Elliott Wave Principle



Ralph Nelson Elliott (1871–1948), a professional accountant proposed that market prices unfold in specific patterns, which practitioners today call "Elliott waves”. Elliott published his theory of market behaviour in the book The Wave Principle in 1938.

Elliott stated that, while stock market prices may appear random and unpredictable, they actually follow predictable, natural laws and can be measured and forecast using Fibonacci numbers. Soon after the publication of The Wave Principle, Financial World magazine commissioned Elliott to write twelve articles (under the same title as his book) describing his new method of market forecasting. In the years after Elliott's death, other practitioners (including Charles Collins, Hamilton Bolton, Richard Russell and A.J. Frost) continued to use the wave principle and provide forecasts to investors.

Frost and Robert Prechter wrote “Elliott Wave Principle”, published in 1978. This work is considered the de facto guide to R.N Elliott’s theory and indeed Robert Prechter's prominence as a forecaster during the bull market of the 1980s helped bring Elliott's wave principle back to market analysts attention during that time.

Elliott Wave Rules and Guidelines

A correct Elliott wave count must observe three rules:

  • Wave 2 never retraces more than 100% of wave 1.
  • Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.
  • Wave 4 does not overlap with the price territory of wave 1, except in the rare case of a diagonal triangle formation.
A common guideline called "alternation" observes that in a five-wave pattern, waves 2 and

4 often take alternate forms; a simple sharp move in wave 2, for example, suggests a complex mild move in wave 4. Corrective wave patterns unfold in forms known as zigzags, flats, or triangles. In turn these corrective patterns can come together to form more complex corrections.[3] Similarly, a triangular corrective pattern is formed usually in wave 4, but very rarely in wave 2, and is the indication of the end of a correction.

The Elliott Wave Principle suggests 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.

Wave Degree

The patterns link to form five and three-wave structures which themselves underlie self- similar wave structures of increasing size or higher degree. Note the lowermost of the three idealised cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of the wave one degree higher is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold according to the five and three- wave structure which it underlies one degree higher. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.
Each degree of a pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree—numbers for motive waves, letters for corrective waves (shown in the highest of the three idealised series of wave structures or degrees). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.

The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

  • Grand Super Cycle: multi-century
  • Super Cycle: multi-decade (about 40–70 years)
  • Cycle: one year to several years (or even several decades under an Elliott Extension)
  • Primary: a few months to a couple of years
  • Intermediate: weeks to months
  • Minor: weeks
  • Minute: days
  • Minuette: hours
  • Subminuette: minutes
Wave Labelling (Nomenclature)

The following table shows the commonly accepted labelling of the Elliott Waves at each degree. We use this labelling on all of our charts with the addition of the colour coding shown in the right hand column. Fibonacci Extensions shown on our charts are also colour coded such that each set of extensions is coloured to reflect the associated wave degree being analysed.

The illustration Below you depicts the general pattern that markets follow. The trend moves up in 5 waves and then corrects in 3–labeled A-B-C. But remember, this is happening on all time frames at the same time, from a tick chart all the way up to yearly and decade charts (and longer).

The opposite is also true in a down trend, where the market moves down in 5 waves and

then corrects upwards in 3.

This next illustration shows how this plays out:

A 5 wave pattern creates Wave 1 on a larger time frame. This is followed by a 3-wave correction which creates Wave 2 on that larger time frame, and so on. The 5-3 patterns on a shorter time frame are the building blocks for longer-term 5-3 patterns.

Elliott Wave Characteristics

Elliott wave analysis dictates that each individual wave has its own characteristics which typically reflects the physiology of the moment. Understanding those personalities is key to the application of the Wave Principle; they are defined below. (Definitions assume a bull market in equities; the characteristics apply in reverse in bear markets.)

Five wave pattern (dominant trend)
Three wave pattern (corrective trend)

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

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 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) of the wave one gains, and prices should fall in a three wave pattern.

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 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 C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realises 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. 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.

We would encourage members to also watch the series of video tutorials inn this section on the Elliott Wave Principle to further enhance your understanding, For those also wanting to study the theory in greater depth we recommend the following reading:

The Elliott Wave Principle Frost & Prechter
Five Waves to Financial Freedom - Ramki N. Ramakrishnan
Mastering Elliott Wave Principle - Constance Brown
 
 
 

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