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Home  >  Technical analysis  >  Elliott (Elliot) wave theory, principle, analysis


Elliott (Elliot) wave theory, principle, analysis



Elliot Wave Theory is one of the most important technical analysis's theories.

Theory named after Ralph Nelson Elliott, who concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves.

Based on rhythms found in nature, the theory suggests that the market moves up in a series of five waves and down in a series of three waves.

The key difference between the Elliott Wave Principle and other cyclical theories is that this theory suggests no absolute time requirements for a cycle to complete.

A brief history of the Elliott Wave Theory

Elliott discovered the Elliott Wave Theory in the 1930s. What he found was that the markets move about in recurring patterns. It took him years and years of study to detect and catalog these recurring wave patterns. He found that these wave patterns were based on Fibonacci numbers.

These wave patterns reflect the dealings or the emotions of humans in the market place and it is a mathematical mirror image of crowd psychology. Elliott alleged that this stream of emotions always exposed itself in the same recurring wave patterns, which subdivide into the same smaller patterns. The most important part of the theory that Elliott discovered was the fractal character of these market waves. Fractals are basically mathematical structures, which repeat themselves on smaller and smaller scales.

In the 1970s the Elliott Wave Principal gained a lot of popularity through the work of Robert Prechter and A.J. Frost. They published one of the most popular market books in history, the Elliott Wave Principal - key to stock market profits in 1978. In this book they predicted the great bull market of the 1980s and the market crash of 1987 almost exactly in time and price.

Waves' categories

The Elliott Wave Theory has assigned a series of categories to the waves in order of the largest to the smallest. They are:

  • Grand Supercycle
  • Supercycle
  • Cycle
  • Primary
  • Intermediate
  • Minor
  • Minute
  • Minuette
  • Sub-Minuette

The basic concepts of the Elliott Wave Theory:

  • Action is followed by reaction.
  • There are five waves in the direction of the main trend followed by three corrective waves (a "5-3" move).
  • A 5-3 move completes a cycle. This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.
  • The underlying 5-3 pattern remains constant, though the time span of each may vary.

To use the theory in everyday trading, the trader determines the main wave, or supercycle, goes long and then sells or shorts the position as the pattern runs out of steam and a reversal is eminent.

Elliott proposes, as well, that all price moves on the market are divided into:

  • five waves in the direction of the main trend (waves 1 to 5);
  • three corrective waves (waves A, B, C ).

The waves are divided into:

  • impulses that create a directed trend (bull or bear) and cause the market to move very actively (waves 1, 3, 5);
  • corrections (rollbacks) that are characterized by moving against the trend (waves 2, 4).

Elliott's main discovery was that market behavior could be identified and measured through a repeating eight wave sequence, consisting of 5 waves that he called "impulsive," followed by a 3-wave "corrective" sequence. Impulse waves are labeled numerically 1 through 5, corrective waves are labeled A, B and C, as per the following example:

You can see that the three waves in the direction of the trend are impulses, so these waves also have five waves. The waves against the trend are corrections and are composed of three waves.

The corrective wave formation normally has three, in some cases five or more, distinct price movements, two in the direction of the main correction (A and C) and one against it (B). Waves 2 and 4 in the above picture are corrections. These waves have the following structure:

Note that the waves A and C go in the direction of the shorter-term trend, and therefore are impulsive and composed of five waves, which is shown in the picture above.

An impulse-wave formation followed by a corrective wave, form an Elliott wave degree, consisting of trends and countertrends. Although the patterns pictured above are bullish, the same applies for bear markets, where the main trend is down.

Wave 1

The first impulse-wave, comprised of five internal waves - three impulsive (1, 3 & 5) and two corrective (2 & 4). Happens when the ?market psychology? is practically bearish. News are still negative. As a rule, it is very strong if it represents a leap (change from bear trend to the bull trend, penetration into the might resistance level, etc.). In a state of tranquillity, it usually demonstrates insignificant price moves in the background of general wavering.

Wave 2

A correction to wave 1. It will normally be comprised of three waves, A-B-C but can become more complex. Happens when the market rapidly rolls back from the recent, hard-won profitable positions. It can roll back to almost 100% of Wave 1, but not below its starting level. It usually makes 60% of Wave 1 and develops in the background of prevailing amount of investors preferring to fix their profits.

Wave 3

The second impulse-wave, comprised of five internal waves - three impulsive (1, 3 & 5) and two corrective (2 & 4). Commonly (but not always) wave 3 is the longest of the impulse waves. Is what the Elliott's followers live for. Rapid increase of investors' optimism is observed. It is the mightest and the longest wave of rise (it can never be the shortest) where prices are accelerated and the volumes are increased. A typical Wave 3 exceeds Wave 1 by, at least, 1.618 times, or even more.

Wave 4

The second corrective wave. It is a correction to wave 3. It will normally be comprised of three waves, A-B-C but can become more complex. Often difficult to identify. It usually rolls back by no more than 38% of Wave 3. Its depth and length are normally not very significant. Optimistic moods are still prevailing in the market. Wave 4 may not overlap Wave 2 until the five-wave cycle is a part of the end triangle.

Wave 5

The third and final impulse-wave, comprised of five internal waves - three impulsive (1, 3 & 5) and two corrective (2 & 4). It is also possible for wave-5 to develop as an extension (see extended waves). Is often identified using momentum divergences. The prices increases at middle-sized trade volumes. The wave is formed in the background of mass agiotage. At the end of the wave, the trade volumes often rise sharply.

Wave A

The first wave in a corrective pattern. In simple corrections (A-B-C) or linked combinations of A-B-C corrections, wave A will be constructed of five waves. However, in more complex corrections wave A is constructed of three waves. In the diagram shown, notice the wave A in waves (2), (4), the wave of one higher degree and the wave a in wave (B). Many traders still consider the rise to make a sharp come-back. But there appear some traders sure of the contrary. Characteristics of this wave are often very much the same as those of Wave 1.

Wave B

The second wave in a corrective pattern. Wave B is always constructed of three waves or a combination of three-wave patterns. It can be the most complex of all waves with a wide variety of three-wave combination patterns that can develop.

Often resembles Wave 4 very much and is very difficult to identify. Shows insignificant movements upwards on the rests of optimism.

Wave C

The third wave in a corrective pattern. In a simple corrective pattern (A-B-C) or a linked combinations of A-B-C corrections wave C is always constructed of five waves. However, in more complex corrections wave C is constructed of three waves.

The diagrams show a simple (A)-(B)-(C) on the left where the wave (C) is constructed of five waves. On the right we see a complex correction in which there are many examples of wave c (in blue) that are part of the triangular wave (B).

All the c waves (in blue) will be constructed of five waves as part of a series of a-b-c patterns. The third wave of this is a wave C (in green) which is constructed of three waves (ie a-b-c) and the final wave (C) (in red) is also constructed of five waves.

A strong decreasing wave in the background of general persuasion that a new, descreasing trend has started. In the meantime, some investors start buying cautiously. This wave is characterized by high momentum (five waves) and lengthiness up to 1.618-fold Wave 3.

Wave D

The fourth wave in a correction, being of a triangle. Wave D will always be constructed of three waves and will only appear in a triangle.

The diagram displays a wave (B) triangle in which wave D is constructed of three waves.

Wave E

The fifth wave in a correction, being of a triangle. Wave E will almost always be constructed of three waves and will only appear in a triangle. In very rare occasions this wave E can be constructed of a triangle itself and thus will be constructed of five waves of three.

The diagram displays a wave (B) triangle in which wave E is constructed of three waves to complete the triangle.

Corrective Wave Patterns

  • Zigzag
  • Flats
  • Triangles

Corrective waves are those that form corrective patterns against the main direction of the trend. For example, wave 2 corrects wave 1 and wave 4 corrects wave 3. Once a 5-wave pattern has been completed there will be a simple, or complex, correction of the entire move that will develop as a single or multiple three-wave move. The numbered phase of A-B-C waves are also corrective.

Elliott, Frost and Prechter classified 21 corrective patterns, from simple forms to more complex structures and combinations. Three of the simple patterns, and those which form the building blocks of the more complex structures, are illustrated below. These are corrective patterns following an uptrend. The patterns would be inverted following a downtrend.

Zigzag:

Zigzag patterns are sharp declines (or advances in a bear rally) that substantially correct the price level of the previous impulse sequence. Often wave B (the counter-trend wave of the ABC pattern) is the shortest relative to A and C. In zigzag patterns, the sequence may double or triple up until the price correction target is achieved. Zigzags internally subdivide 5-3-5 as follows: Wave A (5-waves, motive), Wave B (3-waves, corrective), Wave C (5-waves, motive).

Flats:

Flats are triangular structures that tend to move the market in a what Elliott called a "sidewise" (sideways) pattern. The ABC waves also tend to be equivalent in length. In the flat pattern, wave B will often undo the work of A and frequently tops in the area of the previous wave 5. Because of this action, wave B's tend to fake-out traders who think the correction is over. Wave C then undoes the work of wave B.

There are also variations on the flat correction pattern, which include "expanded" flats (Elliott described them as "irregular") in which wave B tops well beyond the start of wave A, and wave C is substantially larger than A, generally by 1.618 or 2.618 the length.

Expanded Flat

Occasionally in a correction the end of wave B will penetrate the extreme of the end of the impulsive wave. Wave C will normally retrace to the extreme of wave A. Wave A will be comprised of three waves. Wave C will be comprised of five waves. These normally occur before an extended wave and will signal a significant trend. This is also called an irregular correction.

In a "running" flat, waves A & B are similar to an expanded flat, but wave C is shorter than wave A. Flats internally subdivide 3-3-5 as follows: Wave A (3-waves, corrective), Wave B (3-waves, corrective), Wave C (5-waves, motive).

Triangles:

Elliott described two distinct types of triangles: Diagonal and Horizontal.

Diagonal Triangle

This is a five-wave pattern in which the waves are constructed of three waves. The pattern emerges normally between two rising (or falling) converging lines, though they can be parallel. It is most commonly found in wave 5 positions, but can also occur in wave A or wave C. In classic technical analysis it is called a wedge.

Diagonal triangles are part of ending sequences in a wave pattern, and therefore can occur within a wave 5 or a wave C. According to Elliott, diagonal triangles form when market action has moved "too far, too fast" and represent exhaustion of the trend. The 5th wave of the diagonal will frequently spike sharply above the upper trendline of the triangle in what Elliott called a "throw-over." A trader should be alert to a diagonal triangle formation, as it signals an impending and sharp trend reversal. Horizontal triangles, on the other hand, are corrective structures.

Also called "wedges," horizontal triangles are identified by drawing parallel trend lines along the peaks and troughs of the wave labels. D and E labels are added to fill out the sequence. In heavily corrective and choppy markets, there can be as many as 11 to 15 waves within the overall horizontal triangle structure. In all cases, the completion of a triangle pattern is normally followed by a sharp "thrust." The direction of the thrust is determined by the wave pattern in progress.

One unique type of triangle, that is related to the family of "irregular flats" is the "Running Triangle," which was described by Frost and Prechter as one in which Wave B of the triangle exceeds the start of Wave (A). Since Running Triangles are cousins to both flats and horizontal triangles, they are most common to fourth waves and other corrective wave patterns.

Internally, all subwaves in a triangle are "threes", which tend to overlap. The only exception is a structure identified by Frost and Prechter (though not originally by Elliott) called a "leading diagonal" triangle, which occurs in the first wave position and subdivides 5-3-5-3-5 (like an impulse wave). Unlike an ending diagonal, this structure implies a continuation of the trend. They caution, however, against confusing this with a progression of first and second waves, which is far more common.

Expanding Triangle

This is a five-wave pattern in which the waves are constructed of three waves. There are two different forms of this:

1) The pattern emerges normally between two rising (or falling) diverging lines. It is most commonly found in wave 5 positions and occur before a large reversal in trend direction.

2) The pattern emerges normally between one rising and one falling diverging lines. In this situation it is a continuation pattern and is merely an inverted standard triangle.

Corrective Combination Patterns

In forming more complex corrections, the basic corrective patterns may, and often do, combine to extend the corrective process. Most common is a doubling of the pattern, and less frequently, a tripling. These result in the following types of combinations:

  • Double Zigzags and Triple Zigzags (self-explanatory).

    This is an extended correction in which two ABC patterns occur with a Wave X separating them.
  • Double-Three: The components of a double-three include
    • Flats-Flat
    • Flat-Triangle
    • Zigzag-Flat
    • Zigzag-Triangle
  • Triple-Three: The components of a triple-three include
    • Flat-Flat-Flat
    • Flat-Flat-Triangle
    • Zigzag-Flat-Triangle
    • Zigzag-Flat-Flat

To help clarify the labeling when these combinations occur, Frost and Prechter devised the labels W, X and Y to identify the main sections of a double combination, and W, X, Y and Z for triple combinations.

Rules of Wave Labeling

Correctly labeling waves is at the heart of wave analysis. Incorrect labeling can prove very costly to a trader, and so it is important to observe the rules of labeling. Elliott established three simple rules that, if not observed, will invalidate a wave count:

  • Wave 3 can never be the shortest impulse wave.
  • Wave 2 can never exceed the start of Wave 1.
  • Wave 4 can never overlap Wave 1 (i.e., cross into the same price area).

Other types of waves:

Extended Wave

On occasion one of the impulsive waves can extend. An extending wave will be constructed of more than five internal waves, and the additional waves will be of the same degree as the others. Normally there will be 7 or 9 waves in an extended wave. Most often wave 3 will extend, but extensions in wave 5 are also very common.

Failed Fifth

A failed fifth wave occurs when the completion of the fifth wave does not penetrate the extreme of the third wave. It is indicative of either the price target having been met or a sharper reversal in prices.

5-3-5

This is a method of referring to a simple ABC pattern that is comprised of five-wave waves A and C divided by a three-wave wave B. The diagram shows this pattern.

Flat Correction

Occasionally in a correction the end of wave B will complete at the extreme of the end of the impulsive wave. Wave C will normally retrace to the extreme of wave A. Wave A will be comprised of three waves. Wave C will be comprised of five waves.

Impulse Wave

Impulse waves are those that define the main direction of the trending move. They are labeled as waves: 1, 3 and 5. They are comprised of five waves of lesser degree.

Irregular Flat

Occasionally in a correction the end of wave B will penetrate the extreme of the end of the impulsive wave. Wave C will normally retrace to the extreme of wave A. Wave A will be comprised of three waves. Wave C will be comprised of five waves. These normally occur before an extended wave and will signal a significant trend. This is also called an expanded flat.

Lettered Phase

Some analysts refer to the lettered phase. This refers to the section of the wave structure that forms the major corrective waves that are labeled A-B-C and occasionally also D and E.

Numbered Phase

Some analysts refer to the numbered phase. This refers to the section of the wave structure that forms the main direction of the trend. This is the five-wave moves including the two corrective waves, 2 and 4.

Triple Three

This is an extended correction in which three ABC patterns occur with a Wave X separating each of them.

In summary

Ellioticians classify price movements in patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves, whereas waves moving against the trend are called corrective waves. Elliott Wave Theory breaks down impulse waves and corrective waves into five primary and three primary movements respectively. The eight movements comprise a complete wave cycle. Time frames can range from 15 minutes to decades.

The challenging part of Elliott Wave Theory is figuring out the relativity of the wave structure. A corrective wave, for instance, could be composed sub impulsive and corrective ways. It is therefore crucial to determine the role of a wave in relation to the greater wave structure. Thus, the key to Elliot Waves is to be able to identify the wave context in question. Ellioticians also use Fibonacci retracements to predict the tops and bottoms of future waves.

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