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A Primer on Elliott Wave Theory

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Mention EW Theory to most traders and their eyes immediately glaze over. It's a difficult trading method to master but once you get a feel for the movement of the market through EW analysis you start to understand what the next move is likely to be. And if your interpretation of the wave pattern says the market is going to zig but instead it zags, that too can be very useful information. EW Theory is a measure of social mood which can be measured by many different methods. We of course use measurements such as Consumer Sentiment to gauge public mood so as to get an idea how that will affect investor mood. The stock market happens to be one of the best gauges of social mood through history.

EW Theory is probably the most accurate and consistent stock market forecasting strategy ever. It is subject to interpretation and therefore is not foolproof but it provides some of the best forecasting out there. It can be used wherever human beings show their emotions--the stock, bond, commodity and currency markets, in fashion trends, political trends, and any other arena that is subject to a herd mentality and a prevailing social mood. There is some suggested reading material at the end of this article for anyone interested in learning more about this fascinating topic.

Before the stock markets we can see swings in social mood through the history of art, music and writings. Human beings have natural rhythms and together we have up and down cycles. Even in business we see these cycles as business expands and contracts, as does our economy. Left to operate on its own, we see these cycles play out in the stock market and these cycles have names--bull and bear markets. There are larger degree cycles such as Kondratieff cycles which average 54 years from high to low back to high. We've had some significant government interference in the past 20 years that has distorted these cycles but eventually the market forces (social mood swings) will prevail.

Some of the government interference in the market (e.g., injecting massive amounts of money into the banking system through the stock, bond and currency markets) will skew the daily and weekly swings in the market and generally speaking it will aggravate the swings and make them larger or last longer than they would normally. The swings can still be measured with EW analysis. And this analysis is basically done by counting waves. So when asked what they do all day, Elliotticians will say they count from 1 to 5 and say their ABC's.

I'll start this tutorial by stating the study of Elliott Wave is not a quick and short endeavor. What started as a theory by R.N. Elliott in the 1930's has evolved into a trading technique as well as a method to predict large social mood changes and what that will mean to the world. He studied the cycles in the stock market and noted repeating patterns in these cycles. He also noted fractals of these patterns, which basically are the same patterns in different time frames. This is where the real power of EW analysis comes in. Like so many other technical studies of the market, EW analysis can be used intraday, daily, weekly, monthly, you name it. Each wave in a larger wave pattern consists of similar smaller waves and this can be taken right down to tick charts. I will say that this analysis is subject to more error once you get below 60-min charts and this may have to do with program trading and market manipulation but longer time frames tend to smooth out these anomalies.

The Basics
Elliott isolated thirteen patterns of movement, or "waves," that recur in market price data and are repetitive in form, but are not necessarily repetitive in time or amplitude. He named, defined and illustrated the patterns and then described how these structures link together to form larger versions of those same patterns (fractals), how they in turn link to form identical patterns of the next larger size, and so on. The primary patterns are either motive which we'll call impulsive, or corrective. Impulsive moves consist of 5 waves whereas corrective moves are generally speaking 3-wave moves but can be more complex variations. The impulsive wave structure is the easiest one to grasp:

Figure 1

These impulsive 5-wave moves identify the primary trend in the time frame of interest. After a 5-wave move it will then be corrected. The simplest correction is an A-B-C wave count and this is what a correction would look like after the 5-wave move:

Figure 2

Notice in the above chart that after the 5-wave move is completed it is then labeled as a larger degree wave-(1). After the 3-wave A-B-C correction it is labeled wave-(2). Wave-(1) is the motive wave which is the impulsive move and is the one that identifies the trend. Each wave in the direction of the motive is also an impulsive wave and will consist of 5 waves (so it's a smaller fractal of the larger wave). Each wave that is counter to the motive is a correction and will consist of a smaller 3-wave move (or some variation of it). So in the pattern above, waves 1, 3 and 5 will be impulsive and consist of 5 smaller waves whereas waves 2 and 4 will be corrective and will be 3-wave moves. Looking at wave-(2) above, the primary direction is down and waves A and C are in the direction of this primary direction and therefore will be impulsive 5-wave moves (the exception is that wave-A can be more complex and have a corrective count) whereas wave-B is against the move and therefore will itself be corrective.

Putting this together we get a structure that looks like this:

Figure 3

Notice the fractals of the waves within the larger degree waves. Also note the Fibonacci number of waves within the groupings of waves. The Fibonacci sequence is 1, 2, 3, 5, 8, 13, 21, 34, 55 ... (keep adding the previous 2 numbers to get the next number). There are two large degree waves [1] and [2], which consists of 8 smaller waves (5 waves up, 3 waves down), and the number of waves comprising those 8 waves is 34 waves. Not only is the EW pattern comprised of a Fibonacci number of waves but as I'll show later it is typically guided by Fibonacci retracements and projections. This is the natural order of the universe and it's found right here in the stock market.

There are some typical relationships between the size of the waves which is a subject for another article (this will become too long if I go into all the details). But one EW rule is that wave-3 can't be the shortest wave. This is a hard and fast rule, no exceptions, unlike some of the other EW rules. If wave-3 becomes the shortest wave in your count then you have the wrong count. The 5th wave and 1st wave are often the same size. There is usually a Fibonacci relationship (38%, 50% or 62%) between the waves. Along with the count itself this can often help identify price targets where the move might find support/resistance.

Another EW rule is that wave-4 can not overlap with wave-1. So the low of wave-4 must stay above the top of wave-1 in the example above. This rule does have an exception and that's when the 5-wave move is inside an ascending or descending wedge (called diagonal triangles in EW terminology) which might look something like this:

Figure 4

Inside the wave-(5) in the above examples, which is where these wedges are often found, you can see that the 1st and 4th waves overlap. Also note that these wedges consist of all 3-wave moves for each of the 5 smaller waves. These wedges (and triangles discussed later) are the only place you find a lack of impulsive waves for 1, 3 and 5. This is what you look for when you see these wedges forming.

This brings us to some of the corrective wave structures. While there is only one motive wave--a 5-wave move--there are several types of corrective waves and these are by far the most difficult to interpret. It's often times not obvious what the EW count is until after it finishes. This is still helpful in identifying where you might be in the larger pattern and is therefore helpful in identifying the probable direction of the next move. But real time trading corrective moves can be a lot more challenging than trading an impulsive move.

There are two major styles of corrections--sharp and sideways. The sharp correction is a steep pullback against a rally or rally against a decline. A sideways correction tends to chew up time instead of getting a deeper price correction. Corrections will often be identified by the number of waves that make up each leg of the correction. For example, in an A-B-C correction that has waves A and C consisting of 5 waves each and wave-B consisting of 3 waves then it'll be referred to as a 5-3-5 correction and denotes a sharp correction (like the A-B-C corrections in Figure 3 above) and is referred to as a zigzag. The two primary styles of corrections can be broken into four main categories:

Zigzags (5-3-5 structure, includes 3 types: single, double and triple)
Flats (3-3-5 structure, includes 3 types: regular, expanded and running
Triangles (3-3-3-3-3 structure, includes 4 types: 3 contracting types--ascending, descending and symmetrical, and 1 expanding type (reverse symmetrical)
Double threes and triple threes (a combination of the above types)

I'll save a more detailed description of the various corrective types of waves for a follow-up article. Keeping it simple (?) for now, this shows an example of some of the above corrections:

Figure 5

This is a zigzag and shows the 5-3-5 structure of the A-B-C count. This would be a pullback correction to a rally.

Figure 6

This is a flat correction with a 3-3-5 structure. Note that in these 3-wave corrections wave-C is always a 5-wave move. When we're in a correction this is the wave to look for to indicate that the correction is ending. When you see this pattern ending with a 5-wave move you can prepare for a reversal back up in this case. An expanded flat is a little different in that wave-C will extend beyond wave-A. Also, wave-B can be higher than the start of wave-A which can throw off the correct interpretation since the new high is often thought of as the end of the previous move (up in this case) but in fact it may have ended at the previous high. That would look like this:

Figure 7

The common Fibonacci relationship between waves A and C in these expanded flat corrections is wave-C = 162% of wave-A. So again, using that Fib relationship and the final 5-wave move for wave-C will often give you a downside target to watch for a reversal back up.

The next category is triangles and this shows the 4 types:

Figure 8

Notice the internal structure of each of these patterns is a 3-3-3-3-3. In other words there are 5 internal waves (labeled a-b-c-d-e) and each consists of 3 waves. Once again, if you see one of these patterns developing, count the number of internal waves and when you think wave-e is tracing out, get ready for a reversal.

The last category is the double or triple threes. This is simply a combination of the above waves separated by a 3-wave move that is labeled wave-X. It could be a zigzag and a flat separated by a wave-x and would look like this:

Figure 9

You can see how the corrections are much more difficult to deal with than a single type of impulsive 5-wave move. Trading 5-wave moves is much simpler but unfortunately the market spends most of its time correcting and therefore it pays to study and practice these corrective waves. Because our stock market is in a very long term uptrend any pullback is by definition corrective. In other words bear markets are corrections to the longer term impulsive uptrend. That means bear markets are full of corrective moves and it makes EW analysis challenging. But even inside a correction you will see impulsive waves at the smaller degrees and therefore it's a very useful tool in all market conditions.

Practice is the key. There are charting programs out there that make an effort to label the waves for you. I have found all of them deficient and it's mostly due to these corrective waves. Labeling waves by hand on your own chart is the single best way to learn the nuances of them and helps you get a feel for how the market is moving. An example of getting a feel for a wave count is what I call the sniff test. If it doesn't look right it probably isn't. Computer programs have a hard time with the sniff test whereas the human brain is very good (with a little practice). Since the corrective wave count is often not clear until after it finishes, or just before it's about to finish, the human brain is better than a computer at projecting (visualizing) possibilities.

As mentioned above, Fibonacci retracements of a move give us targets for a correction. The most reliable Fib retracements to use are 21.4%, 38.2%, 50%, 61.8% and 78.6%. The combination of these retracements and the Fibonacci projections based on Fib relationships between the waves can be very helpful in identifying price targets. Another useful technique, and quite simple to employ, is the use of trend lines and parallel channels.

The wave patterns very often stick to trend lines and parallel channels. In an uptrend take a parallel to the uptrend line and attach it to the first high between the two lows. Referring to Figure 10 below, draw a line from the start of a rally through the first pullback which is wave-2. The parallel is attached to the top of wave-1 and the extension of it is often times a good guide for where wave-3 will stop.

Figure 10

After drawing in the trend lines as described above, once it appears wave-3 may have ended, draw a line from wave-2 to wave-3 and attach a parallel to wave-2. This lower line will often mark where wave-4 will find support. If wave-4 stops at a different place than the parallel, draw a line from wave-2 to wave-4 and then attach a parallel to wave-3. This parallel line will then often mark where wave-5 will end.

Drawing these kinds of parallel channels also works for corrections. Once you have two highs in a pullback, snap a parallel to the low that is between those two highs and that often marks where the next leg down (wave-C) will stop. This will be especially true if the market gives two equal legs up or down in its correction (wave-A = wave-C).

This is a lot of information to absorb so I'll save more details for future articles. Let's look at a couple of real life examples. Actual wave patterns are never as cut and dried, or as easy to identify, as the above patterns and this is where the subjective interpretation comes into play. A combination of EW analysis, Fibonacci retracements/projections and trend lines/channels makes for a powerful combination to determine price moves. Add in your other favorite technical tools for confirmation and you've got a trading system that is hard to beat. Let's take a look at the May-July rally in the RUT to see how the count progressed:

Chart 1

After the rally got underway, you can take a guess at waves (1) and (2) and then once we got a deeper pullback underway from the high on June 17th we could label that as wave-(3). As an alternative it would have been labeled A-B-C in case it was going to be just a 3-wave upward correction against the decline from earlier in the year. So a red trend line was drawn from wave-(1) to wave-(3) and a purple parallel line was attached to wave-(2). This provided a guide as to where wave-(4) might pull back to. Some times it drops down to it and other times it runs sideways over to it.

And sure enough wave-(4) stopped near that lower trend line. Now it became a question where wave-(5) would end.

Chart 2

As the rally progressed and came up near the upper trend line on July 12th, it looks like it ended and wave-(5) should be at that high. But looking a little closer at the inside of wave-(5) shows why it wasn't to be trusted as the end of the run up--as the rally progressed we got a quick succession of two highs and pullbacks, labeled waves 1 and 2 and then (i) and (ii) in the above chart. It can't be waves 1-2-3-4 because 4 would overlap wave-1 so it has to be another smaller degree 1st and 2nd wave as labeled above. This meant we needed to look for waves (iii), (iv) and (v) to finish wave-3.

Chart 3

Remember, each impulsive wave, as wave-3 is, consists of its own 5 waves so once wave-(v) was finished, that finished one larger degree wave which was wave-3. Then we got a sideways triangle wave-4 and note how this predicted the last move up to wave-5. Sideways triangles in this position of a rally are highly accurate in predicting the last move is coming. Once wave-5 was completed that finished the next larger degree wave-(5), thereby completing the 5-wave count up from the April low. One other thing to note on this chart is the mid-line of the up-channel. I've often found that the final 5th wave ends at this mid-line rather than making it all the way up to the top of the up-channel.

One last technique to help identify where the final 5th wave will end is to look for the relationship between the 1st and 5th waves. The common relationship between these two waves is that wave-5 will equal 62%, 100% or 162% of wave-1.

Chart 4

This chart shows a Fib projection for wave-5 based on the size of wave-1. QCharts has a tool to do this but you can obviously calculate it by hand. Wave-1, of wave-(5), ran from 625.84 to 646.04 so 20.20 points. From where wave-4 ended at 668.82, adding 20.20 points gives us an upside target of 689.02 which is what the Fib projection on the above chart shows. Had the rally not stopped there, I would have been looking for the upside Fib target of 701.50 up near the upper trend line.

Also note the negative divergence as shown by the stochastics on this chart at the top of the rally, which is very typically found at the 5th wave. I didn't get into the "personalities" of the waves but one of the hallmarks of 5th waves is that they lack the breadth of the stronger 3rd waves. This helps you identify whether you've got the correct EW count.

As I said at the start, this is not an easy tool to master. If you're serious about adding this technique to your toolbox, here is a recommended reading list. I would read them in the order listed so as to get a better understanding of the subject without getting overwhelmed with detail that's hard to understand. You may email me any questions you have on the subject. Good luck and have fun with it.

1) The Elliott Wave Principle Robert Prechter and A.J. Frost
2) Mastering Elliott Wave - Glenn Neely and Eric Hall
3) Conquer the Crash Robert Prechter
4) The Wave Principle of Human Social Behavior Robert Prechter
 

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