- 2002: Volume 11, No. 3 Introduction to Elliott Waves

The Elliott Wave Theory was proposed in the early 1930s by R.N. Elliott, a stock market speculator, as the next logical step after Dow Theory. Elliott focused on classifying market activity according to a set of cycles and ratios of movements. As with the waves on the ocean, market activity ebbs and flows in cycles that repeat and can be subdivided into smaller cycles.

The theory states that markets move in repetitive patterns; a five wave advance (impulse waves) and a three wave decline (corrective waves, labeled with letters). This cycle of eight waves can be seen in all time frames from intraday to what Elliott called the "Grand Supercycle" of over 200 years. Each wave in a cycle can be subdivided into smaller cycles.

The diagram below shows how an eight wave cycle advances in five waves and declines in three. One of the rising impulse waves has been broken down into five smaller waves.

Figure 1

One important concept to remember that will tie together several advanced technical analyses is that the wave counts of the cycles and their sub-cycles follow the Fibonacci sequence. The two part cycle has three corrective waves and five impulse waves for a total of eight waves. That is the sequence 1,2,3,5,8 where any number in the sequence is the sum of the two numbers preceding it. Further subdivision of the waves will yield wave counts that follow the Fibonacci sequence higher.

Logical Rationale

While the mathematics of waves and Fibonacci sequences are critical in understanding Elliott Waves, the human behavior underlying the resultant cycles is also important. The "personalities" of waves, as first interpreted by Elliott Wave specialist Robert Prechter, categorize why the waves rise and fall like they do.

Wave "1" includes the changing of market opinion from bearish to bullish. It often is driven by a rebound from depressed prices and is the shortest of the rising impulse waves. Basically, the bargain hunting has begun.

Wave "2" is a retracement of wave "1". Most, if not all of the gains from wave "1" are erased because market participants have used this rally to sell their losing positions at slightly better prices. This wave often presents itself as the right shoulder of a head and shoulders pattern.

Wave "3" represents when the reversal patterns completed by the first two waves break into the new trend. This is the longest and strongest of the impulse waves, at least in the financial markets, as most technical patterns have signaled the new trend and market participants now rush in to follow it.

Wave "4" is the consolidation phase of the advance. Its structure is also fairly complex, yielding many common continuation patterns such as triangles. This wave may never drop below the peak of wave "1".

Wave "5" is final stage of the advance and often shows a divergence with such technical indicators as cumulative volume and relative strength (RSI).

Wave "a" at first appears to be a normal correction to the rally. Elliott Theory says that wave "a" will break down into five, not three, sub-waves. A market move in five waves indicates a new dominant market direction.

Wave "b" is the bear market correction allowing a second chance for sellers to sell.

Wave "c" typically breaks support and the peak of wave "3". Here, many technical indicators confirm that the original rally is over.

Identifying waves is often a difficult activity because there are a number of exceptions and variations in the waves. These deserve a separate discussion for themselves.

The final point to mention is that Fibonacci ratios provide targets for price moves and typically coincide with wave peaks and troughs. The chart below of the Dow Industrials for 300 days shows the bull market interpretation of the US stock market. The peak near 4000 can be considered the end of wave "5" and the start of wave "a". Notice how the Fibonacci retracement levels of the corrective phase (a,b,c) provided resistance to the following impulse waves. The danger here is that our simple interpretation (no consideration of other technical indicators or Elliott extensions and other variations) does not take into account that wave "1" does not rise above the peak of the previous wave "5". This could be cause for revising the bull case to a bear case.

Figure 2

Wave Construction
Elliott Waves measure the ebb and flow of market activity in all time frames. Because they seek to incorporate the crowd psychology component in markets, they help determine the difference between sustainable and dying rallies and declines. Let's examine some additional rules and explanations for various wave concepts such as alternation and complex waves.

The most important thing to know when starting an Elliott analysis is simply where the market is right now. This means that a long-term perspective is critical, even to short-term traders. For example, if a daily chart shows a wave pattern of advance, decline and advance, a weekly chart may reveal whether the waves are part of a new bull market or a completed bear market rally.

The chart found in Figure 3 shows 1-1/2 years of daily prices for the U.S. Dollar/Japanese Yen cross rate. Clearly the April 1995 bottom was a major turning point in the market. We can assume that the 79 level is the start of a five-wave advance in which the major Elliott waves are labeled with numbers.

Figure 3

Note that within each of the major waves there are minor waves. These waves can be simple corrective waves, labeled with small letters a, b and c, or more complex consolidation patterns. We now can see one of the basic rules of Elliott Waves—the rule of alternation. Corrective Waves 2 and 4 alternate between simple and complex forms. For example, note that Wave 2 is a simple, and fast, drop that corrects Wave 1. Short-term charts would reveal that the two-day fall had the a-b-c wave pattern that is difficult to see here. In contrast, Wave 4 not only takes on the shape of a triangle, it takes weeks to complete.

The danger with using Elliott Wave isolation is that waves can be mislabeled. For example, in August 1995, the peak noted with an arrow could have been considered to be the final wave of the major Wave 3. After all, there were logical turning points to be used in the analysis. However, Elliott Waves are not just measuring turning points in prices. They measure turning points in market psychology as well. This means that the final leg of a rally, the part driven by the late buyers and weak hands, is generally accomplished on deteriorating market momentum, volume and breadth. The example here showed a rising 9-day RSI (relative strength index) indicating improving conditions. Major Wave 3 ended with a bearish divergence between price and RSI.

Let's now look at major Waves 4 and 5. If the small triangle could be Wave 4 as discussed earlier, why couldn't the triangle continue to include the next peak and trough ending December 1995? The answer depends on additional rules and concepts that are more advanced. For that part of the move, the novice Elliottician should rely on other technical tools.

Given the hindsight available now, ending major Wave 4 in December would mean that the trough in April 1996 was the end of the minor Wave 4. This is very unlikely as prices fell to the bottom of the presumed minor Wave 2. An equal or lower low is a basic condition for a trend reversal and would not have been consistent with the five-wave rally we are analyzing.

As we can see, Elliott Waves are a difficult subject and require both further study and market experience before being used to make actual trading decisions. This edition of Chartist Corner is still very basic in scope and should be used in conjunction with an introduction edition. In a future edition, we will cover price projections using Fibonacci ratios to see how both retracement and trend objectives can be set.

The Wave Principle
The novice Elliott Wave technician must learn to recognize the differences between trending waves and correcting waves. Using the basic rules of the Wave Principle, most markets can be labeled with a modest amount of analysis.

Impulse Waves
Impulses are the waves that move the market in the direction of the trend. They are relatively easy to recognize and follow a few basic rules. Within impulse waves:

• Wave 2 never retraces 100 percent of Wave 1.
• Wave 3 always travels beyond the end of Wave 1.
• Wave 4 never moves past the end of Wave 1 (overlap).
• Wave 3 is never the shortest of the impulsive sub-waves within a larger impulse wave.

Figure 4

The next set of definitions and rules are still easy to keep in mind. As most casual observers of Elliott will criticize, there are many exceptions to the basic patterns. Extensions and diagonal triangles (wedges) bend the rules a bit but the underlying structures still show impulsive waves in the direction of the larger trend and corrective waves against the larger trend.

• Extensions occur when an impulse wave can be further subdivided into another set of five waves.
• Diagonal triangles assume a wedge shape pointing in the direction of the larger trend.
• Diagonals allow Sub-wave 4 to overlap with Sub-wave 1. Corrective Waves

Corrective waves, labeled with letters, move against the larger trend and represent the jockeying for position of buyers and sellers. This results in interesting shapes on the charts as the market is pulled against the trend and seemingly against its will. Not only do corrective waves take on a myriad of patterns, they also have their own variations. as follows:

• Zigzags are easily recognizable three wave structures against the larger trend.
• Flats also come in three waves but are essentially sideways in nature.
• Triangles are the familiar coiling patterns seen in other analyses but the boundary lines can both be contracting, one contracting and one flat or even both expanding.
• Complex patterns, called double- and triple-three's, combine any two or three of the above patterns and link them with any three wave pattern of equal size (called an "X" wave). Without getting too detailed, the entire pattern is an extended sideways move.

Figure 5

Figure 6

As with impulse waves, corrective waves have several guidelines to follow:

• Zigzags and flats may be linked together in double or triple patterns. Like complex patterns, each is connected with a three part "X" wave.
• Flats may reach an intermediate extreme beyond the impulse wave they are correcting. For example, in a rally, the second leg (Wave B) of a three wave flat may actually set a new high.
• Triangles usually are the final correction and therefore appear alone as a Wave 4 or as the final part of a complex correction.
• The rule of alternation states that waves 2 and 4 have different types of corrective waves. If one is a sharp correction, the other is a flat correction.

Figure 7

This has been an over-simplified approach to Elliott Waves. Please use this article as an introduction to some of the concepts and terms of Elliott Waves but not as a lesson on how to trade with them.

There are many more factors which should be incorporated into Elliott Wave analysis such as channels and the role of Fibonacci numbers. For now, the novice Elliotttician should use the guidelines laid out here to identify trends rather than forecast targets and turning points.