There are countless forms of technical analysis, but I have written this guide to describe 3 areas I personally like to use the most. This is a free educational resource. I may add to the guide over time. This guide may be downloaded as a .pdf file here.
A Wave Theory Primer
The “Wave Principle” was developed by Ralph Nelson Elliott in the 1930s, mostly forgotten about for decades, then returned to public attention by Robert Prechter, who also added many new things to the theory. I like to simply call the whole body of analysis “Wave Theory.”
There are a lot of really bad takes out there about Wave Theory, what it is, what it can do, and how it should be used. In a nutshell, Elliott took note of the fact that trending markets tend to move in five waves, while correcting—or consolidating—markets tend to move in three waves. That’s it. And it often turns out that this is true. And that can be very helpful to us. We label the impulse waves using the numbers 1-5, and we label the corrective waves using the letters A-C (with triangles A-E).
He also noted that these “waves” are fractal in nature. Within any given wave, one can find that it is itself composed of waves, all the way up and all the way down. Within the Theory, we call the 5-wave structures “impulse (or motive) waves,” and the 3-wave structures “corrective waves.” And so the whole Theory is us trying to take a stab at where we might be within all of that hot mess as we go along on all sorts of different timeframes. Are we in an impulse wave that has farther to go? Are we in a corrective wave that is coming to an end? On what timeframe? And on and on.
So, the basic impulse-corrective pattern looks like this:
5 waves up, 3 waves back down (or 5 waves down with 3 waves back up), and that will itself be a part of some larger pattern, but also each part of this pattern will itself be composed of smaller such patterns. Impulse waves are 5-3-5-3-5 structures (with one exception being one of the types of diagonals, which we will discuss later on).
Now, within all of this, there are only 3 “hard rules“ in the theory.
- Wave 2 must never retrace beyond the origin of wave 1
- Wave 4 must never terminate below the end of wave 1 (see diagonals later as the only exception to this)
- Wave 3 must never be the shortest wave
These rules are logical and there is no need to extrapolate more into them. For instance:
- Wave 2 must never retrace beyond the origin of wave 1—but this says nothing about wave 2 terminating above wave 1 (on the left, wave 2 terminates above wave 1, and we don’t care—so long as it doesn’t terminate below where wave 1 started; this is a running flat, which we will discuss later on)
- Wave 4 must never terminate below the end of wave 1—but if wave 4 is complex, parts of it may, it just can’t end below the end of wave 1 (in the middle, parts of wave 4’s triangle encroach into wave 1’s territory, but we don’t care because the final leg of the triangle is above it—we will discuss triangles later on)
- Wave 3 must never be the shortest wave—but this says nothing about requiring it to be the longest (on the right, wave 3 is weirdly short, but that’s ok because wave 5 is even shorter than that; we only care that wave 3 is not the shortest in an impulse wave)
If you follow these rules, you will be able to label something validly. Having a valid count doesn’t mean your count is right; there are always other ways to count things. But a valid count is a prerequisite to finding a good count.
Other than the “rules,” there are also many “guidelines.” These aren’t hard rules, but are generally some things to perhaps consider—this is all an art and not at all a science. Here are a few (but there are more, many of which require nuance and practice)
- Waves should be “proportional”
- One of the 3 motive waves in an a 5-wave pattern (the 1, 3 or 5) should be “extended”
- “Triangles” are commonly ”4th waves” or “B-Waves” (but can on occasion also be leading and ending diagonals)
- There are always tons of things that can go wrong (5th waves can truncate—fail to even make a new high or low—for instance, and all manner of other things)
Impulse waves are 5 wave structures. Many impulse waves look much like the ones I have drawn for examples so far, but at tops and bottoms it can be common to see diagonals. They can be either contracting or expanding, and for these, their wave fours must overlap their wave ones.
- In contracting diagonals, there is often an “overthrow” in the 5th wave (but not always)
- In expanding diagonals, the 5th waves can sometimes fall short (but not always)
- In every case, the 3rd waves must still not be the shortest waves
- And usually, each wave within an ending diagonal is itself composed of 3 waves, and in leading diagonals, each wave is composed of 5
- Some diagonals will resemble actual, regular triangles, which we will discuss later
As if normal impulse waves and then all the diagonal impulse waves weren’t enough, there are are even more corrective patterns. Corrective patterns will most often take the form of zig-zags, flats and triangles (there are complicated double- and triple-three combinations which have become very popular in the last few years, but I rarely find myself needing them—these are additions made by Prechter).
- Zig-zags are often sharp, sometimes retrace deeply; they are your standard pullbacks. These are 5-3-5 structures.
- There are 3 kinds of flats: regular flats, running flats and expanded flats. These are 3-3-5 structures. Regular flats tend to be sideways; running flats correct but don’t pull back, rather they “correct on the go,” in keeping with the trend they are “correcting”; and expanded flats make a first move (A), then B will retrace beyond the origin of A, but then C will go on to take out end of A, expanding in price during the correction before resuming in the original direction.
Triangles are another common corrective pattern, and like diagonals, they can either expand or contract.
- There are 5-swings within a triangle, and we label them A-E
- Each internal leg of a triangle should be composed of 3 wave moves
- Often the “E-Waves” violate the structure or fall short of it
- As noted previously, these should most commonly be found in 4th waves and B-Waves
- Sometimes leading and ending diagonals will assume the shape of a triangle, and will not make the more usual “rising” or “falling” wedge shapes; so if you see a triangle, don’t immediately assume you have more to go. Sometimes these are tops and bottoms
Fibonacci relationships between the lengths of waves is a huge topic that I cannot possibly address fully in a short guide. But, there’s much to measure if you’re keen to measure. One common thing to do when generating targets is to look for appropriate extension in motive waves and to look for appropriate retracement in corrective waves.
- 3rd waves often extend to some “.618” fib, commonly the 1.618 (but also sometimes the 2.618 or even 3.618) extension of the length of their respective wave “ones”
- 2nd wave pullbacks often retrace 50 or 61.8% of the wave ”ones” from which they came
- 4th waves often retrace 38.2% of the length of the wave “threes” from which they came
- Don’t assume for a hot minute that every wave will unfold these ways. These are just common things to look for but these are never hard and fast
Wave Theory recognizes the fractal nature of market structure, which means: each wave both composes other waves and is composed of other waves. Every wave is a part of a larger wave and every wave is made up of smaller waves.
To help to identify which waves we are labelling, we use “wave degrees.” Waves of a higher “degree” are made up of waves of smaller “degrees.”
On my website (and in my Discord), I color code the wave degrees to help them to stand distinct. The most common wave degrees you will find in my work are listed below, from smaller degrees at the top to larger degrees at the bottom of the table (there are both larger and smaller degrees beyond what is listed here, but they are uncommonly seen here in my work).
Let’s see how some of these ideas from this guide may be put together.
- Minor (green) 1 is a leading diagonal with an overthrow composed of 5 minute (blue) waves, which is followed by a 3-wave zig-zag pullback for minor (green) 2.
- Minor (green) 3 is a standard impulse wave composed of 5 minute (blue) waves. This wave has good extension in it.
- Minor (green) 4 is a running flat, correcting while still moving in the direction of the trend it is trying to correct.
- Minor (green) 5 is an expanding ending diagonal in which the final wave falls short of the trend line.
- In the A-B-C decline that corrects the advance, minor (green) A is an expanded flat, making a surprise new high before entering a triangle for minor (green) B in which there is an “e-wave violation” of the triangle that hunts stops before the final decline.
A Chart Pattern Primer
Chart patterns govern the majority of price action. The market moves between periods of excess, and periods of balance, moving from one level to another and consolidating in between them. As it does so, it usually creates “structures” that we can observe. We generally classify most of these structures as either “bullish” or ”bearish” structures, but there is sometimes a misconception about this. Some folks will often assume that a “bullish” structure “needs” to break up. But this is actually sort of backwards.
We are dealing with unknown future price at all times. It is not the case that a bullish pattern “should” break up, but quite something different: what we often find (in hindsight, only once unknown future price becomes known) is that long bullish motions in the market usually have “bullish” structures in them—and vice versa in bearish motions.
So, when we see a structure developing, identifying it is a test. We are testing whether a given bullish or bearish structure is going to lead to bullish or bearish motions in the market. So, I think it is important to get the logic right here: it’s not “if there is a bullish structure, the market will go up,” it’s “if the market goes up, it will often contain some bullish structures.” So the structures are hypotheses. Many people make a similar mistake with Wave Theory, which is often why it gets a bad rap. It’s not the labelling of a big “3rd wave advance” ahead of us that requires it to go up, it’s that a big bullish motion in the market very often has something resembling a 3rd wave advance in it.
Now, as it turns out, this is still often helpful to us. Big bullish trends—for instance—aren’t punctuated by bear flags all the way up. So identifying these structures can help us to at least rule some things out. At market turns, things are difficult, and that is often where these structures can fail, and I will discuss all of that in some more detail in what follows. They are also helpful because they allow us to generate targets.
I will divide the common patterns into these 3 categories:
- Bullish patterns
- Bearish patterns
- Price-agnostic patterns and some miscellaneous patterns and structures
- Bull flags typically have close to parallel rails, but little probes above and below can also be common short-term traps as the structure develops
- Bullish pennants usually form in rapidly advancing markets and will have some contraction in price
- Bullish (or falling) wedges are typically found at lows and can mark reversals
- Double bottoms (sometimes referred to as “W” bottoms) can also mark lows
- Ascending triangles can occur both in the middle of a market and as an accumulation pattern at a low
- And contrary to popular belief, inverse head & shoulders can be both bottoming formations (reversals) and continuation patterns (the “necklines” for these patterns are not always horizontal; they can slant up or down, but they shouldn’t slant too much
- Bear flags typically have close to parallel rails, but little probes above and below can also be common short-term traps as the structure develops
- Bearish pennants usually form in rapidly declining markets and will have some contraction in price
- Bearish (or rising) wedges are typically found at highs and can mark reversals
- Double tops (sometimes referred to as “M” tops) can also mark highs
- Descending triangles can occur both in the middle of a market and as a distribution pattern at a high
- And contrary to popular belief, head & shoulders can be both topping formations (reversals) and continuation patterns (the “necklines” for these patterns are not always horizontal; they can slant up or down, but they shouldn’t slant too much
Now we’ve seen the basic bullish and bearish patterns. Let’s take a look at how things can go terribly wrong.
In each and every case, all of these patterns can fail. When they do this, it’s because they were traps.
And when they fail, they will often do so right at the very moment when they look like they’re about to play out just as expected. Right as the bull flag breaks out, it can collapse there. Bullish wedge beginning to rally, then the rug gets pulled out. The “double bottom” can morph into a bear flag in an instant, etc.
Our job as analysts is to try our best to find when these might happen. Is sentiment too bullish in a bullish structure? Is volume increasing in a bull flag instead of decreasing? (More on volume later in the guide.) And on and on. There are a myriad of clues we can look for, not all of which I can fit into this short guide.
Just as with bullish structure failures, bearish structures can also fail in the exact same way.
In each and every case, all of these patterns can fail. When they do this, it’s because they were also traps.
And when they fail, they will often do so right at the very moment when they look like they’re about to play out just as expected. Right as the bear flag breaks down, it can rally there. Bearish wedge beginning to mature, then the structure morphs into something more like an ascending triangle, etc.
Our job as analysts is to try our best to find when these might happen. Is sentiment too bearish in a bearish structure? Is volume increasing in a bear flag instead of decreasing? (More on volume later in the guide.) And on and on. There are a myriad of clues we can look for, not all of which I can fit into this short guide.
Now that we have looked at some common bullish and bearish patterns and their failures, we can look at some price-agnostic patterns and a few miscellaneous structures as well.
- Symmetrical (contracting) and expanding triangles (broadening formations) can often go either way and can be found anywhere at highs, at lows and in the middle of markets.
- Diamonds can be reversal or continuation patterns in either direction, in both rising and falling markets
- Sideways trading ranges and basic bullish and bearish channels often govern price action
- And I will add cup & handle formations to this chart as well. They are more often seen on long timeframes (not often seen on short-term charts), but the part we are usually interested in has already been discussed above anyways: the “handles” are bull flags and bear flags (so this pattern is slightly repetitive in that regard).
A Brief Look at Momentum & Volume
Now that we have looked at Wave Theory and some of the classical chart patterns, we may look at some classical momentum oscillators. Two that I like are the RSI (Relative Strength Index) and the MACD (Moving Average Convergence/Divergence). There are others (such as Stochastics, etc.). These indicators “oscillate” back and forth in a range (and the settings on these can vary greatly and involve some personal preference). They help us to define overbought and oversold markets on any timeframe.
The key for most of these is looking for divergence between price and momentum, which can often signal trend reversals. In our example, at these two lows, while price was making its lowest low, the momentum oscillators made higher lows; and at our example high, when price made a new high at the high, the momentum oscillators made a lower high. They were signals. Sometimes momentum can cool at highs, and then pick right back up again, and sometimes divergence can persist for long periods, so divergences like these are not always immediate buy and sell signals, and should be incorporated with other things (like patterns!).
Another tool that I like to use is the Bollinger Bands. The invention of John Bollinger, they are bands that calculate statistical 2-standard deviations of price above and below a midline. This produces an “envelope” within which price remains most of the time.
There are two things we often try to use these for:
1.When price violates the bands, we know the move is statistically unusual, and price does not like to stay outside of the bands for long, and
2.When the bands contract, it can often mean a big move is coming soon after (though it does not tell us direction)
In fast rising and falling markets, price can remain outside of the bands for longer than we might think, and sometimes the bands can stay pinched longer than we thought possible. So, as with any indicator, these should be used in conjunction with other things (like momentum oscillators and patterns!).
My last remarks in this guide will be a few comments on volume. Volume is a crucial component of analysis. There are many, many things that can be monitored by means of volume, but I will just show a few hypothetical examples.
- Let us suppose we saw a bull flag on this instrument (but didn’t know at the time that it was going to fail). If you look carefully, as price fell into the “flag,” volume increased. In bullish consolidations, it’s best to see price decrease, so perhaps this would have warned us.
- Toward the low, let us suppose we saw an inverse head & shoulders pattern. In this case, as the structure entered the “right shoulder,” volume did decrease, which could have been a good sign.
- And finally, as it began to break out of that bottoming formation, we can see a huge increase in volume, showing some real conviction.
These are just a few examples of the many ways we can use volume to help assess our analyses.
I hope you have enjoyed this brief guide to some of my favorite areas of technical analysis.
By combining many of the tools discussed briefly above, one can develop strategies for navigating the market from a technical perspective. Combining that with a well thought out understanding of the macroeconomic forces which unfold around us can augment the technical picture that the tools above help us to develop.
If you are interested in seeing me apply some of these strategies in the market and learning about many of the nuances that cannot be easily communicated in such a short guide, I invite you join our community, either through subscribing to my newsletter on this website or by joining the Discord server.