According to the field theory, humans resist change and prefer status quo. It is easier. This is why the concept of ‘Life in a Leaf’ is still being challenged and refuted. Life in a leaf metaphorically sums that a fractal defines life and everything connected with it, even economics.

It is almost 80 years since Ralph Elliott formulated the Wave Theory. The theory is based on the observation that market prices unfold in recognizable patterns. It is a simple explanation of how the markets behave and how fractals can forecast. Analysts have made incredible forecasts since 1930s using Elliott Wave Theory. Elliott himself made the forecast of the super decade bull market in 1930s. The subject overshadows every other forecasting tool in terms of accuracy, both over short and long term. But still Elliott Wave remains difficult to understand and apply and continues to have many critics that dispute its value.

The Elliot Wave theory is based on crowd psychology. Human beings behave predictably in a group. Their transition from optimism to pessimism is translated to market movements and forms specific patterns that repeats over and over again. That’s why Elliot Waves theory can be applied not only to stock markets, but also for commodities, currency and practically in each situation that may reflect the psychology of its participants.

According to the wave principle, the market’s trend takes a five wave form, an impulse. A clear structure, sharp, fast, certain, just like the social mood behind it, clear and trended. Three of these five waves, which develop in the direction of the main trend and are called motive, or actionary waves, and two are counter trend movements, named corrective or reactionary waves.

After the certainty of the trend comes the uncertainty, between trends come counter trends, the five waves motive phase followed by the three waves correction. These three wave structures are more complex, mostly overlapping and sometimes unclear. The wave succession repeats itself and can be found at every time frame (degree), from multi-century to the smallest tick. Thus, the theory can be successfully applied for any time frame, by speculators, intraday traders and long term investors.

The complete market cycle consists of eight wave, five up and three down. Each actionary wave can be subdivided into another five wave structure of a smaller degree. For a clear structure, the motive waves are counted using numbers from 1 to 5, while the correctives are counted using a, b and c letters. Going further, there is a specific nomenclature that uses Arabic and Roman numerals and upper and lower case letters, to distinguish between different degrees of the trend. The nomenclature was first established by Ralph N Elliott and is still widely followed.

There are two basic rules that define an impulse. First, wave 2 never retraces more than wave 1. Second, Wave 3 is never the shortest, everything else is a guideline. Elliott wave theory requires patience and a meticulous observation of the markets. It is a test of discipline, test of fractal watching visual skill and test of identifying patterns. We at Orpheus also think it’s a test of common sense, which is extremely rare. The fractal theory of more than 130 years has proved that crowds herd and markets discount information fastest. But still, we humans believe in information and access to it as more important than an Index price history. This is despite the known fact that pattern recognition is considered as a top skill for professional success across a cross section of industries.

There are thirteen types of Elliott patterns. The Wave theory has a mathematical ground and is linked with non linear mathematics, Fibonacci sequence and the number Phi. Though Elliott witnessed the patterns in 1930’s, Charles Dow was the first one to observe them in 1880’s. Elliott was inspired by the Dow Theory and ended up redefining the basic five and proving that life indeed exist in a leaf.

Author: Orpheus | Date: 03 January 2009 | Comments (0)

Tags: Elliott

Categories: Primers

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BEATING THE MARKET – INDIA – The first rule of investment psychology is that mastering the market is easier than mastering yourself. Behaviorologists make a similar opinion, but differently. They say that if a majority cannot do it, then beating the market is an illusion. The subject has merit, but the guru’s are still busy highlighting how flawed conventional technical and fundamental research is rather than making predictions themselves. They also say that market behavior is like the toss of a coin, markets can’t add and subtract, more risk does not mean more return, beta is dead and other generalizations. Behaviorologists don’t have a strategy for 2009 or till 2012.The subject still focuses on the mistakes of majority, rather than the approach of smart investors like John Paulson, who profited a billion dollar gain betting on the crisis.

And he was not just alone. Jim Simons, Renaissance Technologies delivered 58% returns for 2008. A specialist in risk arbitrage, Paulson topped the charts by minimizing market correlations and long short risk arbitrage strategies. And some of these funds have survived despite a 40% fee. They delivered more than 70% annual returns in 2007. The recent Bloomberg Market cover story on richest hedge funds only confirms the point further that for a majority crying over a crisis, there will always be smart investors thriving. Medallion is almost exclusively owned by Renaissance employees, who include mathematicians, astrophysicists, statisticians and computer programmers. Just like some few, they too search for patterns.

We started the year with the call of decade high on Sensex in 2008. We saw the drop till 21 Jan as a correction when we wrote ‘Understanding Corrections’. We projected 18,000 as a key inflexion point. Prices pushed up from 15,332 till 18,895. Later on 31 Mar we wrote about the ‘Three legged Bear’, when we said, “Though marginal, we have seen an intermediate low in March.” The prices continued to hold up till 16 May, as prices continued to hover near 18,000 levels (17,735). Then we had the 4 Aug, ‘The late economic cycle’ writeup, where we talked about abstaining from early and mid economic sector components. It was then we clearly shifted our stand from investment to trading and talked about few weeks of upside and how to expect a bounce back till Q1 2009 was a low probability scenario. We said 18,000 was a best case. Prices bounced till 15,579 and turned back on 11 Sep. 08 Sep we also wrote about ‘The OCT decline’ where we said “October lows have extreme sentiments linked to them, making them potential bottoms.” Not only prices fell from a high of 15,107 by 50% down till 7,697, but 27 Oct lows held and prices moved up 42%. We are in Jan 2009 now and we don’t have a turn down yet.

What now? Starting Aug 1992, Sensex has shown an average 40 month cycle. Three of the 40 month cycle make a decade cycle. The first decade cycle ended in 2002 and the second decade cycle should end somewhere around 2012. We are now in the last 3.3 year cycle up. Since the markets have erased most of the gains made since the decade up cycle started in Sep 2001, the expected bounce should be choppy and time consuming. We won’t be surprised if prices retest Oct lows or breach them marginally early Q2 2009. And this means selective stock picking and better to minimize market exposure by doing quantitative long short strategies. 13,000 – 15,000 is an achievable high for Sensex in 2009.

BSEMETALS was the worst performing sector of the year at -72%. We expect it to deliver better returns, atleast for Q1 2009. We also expect BSEOIL to outperform Sensex over Q1 2009. Indian markets still lack instruments for doing advanced quantitative strategies. But long BSE500 short Sensex also seems an attractive pair for Q1 2009.

In conclusion, don’t get too much into the negative mode despite all crisis and majority is foolish talk. Try looking top down, give more weightage to back tested systems, understand fractals and cycles and read behavioral finance, it will definitely help you remove biases, even if not give you a market beating forecast.

Author: Orpheus | Date: 03 January 2009 | Comments (0)

Categories: Accuracy India, India

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