Elliott Wave Analysis: Limitations
You can’t apply this technique to everything
Socionomics: The Underlying Requirements for Elliott Waving
Many people who don’t understand Elliott Wave have certain misconceptions and distaste for this technique of technical analysis. I would say that a lot of Elliott Wave practitioners themselves does not have in-depth understanding of this technique. Why do I say that?
Because knowing the technique to counting waves is only half of the complete knowledge and skillset of an Elliott Waver. Many people, EW practitioners included, do not know that there is actually an underlying theory, or context, or assumption, or axiom, that backs the technique. This is called Socionomics. In it’s simplest form, and in layman’s term, the “reasoning” or context/background that allows EW techniques to be applied is “herding”. Herding behavior in humans.
Yeah, like sheep herding.
What this means is that if certain stocks, or other instrument, does not display herding behavior, you can’t apply Elliott Wave counting to that product.
Some Negative Examples
Over in this section, I will give you a few examples.
Spread Trading
Spread trading is a general term for a certain style of trading where a trader longs an instrument and sell another instrument at the same time. These 2 instruments should have some fundamental relationship that can be quantitatively verified (minimally a correlation test, but better to be co-integrated).
A few examples:
Stocks: Long AAPL, Short MSFT
Futures: Long TOPIX, Short Nikkei 225
Cross Border Relative Value: Long 939.HK, Short 601939.SSE (both are China Construction Bank but listed in Hong Kong Stock Exchange and Shanghai Stock Exchange respectively)
A spread chart looks similar to this:
There is usually certain spread ratios that are applied to different spreads in order to get the spread to be “stationary”. But I am not here to teach spread trading so I’ll just leave it at that. What you must understand is that a spread pair DOES NOT HERD. And thus you cannot apply Elliott Wave to it.
Extremely Mature Stocks in some Domestic Markets
This may not sound that intuitive, but it really is. Certain stocks, especially if they are big names in certain domestic markets, are big enough and their market participants are not big enough. There is a relative mismatch between the size of the stock vs the liquidity of the market vs the market psychology. I know that is quite a mouthful and confusing statement. Blame me for not being able to express myself well enough. So I’ll illustrate it with an example.
Take a look at the above chart which is one of the top 3 banks in Singapore. It is a very mature and safe business. And you will be able to see “waves” in the stock price. However, you will face issues trying to count Elliott Wave on this 12 years chart. Why?
Because the 3rd rule of Elliott Waves that wave 4 will not enter the territory of wave 1 will not hold. Even the biggest bank in Singapore, DBS, will fail this rule.
If you look at the chart above, you will notice that the big picture count looks correctly (and even nice) structurally, but look at the red line that I’ve drawn also. This breaches rule 3.
At the lower timeframe, you may still be able to use EW, but you need to know if the period of analysis is a period of herding. Or at least, exhibits herding behaviors.
Now, whether certain stocks in certain markets will exhibits herding characteristics will require you to understand the market participants, their culture, their way of thinking, and sometimes even the regulations.
Illiquid Stocks
I thought that is will go without saying because if no one is looking at the stock, there won’t be any “herd”.
Conclusion
Every technique has it’s limitations, when it works and when it doesn’t. Understanding these will help you to be a better analyst, if not a better trader.
Good luck!
