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Basically, The Elliott Wave Principle is a form of technical analysis
that traders use to analyze financial market cycles and forecast market trends
by identifying extremes in investor psychology, highs and lows in prices, and
other collective factors. He proposed that market prices unfold in
specific patterns, which practitioners today call Elliott waves, or simply waves.
The Elliott Wave Principle posits that collective investor
psychology, or crowd psychology, moves between optimism and pessimism in
natural sequences. These mood swings create patterns evidenced in the price
movements of markets at every degree of trend or time scale.
In Elliott's model, market prices alternate between an
impulsive, or motive phase, and a corrective phase on all time scales of trend,
as the illustration shows. Impulses are always subdivided into a set of 5
lower-degree waves, alternating again between motive and corrective character,
so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces
of waves 1 and 3. Corrective waves subdivide into 3 smaller-degree waves
starting with a five-wave counter-trend impulse, a retrace, and another
impulse. In a bear market the dominant trend is downward, so the pattern is
reversed—five waves down and three up. Motive waves always move with the trend,
while corrective waves move against it.
Five wave pattern (dominant trend)
Wave 2: Wave two corrects wave one, but can never extend
beyond the starting point of wave one. Typically, the news is still bad. As
prices retest the prior low, bearish sentiment quickly builds, and "the
crowd" haughtily reminds all that the bear market is still deeply
ensconced. Still, some positive signs appear for those who are looking: volume
should be lower during wave two than during wave one, prices usually do not retrace
more than 61.8% (see Fibonacci section below) of the wave one gains, and prices
should fall in a three wave pattern.
Wave 3: Wave three is usually the largest and most powerful
wave in a trend (although some research suggests that in commodity markets,
wave five is the largest). The news is now positive and fundamental analysts
start to raise earnings estimates. Prices rise quickly, corrections are
short-lived and shallow. Anyone looking to "get in on a pullback"
will likely miss the boat. As wave three starts, the news is probably still
bearish, and most market players remain negative; but by wave three's midpoint,
"the crowd" will often join the new bullish trend. Wave three often
extends wave one by a ratio of 1.618:1.
Wave 4: Wave four is typically clearly corrective. Prices
may meander sideways for an extended period, and wave four typically retraces
less than 38.2% of wave three (see Fibonacci relationships below). Volume is
well below than that of wave three. This is a good place to buy a pull back if
you understand the potential ahead for wave 5. Still, fourth waves are often
frustrating because of their lack of progress in the larger trend.
Wave 5: Wave five is the final leg in the direction of the
dominant trend. The news is almost universally positive and everyone is
bullish. Unfortunately, this is when many average investors finally buy in,
right before the top. Volume is often lower in wave five than in wave three,
and many momentum indicators start to show divergences (prices reach a new high
but the indicators do not reach a new peak). At the end of a major bull market,
bears may very well be ridiculed (recall how forecasts for a top in the stock
market during 2000 were received).
Three wave pattern (corrective trend)
Wave A: Corrections are typically harder to identify than
impulse moves. In wave A of a bear market, the fundamental news is usually
still positive. Most analysts see the drop as a correction in a still-active
bull market. Some technical indicators that accompany wave A include increased
volume, rising implied volatility in the options markets and possibly a turn
higher in open interest in related futures markets.
Wave B: Prices reverse higher, which many see as a
resumption of the now long-gone bull market. Those familiar with classical
technical analysis may see the peak as the right shoulder of a head and
shoulders reversal pattern. The volume during wave B should be lower than in
wave A. By this point, fundamentals are probably no longer improving, but they
most likely have not yet turned negative.
Wave C: Prices move impulsively lower in five waves. Volume
picks up, and by the third leg of wave C, almost everyone realizes that a bear
market is firmly entrenched. Wave C is typically at least as large as wave A
and often extends to 1.618 times wave A or beyond.
Basic Sequence
There are two
types of waves: impulse and corrective. Impulse waves move in the direction of
the larger degree wave. When the larger degree wave is up, advancing waves are
impulsive and declining waves are corrective. When the larger degree wave is
down, impulse waves are down and corrective waves are up. Impulse waves, also
called motive waves, move with the bigger trend or larger degree wave.
Corrective waves move against the larger degree wave.
The chart above
shows a rising 5-wave sequence. The entire wave is up as it moves from the
lower left to the upper right of the chart. Waves 1,3 and 5 are impulse waves
because they move with the trend. Waves 2 and 4 are corrective waves because
they move against this bigger trend. A basic impulse advance forms a 5-wave
sequence.
A basic
corrective wave forms with three waves, typically a, b and c. The chart below
shows an abc corrective sequence. Notice that waves a and c are impulse waves
(green). This is because they are in the direction of the larger degree wave.
This entire move is clearly down, which represents the larger degree wave.
Waves a and c move with the larger degree wave and are therefore impulse waves.
Wave b, on the other hand, moves against the larger degree wave and is a
corrective wave (red).
Combining a
basic 5 wave impulse sequence with a basic 3 wave corrective sequence yields a
complete Elliott Wave sequence, which is a total of 8 waves. According to
Elliott, this complete sequence is divided into two distinct phases: the
impulse phase and the corrective phase. The abc corrective phase represents a
correction of the larger impulse phase.
These 8-wave
charts show two larger degree waves (I and II) as well as the lesser degree
waves within these larger degree waves. Waves 1-2-3-4-5 are one lesser degree
than Wave I. By extension, Wave I is one larger degree than Waves 1-2-3-4-5.
Waves a-b-c are one lesser degree than Wave II.
Fractal Nature
Elliott Wave is
fractal. This means that wave structure for the GrandSuper Cycle is the same as
for the minuette. No matter how big or small the wave degree, impulse waves
take on a 5-wave sequence and corrective waves take on a 3-wave sequence. Any
impulse wave subdivides into 5 smaller waves. Any corrective wave subdivides
into three smaller waves. The charts below show the fractal nature of Elliott
Wave in action.
Three Rules
Believe it or
not, there are only three rules when it comes to interpreting Elliott Wave.
There are many guidelines, but only three HARD rules. These are unbreakable.
Guidelines, on the other hand, are bendable and subject to interpretation.
Furthermore, these rules only apply to a 5-wave impulse sequence. Correction,
which are much more complicated, are given more leeway when it comes to interpretation.
Rule 1: Wave 2 cannot
retrace more than 100% of Wave 1.
Rule 2: Wave 3 can
never be the shortest of the three impulse waves.
Rule 3: Wave 4 can
never overlap Wave 1.
Wave 2 cannot
move below the low of Wave 1. A break below this low would call for a re-count.
Even though Wave 3 is typically the longest of the three impulse waves, there
is a specific rule that it cannot be the shortest. 1 or 5 can be longer than
Wave 3, but both cannot be longer than Wave 3. It is probably best to use
percentages or log scales when measuring Wave length. Elliott Wave indicates that
Wave 3 must exceed the high of Wave 1. Failure to exceed this high would call
for a re-count. Impulse moves are all about making progress. Failure to exceed
the high of Wave 2 would not be making progress. The third, and final rule, is
that Wave 4 cannot overlap Wave 1, which means the low of Wave 4 cannot exceed
the high of Wave 1. Such a violation would call for a re-count.
Three Guidelines
There are
numerous guidelines, but this article will focus on three key guidelines. In
contrast to rules, guidelines should hold true most of the time, not
necessarily all of the time.
Guideline 1: When Wave 3
is the longest impulse wave, Wave 5 will approximately equal Wave 1.
Guideline 2: The forms for
Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, Wave 4 will
be a flat correction. If Wave 2 is flat, Wave 4 will be sharp.
Guideline 3: After a
5-wave impulse advance, corrections (abc) usually end in the area of prior Wave
4 low.
The first
guideline is useful for targeting the end of Wave 5. Even though Wave 5 could
be longer than Wave 3 and Wave 3 could still be longer than Wave 1, chartists
can make initial Wave 5 projections once Wave 4 ends. In a larger uptrend,
chartists simply apply the length of Wave 1 (percentage change) to the low of
Wave 4 for an upside target. The opposite is true for a 5-wave decline. The
percentage decline in Wave 1 would be applied to the high of Wave 4 for a Wave
5 estimate.
The guideline
of alternation (2) is useful for determining the time of correction for Wave 4.
After a sharp decline for Wave 2, chartists can expect a relatively flat
correction for Wave 4. If Wave 2 is relatively flat, then chartists can expect
a relatively sharp Wave 4. In practice, Wave 2 tends to be a rather sharp wave
that retraces a large portion of Wave 1. Wave 4 comes after an extended Wave 3.
This Wave 4 marks more of a consolidation that lays the groundwork for a Wave 5
trend resumption.
The third
guideline is useful for estimating the end of a Wave II correction after a Wave
I advance. Waves I and II are the larger degree waves. Waves 1-2-3-4-5 are
lesser degree waves within Wave I. Once the Wave II correction unfolds,
chartists can estimate its end by looking at the end of the prior wave 4
(lesser degree wave 4). In a larger degree uptrend, Wave II would be expected
to bottom near the low of lesser degree Wave 4. In a larger degree downtrend,
Wave II would be expected to peak near the high of lesser degree Wave 4.