Commodity Futures

Elliott Wave Principle and Commodity Market Psychology

Anand James, Commodity Analyst, Geojit

Named after Mr. Ralph Nelson Elliott (1871-1948), who developed the concept in the 1930s, the Elliott Wave Principle is considered one of the best forecasting tool ever, giving a detailed description of how markets behave.
One of the principle’s main propositions is that the collective investor psychology moves from optimism to pessimism and back again. When this aspect of the human nature take effect on the markets, it takes forms and patterns which are recognizable. The wave principle says that in markets progress ultimately takes the form of 5 waves and correct in 3 waves. The waves labeled 1,3,5 in the dominant 5 wave pattern effect the directional movement, while the 2 and 4 waves are counter moves against the dominant trend. The corrective pattern to this dominant 5 wave trend evolves in 3 wave pattern and is labeled A, B, C. Even though there could be various extensions and variations to each wave, and each wave could again subdivide in subwaves, or could be a part of a bigger trend., this article has limited the discussion of nomenclature to the 5 + 3 pattern, for simplicity stake.
Let us look at a complete 8 wave (5 directional move and 3 corrective moves) in a bull trend, and the general psychology around each wave.
Wave 1. This rise may signal the bottom of a major bear trend. At the start of this wave, fundamental analysts may still be lowering their demand forecasts, and giving out pessimistic price forecasts, mood could be overwhelmingly bearish, keeping sentiments and volumes low.
Wave 2. This is the profit booking move after the Wave 1. The news coming out at this stage is still bad, and the normal investors are still wedded to the belief that prices are still in a major downtrend.
Wave 3. This is often the strongest and the largest of the 5 waves, and would signal change of pessimism to optimism, where more people try get into the trend with renewed enthusiasm.
Wave 4. This is the profit booking move after the Wave 3. This is often seen as the corrective dip for those investors who has spotted the trend right, and has also judged the one more thrust (Wave 5) is possible.
Wave 5. This wave is not as big as Wave 3, and signals the end of the trend.
The next three waves are corrective to the dominant 5 wave trend. Of these, in wave A investors are still positive, and they see the dip as yet another opportunity to buy into the bull trend. In Wave B, prices reverse higher again, assuring those investors that bought into the wave A, and those that stayed away that bull trend is not all over again. However, fundamental news do not improve any more at this point, and volumes are generally lower than wave A. Wave C is the third leg of the corrective downside move, by which time, most investors awake to the reality that the bull market had long ended. Volumes at this stage are higher and moves are sharp.
Of course, there are arithmetic formulae used for judging the beginning and end of each wave and the relationship to each other, but they are outside the scope of this article. But let us now look at how a normal investor in Commodities market can make use of this theory.
• Even though it is practically impossible to exactly pick the wave 1 (or the start of a bull trend), a closer look at the news flowing out could tell you atleast to avoid being too bearish at the market.
• Wave 3 is mostly the best and the strongest part of a trend, and hence the most rewarding. To pick this move, one has to stay close enough to the market to sense that a wave 1 and 2 might have taken place.
• During Fifth wave moves in commodities, there would be a plentitude of fear of inflation/war, and at times ridiculous news flowing out, or highly charged up investors who are blindly positive about the market. We have seen such euphoric news coming out in Crude Oil market, just before, there is a big correction. Ideally, 5th wave is when one has to begin booking the profits one by one of those longs entered earlier. Entering longs at this juncture is not entirely discouraged, but investors are best advised to stay close to the market at this point of time to position oneself for a quick exit. A strategy that very often fails a normal investor at this point of time, is when he takes long “ with a supposedly “long term strategy” as he is ignorant about the fact that this 5th wave is the last of the major bull trend. It pays well to note that wave 5 may be shorter than the wave 3, and may be at the back of the investors’ mind, for he may have either participated in it in a small way or may have completely stayed away, both of which gives him reason for holding longs, even though prices start falling.
• Corrective B wave is one of the worst part of a trend, where in the mood of the market resembles wave 5, injecting false enthusiasm into the market, luring people into longs, when infact, the market is accumulating enough for a sharper downside C wave.
To summarize, it helps to know, that trends unfold in waves. An investor would hence know, even if the fundamentals may not seemingly match at some point of time, they fall into larger picture. Even a brief understanding of Elliott Wave Principle, ideally makes them less disillusioned by the markets and could help in timing the entry/exit.