One of the most common topics of conversation for traders is Elliott Wave analysis. Ironically, few traders actually apply this method because many are unsure about the intricacies of the Elliott Wave. In truth, correct analysis and counting of the waves can be a daunting task. However, even without the help of electronic wave analysis, traders should be able to enhance their profitability with a disciplined use of Elliott's method.
How It All Started
In the first half of the 20th century, Ralph Nelson Elliott concluded that financial markets have a striking resemblance to a basic harmony found in nature and postulated that price movements in financial markets follow patterns but not necessarily in time or amplitude. Elliott set up the Wave Principle on empirically derived rules for interpreting the price action.
Basics of Wave Analysis
Elliott postulated that financial prices unfold according to a basic rhythm or pattern: five waves in the direction of the trend and three waves counter trend. He named the five-wave upward movement an impulse wave, and the three-wave counter trend- a corrective wave.
Within the five-wave bull move, waves 1, 3 and 5 are called impulse waves. They are subdivided into five waves of smaller scale. The subwaves of impulse sequences are labeled with numbers. Waves 2 and 4 are corrective waves, subdividing into three smaller waves each. The subwaves of corrections are labeled with letters.
Waves of any degree in any series can be subdivided and then subdivided again into waves of a smaller degree, as follows:
IMPULSE CORRECTIVE CYCLE
Waves 1 1 2
First subdivisions 5 3 8
Second subdivisions
Subdivisions 21 13 34
Third subdivisions
Subdivisions 89 55 144
Elliott's Rules of Interpretation
Elliott identified three essential rules of interpretation of his wave principle:
Wave 2 may never retrace more than 100% of wave 1.
Wave 3 is never the shortest; most of the time the longest.
Wave 4 can never enter the price range of wave 1.
Characteristics of the Waves:
- Wave 1.
Wave 1 is difficult to identify because it appears to be more of a correction. It is often the shortest of the impulse waves. - Wave 2.
Wave 2 should be easier to identify due to its three-subwave structure. It tends to retrace by about .618% of the first wave. - Wave 3.
Wave 3 is usually the longest and it is never the shortest. It has a dynamic move, and the penetration of the top of Wave 1 attracts more demand in a bull market. Naturally, this makes for a good volume and fundamentals support the move. - Wave 4.
According to the rule of alternation, if wave 2 is complex, then wave 4 tends to have a less complex pattern and vice versa. Of course, Wave 4 can never enter the price range of Wave 1. - Wave 5.
Wave 5 can be dynamic and extended, as Figure 8 shows. By now everyone has figured out the long-term trend and these conditions can create a good overshooting scenario. - Wave A.
Wave A is difficult to catch through all the euphoria. A good hint comes from the break into five subwaves. - Wave B.
Wave B may be of different complexities and lengths since the last bulls are making their final mark in a previously rising market and the bears are testing the waters and starting to go short. - Wave C.
Wave C puts the stamp on the end of the trend. Following a bull market, wave C should fall below the bottom of wave A.
Impulse Waves - Variations
Elliott Wave identifies several extensions, which are not easy to use. In the five-wave sequence, one of the three impulse subwaves tends to generate an extension. These subdivisions are of nearly the same amplitude and duration as the larger-degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence.
Extensions can be useful guides to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Therefore, if the first and third waves have about the same magnitude, the fifth wave will probably be extended. Extensions may also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves.
FAILURES OR TRUNCATED FIFTHS
Elliott called failure any impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave.
Corrective Waves
Market swings tend to move easier with the trend of a larger degree than against it. Therefore, corrective waves can be highly complex, choppy and often difficult to interpret before completion.
The most important characteristic about corrections is that they never consist of five subwaves. Only impulse waves consist of five subwaves.
Elliott identified the following four corrective patterns:
1. Zigzags (5-3-5)
2. Flats (3-3-5)
3. Triangles (3-3-3-3-3)
4. Combined structures
Zigzags are simple three-wave patterns, subdivided into 5-3-5 structures, in which the extreme of wave B remains a significant distance from the beginning of wave A. Occasionally, a double zigzag formation may occur.
FLATS - Flat corrections have a 3-3-5 structures. The original movement of wave A lacks the momentum to develop into a full five waves, as in a zigzag. Wave B also lacks countertrend pressure and often ends at or beyond the start of wave A. Wave C usually finishes near the extreme of wave A, rather than significantly beyond it, as in a zigzag. Elliott identified four types of flats: regular, expanded, irregular and running.
TRIANGLES - Triangles tend to occur just before the final rally in the direction of the trend. They tend to be extended because of low volume and low volatility during a consolidation period. Triangles consist of five waves, labeled A-B-C-D-E, subdivided into three waves each. The four types of triangles are symmetrical, ascending, descending and expanding. After completion of a triangle, the final impulse wave of the larger trend is usually swift and has a price objective equal to the base of the triangle. This movement is called a thrust.
COMBINED STRUCTURES - In Elliott Wave analysis, zigzags and flats are often called threes. These combined structures consist of two or more threes separated by smaller three-wave movements, labeled X waves. For example, a double three may consist of a flat, a smaller zigzag-forming wave X and a second flat, or it might contain a zigzag , a smaller flat in wave X and a second zigzag. The combined structures are generally sideways formations reflecting market hesitation.
Conclusion
A disciplined analysis and a trained eye should help you get a good grip on Elliott's method. While it can be complex and time consuming, it is also an excellent approach to true forecasting.
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