Tips on Technicals - Elliott Wave
| Indicator type: |
Cycle finder, market target finder |
| Used to: |
Identify primary trends and their counter trends |
| Markets: |
All cash and futures, not options |
| Works Best: |
All time frames and market types |
| Formula: |
There is no mathematical formula although there are guidelines used to identify wave types. Uses Fibonacci ratios to forecast targets. |
| Parameters: |
N/A |
| Theory: |
The theory states that markets move in repetitive patterns; a five wave advance (impulse waves, labeled with numbers) 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." Each wave in a cycle can be subdivided into smaller cycles that follow the Fibonacci sequence.
The two part cycle has five impulse waves and three corrective waves for a total of eight waves. That is the sequence 1,2,3,5,8 (Fibonacci). While the mathematics of waves and Fibonacci sequences are critical in understanding Elliott Waves, the human behavior underlying the resultant cycles is also important.
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| Interpretation: |
See below |
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. Note that identifying waves is often a difficult endeavor because there are a number of exceptions and variations involved.
| 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" |
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. |
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.
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% 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
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 waves 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 and "X" wave). Without getting too detailed, the entire pattern is an extended sideways move.
1 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.
1 Graphics courtesy of Elliott Wave International
