The Elliott Wave Principle
Background & History
R N Elliott postulated his wave theory in the 1920's. It was forgotten by the investment community for some years following his death in 1948, his students thought it best to keep his discovery secret. A book called "Elliott Wave Principle - Key to Stock Market Profits" by A J Frost & Robert Prechter revived the theory and saw a new breed of chartists attempt to apply the theory to the futures markets in the 1970's.
The Elliott Wave Theory suggested that markets traded according to some sort of universal natural order rather than the result of a conflicting random walk theory.
The Broad Concept
The basic rhythm of the market unfolds as five waves up and three waves down. Each advancing wave (1, 3 and 5) is called an impulse wave and each down wave (2 and 4) is referred to as a corrective wave. .
The diagram below shows how the basic cycle can be further dissected to reveal each impulse wave containing five waves, including the bear market impulse moves.
The basic tenets of the theory are:
1. Action is followed by reaction
2. Movements in the direction of the trend divide into five waves and moves against the trend corrective waves divide into three waves
3. The cycle keeps repeating it self in ever expanding magnitude from Sub-minuette through nine categories to the Grand Super-cycle
4. The wave pattern exists irrespective of time. Waves may be stretched or compressed, but the underlying pattern is constant.
As a result of Prechter's work in the 1970's two more tenets emerged. They are:
Wave three is never the shortest.
Wave four never overlaps wave 1.
If wave four does overlap wave 1 then the move is probably not an impulse move, but an ABC correction.
Impulse Waves - Variations
Extensions
Any of the five impulse waves in one cycle, three up and two down, can result in an extension. Extensions are more common in wave five and three than wave one, but nevertheless can exists in any impulse wave. Not only primary impulse waves can extend but extensions within extensions can also exist, in the case of a telescopic type market.
The above diagram illustrates a fifth wave extension of a fifth wave extension, in descending magnitude. By the same token the same sort of extension within extension can exist in wave three, which is the next most common wave to make an extension.
Diagonal Triangles
These occur in the fifth wave generally as a result of the third wave going too far too fast. They borrow from the classic charting patterns of old and are essentially wedges, with each sub wave dividing into three. A rising wedge is bearish and often results in a sharp decline at least back to the inception point of the triangle began.
Failures
Elliott used the word failure to describe the failure of the market to make a new high (or low) as a result of the fifth wave. The fifth wave falling short of the third wave is a failure, which, is an exceptionally bearish signal.
Elliott Wave Principle - Variations
There are more variations in corrective waves than there are in impulse waves. Their complexity is often a function of the degree. That is as they become more varied they become more complex.
Corrections
Elliott suggested that market corrections generally fall into four categories:
Zigzag Correction
A zigzag A-B-C type correction has 5-3-5 sub waves. This includes the double zigzag variation.
The zigzag correction is the most basic a-b-c type correction. The above example is obviously a bull market correction, with the impulse moves being against the trend in the next degree. The waves have been broken into their subcomponents.
Flat Correction
A flat correction is also an A-B-C type correction and has 3-3-5 sub waves. It also has variations called irregular and running corrections.
The flat correction above is also a correction to a bull market. Wave C in any flat correction generally terminates very close to wave A rather than significantly lower as in a zigzag. the tell tale characteristic is of course the wave count, which is 3-3-5. This then gives rise to several variations while still adhering to the basic wave count.
Irregular Variations
There are two variations to the flat correction and both are referred to as irregular corrections.
The B wave could actually make a new high, in the case of a bull market and the C wave could extend beyond wave A as in the above diagram. Flat corrections are seen as mild corrections as they do less damage to the underlying trend than their zigzag cousins.
If wave C drops below wave A (as in diagram 51) it can be interpreted as having a negative, dampening effect on the next impulse move, in this case higher.
If on the other hand, the C wave were to fall short of a wave A, (as in Diagram 52) it could be interpreted as strengthening, supportive for the underlying trend and the next impulse wave.
Triangle Correction
A triangle correction is made up of five waves labelled as an 'a-b-c-d-e' type correction having 3-3-3-3-3 sub waves. There are four variations: ascending, descending, contracting and expanding.
The above diagram is an example of an ascending horizontal triangle. It has a flat top and a rising bottom. The other variations are descending, contracting and expanding, which should be self explanatory. The important thing to look for is the 3 wave sub-count within each wave of the triangle.
Double threes and triple threes
A single three is any zigzag or flat consisting of three basic waves A-B-C. Double threes are as the name implies a combination of two threes, two zigzags or two flats. Triple threes are yet another three tacked on. The intermediate wave is referred to as an X wave.
The example above is a double three made up of two flat corrections.
Complex Combinations
It is important to keep in mind which particular degree of complexity the structure is in. A correction may start off as a simple flat correction as in the example below (see diagram 55) the first a-b-c is merely the A part of the correction.
It's not until the C leg breaks below wave a of B, that we can actually say that the centre three wave, B wave, is complete and we can then look for a C wave decline. The C leg can be a 3 or 5 wave decline, as it is against the underlying trend of the market.
During any correction the waves in the same direction as the underlying trend are always in 3's while the counter move waves, against the trend can be either 3 wave or 5 wave legs.
Associated Rules and Guidelines
The Rule of Alternation
This rule should be kept in mind at all times when analysing wave formations and projecting targets. Alternating patterns should be expected in all wave formations.
The most basic aspect of this rule can be applied to corrections and it virtually states that no two sequential corrections of the same magnitude will ever be the same type. For example if wave two is a simple correction, then wave four will most likely be complex.
Simple corrections are usually zigzag's or basic flat corrections, while complex corrections are more likely to be triangles, double threes, intricate flats or any other complex pattern.
The same rule can be applied to large magnitude complex corrections. A complex three for example will probably alternate between patterns. For example a large correction might start with a flat ABC type correction and then be followed with a zigzag. Alternatively if the correction started with a zigzag we could expect a flat to follow.
Strength of Trends
Corrective patterns provide a lot of information about the strength of an underlying or subsequent trend. The slope of the impulse waves can also be revealing with respect to the underlying trend.
In general zigzags indicate ordinary or normal conditions and therefore normal trend strength. Complex corrections on the other hand denote a strong trend and often occur prior to or immediately after an extension. Extensions are also a sign of strength.
Zigzag or double zigzags indicate ordinary strength
Flat and Irregular corrections indicate a strong trend
Running corrections reveal an unusually strong trend
Double and triple threes indicate a strong trend
Triangles indicate thrust, swift but short
Depth of corrective Waves
How low can you go? A vital piece of information is provided by Elliott wave theory when it comes to market corrections. The rule is that corrections, especially wave four corrections, tend to terminate within the range of the previous wave four by lessor degree. The most likely level of retracement is the bottom of wave for by lessor degree.
Wave equality
It is one of the tenets of Elliott wave theory that two impulse waves will always tend toward the same size in both time and price. It generally holds true for two non-extended waves and especially true if wave 3 is an extension. If two of the waves are not perfectly equal then the relationship is probably a multiple of 0.618.
Correct counting - Overlaps and Wave Length
Wave four should never overlap wave one
Wave three is often the longest and never the shortest
Alternative Counting
There are often alternative counts, which is a tool that can be employed to isolate the correct count. Hindsight will always provide the ultimate resolution. But it is very handy to have a "if this happens, then it can't be this count and therefore it must be the alternative one" type of tool in our arsenal. Therefore there is an alternative to the above count.
Time Frames
The most common time frame for an intra day chart is an hourly chart, however when analysing large samples of time an hourly chart can become unworkable. Percentage charts or semi-log charts are best when analysing large market moves that may span decades. Daily charts are of course most apt and a standard when applying Elliott wave principles.
The foremost aim of wave classification under the Elliott wave theory system is to determine where we are in the cycle. This is easy to do in a clear wave count, which is often the case for fast moving or extending markets. As long as you can see fives waves you've got a start.
It's not so easy in tired and choppy markets. Complexity and lethargy are often frustrating for any analyst, but especially for the Elliott wave analyst. It has often been suggested that when the market rests the trader should also take a rest.
Channels
Parallel trend channels can be employed to assist in determining a potential target and/or market developments. One can start drawing the channel at the termination of wave 2. The bottom trend line is an extension of the trend line drawn from the inception point of the new wave formation and the bottom of wave two. A parallel trend line can then be extrapolated from the top of wave one and provides a logical target fro the termination of wave three.
Quite often wave three will extend beyond the high side of the original channel, in which case the channel should be revised. A new top line should be drawn through the top of wave one and wave three, a parallel line is then drawn through the bottom of wave two and a new channel should be the result.
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