for a reversal in price.

Moreover, since not everyone is willing to part with their hard-earned money until the market actually provides us with that reversal, in my example, I am going to assume you want to wait for the reversal to occur.

So, let’s look at a standard Fibonacci Pinball structure. Please continually view the chart below as we go through the narrative for the path of a 5-wave structure within our Fibonacci Pinball perspective.

We will begin by assuming you are waiting for the initial 5-wave structure to develop off a bottoming expectation. That would be the point at which wave i on the attached chart completes. At that point in time, you are looking for a corrective 3-wave pullback in wave ii, which often targets the .618 retrace of wave i. Once you have waves i and ii in place, you then set up your projections based upon three points – the bottom of the chart where the turn up began, the top of wave i, and the bottom of wave ii. As you can see, this sets up our Fibonacci Pinball structure, which will then guide you in the expected path for the upcoming rally.


Now, let’s move through how wave iii subdivides into 5 waves.


Wave 1 of wave iii will often target the .382-.618 extension of waves i and ii, and then provide another corrective pullback for wave 2. We now have a i-ii, 1-2 structure, which is the typical structure that any trader/investor should be looking for in any chart you follow.

You see, once wave 2 completes its pullback, the market embarks on what we call the heart of the 3rd wave, which is usually the most powerful part of the rally structure, wherein we see a strong and fast rally to the 1.236 extension of waves i and ii, as we complete wave 3 of iii. So, the ideal entry point would be as wave 2 nears completion, with your natural stop being the bottom of wave 1. (Remember that an impulsive structure will be invalidated if wave 2 retraces more than 100% of wave 1.)

After price strikes the 1.236 extension in wave 3 of iii, we usually see a corrective pullback towards the .764 extension for wave 4 of iii, which then sets up the next segment of the rally to the 1.618 extension for wave 5 of iii. As you can see from the chart, we then see a pullback from the 1.618 extension back towards the 1.00 extension for wave iv, which then sets up wave v towards the 2.00 extension of waves i and ii.

As far as trading guidelines, once we strike the 1.236 extension you can move your stops up from the bottom of wave 1 of iii to just under the .764 extension, and you may then choose to exit your position once the market strikes its completed 5 wave structure for wave 5 of iii. Since 4th waves are often “premium killers,” most traders will take their profits at this point, and look for a reentry once wave 4 nears its completion. Many traders do not even trade the 5th wave, as catching a 3rd wave is what most traders are really focused upon.

This is how Fibonacci Pinball works in its simplest form. Of course, there are often small adjustments we make along the way in real time based upon how the market develops within the sub-waves, but this is the general structure.

The other path we see most commonly is posted on the chart below.

Within this structure, we see wave 3 of iii targeting the 1.00 extension.

Remember, since wave 3 of iii is also supposed to be 5 waves and must adhere to the same Fibonacci Pinball structure in its 5-wave structure, its 2.00 extension would be targeting the larger degree 1.00 extension of waves i and ii. This is how we know in advance that this structure is more likely than the one outlined above.

Now, this structure is of utmost importance in determining the difference between a standard 5-wave structure which will target much higher levels, and a corrective structure which will ultimately break down and point us to levels below the starting point of what we identified as the start of wave i. Allow me to explain.

This is a good time to review the standard ratios within a corrective structure. We have noted before that corrective structures are 3-wave structures, and are labeled a-b-c, as compared to the 1-2-3 in the impulsive structure.

The most common ratio within these corrective structures is where the third wave (the c-wave) is equal to the size of the first wave (the a-wave). When we apply this within out Fibonacci Pinball structure, it gives us early warning that a pattern will fail, even though we initially thought it would follow through as an impulsive rally to the 2.00 extension. Allow me to explain how we get that early warning.

As before, we have the initial rally off the turning point low, initially labeled as wave i. We then see a corrective pullback, initially labeled as wave ii, which is then followed by the next rally which we initially believe will be a 3rd wave.

Should that next rally target the 1.00 extension for wave 3 of iii (as presented in the second chart above), the wave 4 pullback will most often target the .618 extension. However, should the market break down below the .618 extension with its own impulsive sub-wave structure off the 1.00 extension, it provides us with early warning that the rally we have been tracking is likely only a corrective structure, and the market is likely setting up to break below the turning point from which began wave i.

However, as long as the market pulls back correctively and holds the .618 extension as support, we are likely pointing up towards the 1.382 extension in the resumption of the impulsive structure in the 3rd wave. That is why we usually place our stops just under the .618 extension once the market strikes the 1.00 extension. This is how we lock in profits from our entry below, and even if the market reverses, we get stopped out with profit since our stop out is above our entry.

I know this type of analysis is quite technical in nature, and is not easy to initially understand by most of you who are only used to fundamental analysis. But, as my longtime members have noted, it will open your eyes as to how the market works based upon Fibonacci mathematics. As some of them have specifically stated:

“Fibonacci Pinball is one of the most profound discoveries in EW analysis, as well as one of the most useful practical tools. . . there is simply no better system of applying EW analysis, period. It is that good. There is no sentient life form or computer software that could explain this chart pattern without using Avi’s Fibonacci Pinball!”

“I will say for a fact that EWT with Fibonacci can map out the way up or down through these waves more precise then anything on earth.”

“Avi, Your FibPinball is mind blowing . . . the most useful tool I have ever traded with”

So, while this methodology may be completely foreign to many of you at this time, I urge you to consider something that may very well open your eyes to an entirely different side of the market you may not have known exists.

Our next chapter will conclude this series, and will provide a brief explanation as to how we use technical indicators to assist in our Elliott Wave analysis.


Chapter 6

  • 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 chapters I have recently penned 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.