IBM is shown with the medium-term momentum indicator on the weekly chart. Signals are given when the trend reverses an extreme levels. The stock is said to be OVERBOUGHT when the momentum oscillator reaches an extreme upper level above the zero line and OVERSOLD when it reaches an extreme lower level below the zero line. The oscillator acts like a rubber band: the further it stretches, the more the prices need energy to sustain the trend, i.e. a trend reversal should be expected the more stretched the momentum indicator becomes. Sometimes signals leave room for interpretation (technical analyis is an art not a science). The indicator does not always cross the zero line before giving a new buy or sell signal. These signals are called redistribution examples (see scheme on the right and chart above) or re-accumulation.
Sometimes, the oscillator turns upwards again from a high level above the zero line instead of bottoming below the zero line. This is seen as a high-risk buying opportunity. Most of the time the ensuing price rallies are short-lived and are, more often than not, fully retraced. The same pattern can occur in the opposite direction when the indicator turns downward again froma low level below the zero line (still oversold) instead of topping above the zero line (overbought level).
This is seen as a high-risk selling opportunity.Most of the time, the ensuing declines are short-lived and are, more often than not, fully retraced. The pause and delay in the aberrated trend is often psychologically quiteunnerving for the investor. Therefore, patience becomes a tactical requirement, allowing the major underlying trend forces to re-base at the adjusted price level.
The Elliott Wave Principle
The Wave Principle was Ralph Nelson Elliott’s discovery of how social or crowd behaviour trends and reverses in recognizable patterns. It is a detailed description of how financial markets behave. The description reveals that there is a PSYCHE OF THE CROWD inherent in all representative financial market series. The crowd is not a physical crowd but a psychological crowd. It constantly moves from pessimism to optimism, from fear to greed and from euphoria to panic and back in a natural psychological sequence, creating specific patterns in price movements. This concept of recursive patterns across finer and finer scales in the financial markets (their fractal nature), was proposed by Elliott in the 1930s, which antedates today’s formal study of non-linear dynamics and chaos. The main point emerging from the Elliott Wave concept is that markets have form (pattern). It is here that the investor finds determinism in a seemingly random process. Elliott discovered what the main initiator of the chaos theory, Benoit Mandelbrot, confirmed 50 years later in collaboration with Henry.
Houthakker, an economics professor at Harvard: that patterns made by taking very short-term “snapshots” of stock prices, for example every day are similar to patterns formed by snapshots taken once a week, or once a month, or even once a year. Elliott isolated thirteen patterns. He cataloged them and explained that they link together, and wherethey are likely to occur in the overall path of the market development.