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A Primer on Elliott Wave Theory--Part I

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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. The market is primarily driven by investor mood. Many traders would like to believe that fundamentals control a stock's price but in fact a stock's price is often something that has nothing to do with fundamentals. Social mood dictates whether investors are feeling generally bullish or generally bearish and that mood translates to bull and bear markets and cycles within these markets.

I'll break this EW primer into two parts with the second part in next week's Trader's Corner.

EW Theory is a technique used to measure social mood. There are several ways to measure social mood such as Consumer Sentiment. This helps us gauge public mood so as to get an idea how that will affect investor mood. The songs written over the ages reflects social mood--think about music of the 1950s versus the 1960s. Writings over the centuries have reflected social mood of those times. But there's no better direct measurement of social mood than the stock market as it happens to be one of the best gauges of how people are feeling. And this is true back to the beginning of record keeping for publicly traded commodities. People are generally hopeful and bullish and that's why the stock market stays on an upward trend over long periods of time which smoothes out the boom and bust periods.

Even bubbles haven't changed over time--speculation brought to a fever pitch, controlled by fear and greed just as it's always been. Tulip bulb mania in 1635 (trading prize tulip bulbs), the South Sea Company bubble in 1720 (slave trading), gold in 1980, Beanie Babies in 1997 (a $5 doll was fetching $600), the tech market in 2000, the housing market in 2006--these are all examples of speculation taken to new levels and without regard to the true fundamental value. And then of course we see the opposite end of the cycle where people can't get rid of their investments fast enough and it's usually at the bottom of the cycle. Social mood is cyclical in nature and understanding how to read these cycles in bull and bear markets can help you be a successful trader/investor.

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 one of the best windows into the mind of the market--people. 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.

Left to operate on its own, the markets would reflect the ups and downs of social mood. We can see cycles on whatever time scale we want to observe the market. Intraday cycles to monthly to yearly and decades/centuries all show the same patterns. Smaller time frames show the same patterns as fractals of the larger patterns. This is what Elliott Wave Theory studies--these repeating patterns in different time frames of trading. Over the past couple of decades we've had more government interference in the market place, which seems to be getting worse (e.g., injecting massive amounts of money into the banking system through the stock, bond and currency markets) and this action 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 normally would. But 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:

The Basic Pattern

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:

An Impulsive and Corrective Count

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 of the move is down. 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:

Complete Impulsive and Corrective Count

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 relationships between the waves. This is the natural order of the universe and it's found right here in the stock market. It means we humans are part of the natural order as well. We think we're smarter than that with all our computers and analysis but in the end we're affected by the same emotions and simply following the natural order and patterns.

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 and 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 in a move to the upside the low of wave-4 must stay above the top of wave-1. This rule does have an exception and that's when the 5-wave move is inside an ascending or descending wedge (called diagonal triangles or ending diagonals in EW terminology) which might look something like this:

Ending Diagonals

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 waves making up the wedge. 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 and make projections for how far the next move will go. 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 bounce against a decline. A sideways correction tends to chew up time instead of getting a larger 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 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 sets of corrections)
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) which looks like a megaphone pattern
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:

Zigzag 5-3-5 Correction

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

Flat 3-3-5 Correction

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 wave-C is the one 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.

In the figure below, 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. The best way to tell is by looking for the move up, wave-B here, to see if it's only a 3-wave move in which case it should be middle of the correction and you should look for a sharp move down to finish it. That would look like this:

Expanded 3-3-5 Correction

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:

Triangle Corrections

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:

Double and Triple Corrections

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.

Next week I'll wrap up this introduction to EW Theory with some practical work, showing actual patterns and how it can be used in live trading. If you'd like to get some additional information on EW Theory, I put together 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. The last two books are less about the details of wave structure and more about the market and the economy and how you can see the application of EW Theory. You may email me any questions you have on the subject.

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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