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Elliott Wave Principle

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  1. Elliott Wave Principle Steven W. Poser Managing Director, Research New York Stock Exchange 212-656-4512 sposer@nyse.com

  2. Today’s Objectives • Review fundamentals of the Elliott Wave Principle (EWP) • Preparation for CMT II&III • Text: Elliott Wave Principle: Key to Market Behavior (A.J. Frost, Robert Prechter Jr.)

  3. Overview • EWP’s primary value is as a description of how markets behave. • Provides context for market analysis. • Prechter and Frost state EWP “is not primarily a forecasting tool” • EWP patterns also visible in economic data and in general human behavior

  4. Basic Tenets • EWP is governed by man’s social nature, which is expressed in repetitive form. • In markets, this is shown as progressions of five waves, followed by three waves. • Three rules • Wave-2 never moves beyond start of wave-1 • Wave-3 never the shortest • Wave-4 never overlaps wave-1, except in a diagonal triangle

  5. Elliott Wave Theory Basics • Developed by Ralph Nelson Elliott, mostly in the 1930s • Related specific price patterns in the stock market as being nature’s law – in essence, price patterns were deterministic • Although most reasonable Elliotticians would not call EW deterministic, it does give us deep insight into market behavior

  6. Elliott Wave Theory Basics • Classic patterns are based deeply in market psychology • Each wave and sub-wave has a characteristic market psyche attached to it • This improves forecasting capability

  7. The Basic Wave Pattern 5 3 B 1 4 A C 2

  8. Elliott Wave Basics • Wave modes • Motive waves – subdivide into five waves • Corrective waves – subdivide into a three wave structure or a triangle • A complete cycle is eight waves: • Five wave motive (1-2-3-4-5) • Three wave corrective (a-b-c) • Even numbered waves are also corrective within a motive move

  9. Elliott Wave Basics • Waves are fractal • Wave-1 breaks into five smaller waves • Wave-2 subdivides into a three wave move, etc. • Wave-a is motive against the trend of one larger degree • Any cycle of five waves forms a larger cycle of one degree higher than the individual waves. Degree is based on form, not price and time (despite nomenclature discussed later). • Even numbered waves are also corrective within a motive move • Five wave moves have nothing to do with bull or bear markets: they can be in either direction. Action in the same direction as the larger trend is five waves, and countertrend action develops in three waves.

  10. Elliott Wave Basics • Actionary moves are motive cycles that are not diagonal triangles (no overlapping between wave-1 and wave-4). Also known as impulse moves. • A diagonal triangle is also known as a wedge in classic TA and usually shows up in wave-5 or wave-C, rarely wave-1.

  11. Elliott Wave Notation • Elliott created names for cycles of varying sizes and time. Frost and Prechter revised the names and notations • Supermillenium 1 A • Millenium (1) (A) • Submillenium 1 A • Grand Supercycle I a • Supercycle (I) (a) • Cycle I a • Primary 1 A • Intermediate (1) (A) • Minor 1 A • Minute i a • Minuette (i) (a) • Subminuette i a • Micro 1 A • Submicro (1) (A) • Miniscule 1 A

  12. Extensions • Usually, one wave in an impulse move extends – breaks into a larger five wave move. This is typically the third wave in the stock market and is often the fifth wave in the commodity markets. • A full five wave impulse therefore breaks into a nine leg cycle. For example: (1)-(2)-1-2-3-4-5(3)-4-5 where wave-(3) extended into 1-2-3-4-5. • Extensions can extend as well: 1-2-3-4-(1)-(2)-(3)-(4)-1-2-3-4-5(5)5 • The circled waves are primary, the ones in parentheses are intermediate and the last are minor degree.

  13. Truncations • More commonly known as failures, but Frost/Prechter changed the name to truncation. • When the fifth wave does not move beyond the end of the third wave.

  14. Diagonals • Motive, but not actionary (impulsive) • Each leg is three waves. One exception is that a diagonal can appear in wave-a of a zigzag or wave-1 of an impulse. In those cases, the subdivisions can – but do not have to – develop as 5-3-5-3-5. • Third wave still never the shortest • Usually in fifth and sometimes in c-wave. If in a double three, can only be in wave-c of the second of the doubles. • Looks like wedge, with 5th sometimes over shooting, sometimes undershooting. Frost/Prechter mentions one case of expanding diagonal. • Fifth wave extensions, truncated fifths and ending diagonals often result in dramatic reversals.

  15. Corrections - Categories • Three basic types: • Zig-zags – 5-3-5 pattern. Also double zig-zag and triple zig-zag, which represent multiple zig-zag patterns joined together. These are usually the sharpest corrections. • Flats – 3-3-5 pattern. Includes regular, expanded (Frost/Prechter term for irregular) and running. These corrections are usually horizontal. • Triangle – Actually have five legs (3-3-3-3-3). Divided into symmetrical, ascending, descending and expanding (reverse symmetrical). Always in last correction of an actionary wave of one larger degree (but can also be part of a combination). Frost/Prechter then says in very rare cases it can be a second wave, but usually as part of combination. • Combination – Double or triple, combining flats, zig-zags and triangles

  16. Corrections – Labeling • If you see a five wave move after a motive cycle, then there will be another five wave move to come, forming a correction (ie, a zig-zag). Five wave moves never stand alone. • Labels for a zig-zag or flat are of the A-B-C variety. • For combinations (double three and triple three), each individual “three” is labeled as W, then Y and then Z. The overall labeling then would be: a-b-c(W), a-b-c(X), a-b-c(Y), a-b-c(X), a-b-c(Z). The waves between the W,Y and Z are called X-waves and can be any kind of corrective pattern, but it is usually a zig-zag. • If part of a combination is a triangle, that is labeled a-b-c-d-e instead of a-b-c.

  17. Corrections – Zig-Zags • Both waves are 5-wave motive moves. • Wave-A is rarely a diagonal triangle. • Wave-B can be a triangle, or any other type of correction. • Wave-C is often like wave-3, very powerful, but can occasionally be a diagonal triangle. • Zig-zags are usually faster and correct more price territory than flats. • You should look for a double zig-zag if a zig-zag completes that has ended too quickly and more importantly has not retraced enough price territory. • A zig-zag can appear, usually as a Y or Z as part of a combination.

  18. Corrections – Flats • Usually retraces less ground than a zig-zag. • If a flat ends too quickly, although much of the price retracement may have taken place, look for a double-three or triple-three to allow for more time (range trading). • Wave-B can retrace more than 100% of wave-A. This is known as an expanded flat (Elliott called it an “irregular”, and that term is used by many Elliotticians).

  19. Corrections – Flats (con’t) • Wave-C typically ends near the end of wave-A. • In expanded flats, wave-C may end well beyond the end of wave-A. • In a running flat, wave-B ends far beyond the start of wave-A. This implies strength in the trend of one larger degree. Wave-C usually ends well before the end of wave-A in these cases. These types of corrections are very rare!

  20. Corrections – Triangles • Possibly the single most important thing you can learn from triangles is that the classic technical analysis books have triangles all wrong: • You can always predict which direction a triangle will break. • Although an ascending triangle is more likely to appear as a correction in an up trend, the direction it breaks is based on the prior wave pattern. They are not inherently bullish. The same is true of descending triangles. • Triangles, in this terminology are always corrective. If a triangle appears elsewhere in a trend, in Elliott terms, it is something different, even if classic technicians call it a triangle. In all likelihood, these triangles are less perfect triangles in standard TA terms.

  21. Corrections – Triangles (con’t) • Triangles are virtually never in wave-2. • Running triangle – When wave-b of the triangle moves past the starting point of wave-a. • Fifth waves after triangles are usually fast and the reversals are sharp. The size of wave-5 is then often about the same as the width of the triangle (similar to the classic TA projection measure).

  22. Terminology • Frost/Prechter state that stocks are directionally progressive. That is, that the general direction of stock prices is higher. • In other words, stocks are upwardly directional, due to man’s general progress. • Waves denoted by numbers are called cardinal waves. Waves denoted by letters are called consonant or sub-cardinal. We can always says we are in a cardinal wave of whatever is the current largest degree.

  23. Irregular Tops • Frost/Prechter disagree with Elliott’s irregular top idea. • Elliott stated that major cycle highs were often irregular. This would result in a tiny wave-a and an enormous wave-c. • The authors state this is because Elliott favored extended fifth waves, leaving an extra leg at the end of the cycle. Frost and Prechter prefer using an extended third wave, which often removes this requirement. • They note that the Elliott counting often had a strange second wave which combined an expanded flat with a short c-wave. (See figure 1-50 in Frost/Prechter).

  24. Alternation • This is not a rule, but it is a strong tendency. • It states that wave-2 and wave-4 do not usually develop in a similar fashion. The definition is vague, but examples may include: • Flat versus zig-zag • Expanded versus regular flat • Combination versus triangle • Fast versus slow • Deep versus shallow retracement • In other words, alternation may be in any dimension: size, time or form. • Alternation also exists in corrections • If wave-a is a flat, expect a zig-zag for wave-b • If wave-a is simple, wave-b may be complex and wave-c even more complex.

  25. Depth of Correction • Fourth waves usually end near the terminus of the fourth wave of the prior wave of one lesser degree, especially if the current corrective wave is a fourth wave itself. • For example, wave-4 will typically terminate near the end of the fourth wave of the just completed wave-3. • When wave-5 extends, the next correction will often end near the end of the second wave of wave-5, though it could end as far as the end of the prior fourth wave.

  26. Symmetry • In an impulse move, the two non-extended waves tend to be about equal in size. • The best measurement tool for equality, for all but very minor cycles (ie, above minor) is percentage, not price points. • If equality does not happen, a Fibonacci ration between the two (say wave-5 = 61.8% of wave-1) often occurs. • The extended wave will tend to be at least 1.618 times the size of the non-extended waves. • Note: The book talks about how you cannot use intraday highs and lows in the Dow. This is no longer true, although it was correct at the time the book was first published.

  27. Channels • A whole impulse cycle often develops in a channel. • Alternately, you may be able to draw a channel by connecting the lows of waves 2&4 and projecting from the extreme of wave-3 to provide you with a fifth wave target area. • If a fifth wave approaches its resistance line on lower volume, it may fail to reach that resistance line. • A move above the resistance line in wave-5, known as a throw over, is often preceded by a throw under for wave-4. A throw under is when wave-4 briefly falls below channel support. • If volume in a fifth of less than Primary degree is seen, you are probably in a fifth wave extension. • Volume tends to be higher if fifths of Primary degree and higher (capitulation or blow-off in classic TA terms of major cycles).

  28. WaveCharacteristics • Wave-1 (I am writing this from the perspective of a bullish first wave. It can also be bearish, just reverse bull for bear and bear for bull in all sentences) • Start of bull move • Almost everybody still bearish • Rally seen as selling opportunity • Volume may not be very high, but usually there is a small increase in volume and improved market breadth. • About half of first waves have very deep retracements. • Fundamental news probably still bad • In futures, open interest might fall • In stocks, A/D line may have already been improving before bottom.

  29. WaveCharacteristics • Wave-2 • Correction of first leg of bull move • Fundamentals still mostly negative • Drop seen as resumption of bear trend • Bears tell bulls, “I told you so!” • But, volume weaker on drop • In futures, open interest falls • Most sentiment surveys still bearish

  30. A Diversion: Behavioral Finance • Studies how human emotion and crowd psychology can cause inefficiencies in the markets • Can be used to support both fundamental and technical analysis as being able to offer positive alpha

  31. Behavioral Finance • Some academics in behavioral finance have embraced technical analysis as a tool in their cadre. • Two examples are be Blake LeBaron (Brandeis) and Andrew Lo (MIT)

  32. Back to Elliott – Wave-3 Characteristics • Elliotticians dream of third waves (they don’t have much of a life, do they?) • Usually most powerful and largest price move • The public jumps on board during this move • High volume, momentum confirms • Typically at least 1.618 times as large as wave-1 • Fundamentals (finally) confirm the positive price action • Breakouts, continuation gaps are common. • Excellent market breadth with Dow Theory confirmation for higher degree stock market bull cycles.

  33. Wave-3 and Behavioral Finance • Sentiment should be at highest level during this move • Forecasts should show revisions to extend earlier expectations • Recognition that this is a bull market is likely • While should be easy to get in, some will want to wait for a pull back to get a bargain, and they will miss the boat

  34. Wave-4 Characteristics • Often the most difficult wave to trade • Trend is still up • Extended range trading possible, and irregulars very common • Seen as buying opportunity. • Forms first support in head and shoulders neckline • Preferably, trend line drawn from start of wave-1 through bottom of wave-2 is not breached

  35. Wave-5 Characteristics • Everybody is bullish; it is a true bull love fest • Bears are regularly ridiculed in the financial media • The news is all good • Prices make new highs BUT....

  36. Wave-5 Characteristics • Volume probably lower than at end of third wave, except in Primary degree and higher where there can be a blow-off type situation. Also, volume is high in a fifth wave extension. • Open interest (in futures) might not confirm gains • Usually see momentum divergences • COT reports may show growing short positions held by hedgers • Optimism is extreme. The bull market will never end!

  37. Wave-5 Behavioral Clues • Forecast targets extended to allow for new paradigms • Your friendly neighborhood plumber is talking about the investment • Cover stories in mass media magazines such as Time and Newsweek • Nobody will talk to all of the famous bearish gurus, except to ridicule them. Remember how technical analysts were treated in early 2000 by the mainstream financial media?

  38. Wave-A Characteristics • At the start of the bear market, people still think they should be buying dips. • Sentiment is still bullish. • If Wave-A is five waves, it means that the bear market will be a zig-zag

  39. Wave-B Characteristics • A wolf in sheep’s clothing. • Market participants still following the bullish mantra and see the just completed wave-A as corrective. • Everything is going to be okay. • But, volume probably not very strong (except in Primary Degree and higher) and market breadth is poor even if sentiment is still strong and fundamentals, which tend to be trailing, still look constructive. • Wave-B is the right shoulder of the classic head and shoulders reversal pattern.

  40. Wave-C Characteristics • Cousins of third waves. • Usually impulsive, but can be diagonal triangles. • High volume as end of wave is reached (at the end of a bear, this would be termed a capitulation) • Everybody finally buys into the bear market. • However, as the end approaches, there might even be some technical lights at the end of the tunnel (which are not an oncoming train).

  41. Waves D&E (Triangles) • Wave-D might see higher volume in non-expanding triangles. • This may be due to the fact that they follow c-waves and can be initially believed to be the start of the next cycle and the end of the correction. • E-waves look like the resumption of the bear market and news can be very negative. They often break below triangle support. But, they are a fake-out as the market is then ripe for a return to the prior up trend.

  42. Da Rules! • It is not worth going through all of the guidelines and rules noted in the 2005 edition on pages 86-91, but you should be familiar with most of them. • Note that most of these guidelines have been discussed in prior slides. • Here are a few of the less obvious but more important rules and guidelines: • Usually, only one motive wave extends, but two might in Cycle or Supercycle degree. • When wave-5 extends, it is typically in a Fibonacci proportion to the distance traveled by waves 1-3 • Wave-4 usually ends in the area of the fourth of wave-3 • Wave-4 often subdivides the entire impulse in a Fibonacci price or time proportion

  43. Da Rules! (con’t) • An ending diagonal always appears as wave-5 of an impulse or wave-c of a zig-zag or flat. • A leading diagonal always appears as wave-1 of an impulse or wave-A of a zig-zag or flat. • All waves of an ending diagonal and waves 2&4 of a leading diagonal always divide into a zig-zag. • Wave-4 of a diagonal always overlaps wave-1. • Diagonals look like classic TA wedges. • Wave-3 is still never the shortest wave and in an expanding diagonal wave-5 always ends beyond the terminus of wave-3. • Waves 2&4 usually retrace 66% to 81% of the prior wave.

  44. Da Rules! (con’t) • In an impulse, a diagonal is unlikely unless wave-3 is extended. • In a zig-zag, wave-B never retraces more than 100% of wave-A • If wave-B is a running triangle, it will typically retrace 10-40% of wave-A • Wave-B usually retraces 38-79% of wave-A if it isn’t a running triangle. • If wave-B is a zig-zag, it typically retraces 50-70% of wave-A. • Wave-A is never a triangle in a flat (or a zig-zag). • Wave-B always retraces at least 90% of wave-A and usually retraces 100-138% of wave-A in a flat. • In a flat, wave-C is typically 100-162% of wave-A. • Wave-C usually ends beyond the end of wave-A in a flat.

  45. Da Rules! (con’t) • An expanded flat is when wave-B is more than 105% of wave-A and wave-C ends beyond the end of wave-A. • If wave-B is more than 100% of wave-A, but wave-C does not move past the end of wave-A, then the flat is called a running flat. • In a contracting triangle, at least four of the waves must divide into a zig-zag or a zig-zag combination. • Except for wave-E, a wave in a contracting triangle never retraces more than 100% of the prior wave. • A triangle never has more than one complex wave and if it does, it is either a zig-zag combination or a triangle itself. • About 60% of the time, wave-B does not end beyond the end of wave-A. This is a running triangle. • Wave-5 following a triangle is typically either brief or an exceptionally long extension.

  46. Da Rules! (con’t) • In an expanding triangle, waves c,d and e retrace at least 100%, but not more than 150% of the prior subwave. They usually retrace 105-125% of the previous subwave. • Combinations are formed by two or three corrective patterns separated by corrective pattern(s) in the opposite direction. • A double three flat is either a zig-zag&flat, a flat&zig-zag, two flats, a zig-zag and triangle or a flat&triangle. • A triple three flat comprises three flats. • Double and triple zig-zags take the place of zig-zags while double and triple threes stand in for flats or triangles. • An expanding triangle has never been seen as part of a combination.

  47. Determining Your Count • You should consider all factors discussed to this point in developing a wave count. • More than one count may be possible. Frost&Prechter recommend always having an alternate count. Alternates must also abide by these rules and guidelines. • Never forget that wave form is more important than volume, exact timing, price target calculations of non-Elliott indicators, be they technical or fundamental in developing your count. • In the next section, we will cover in greater detail Fibonacci ratios to help you more closely compute potential time and price targets. However, these calculations remain less important than wave form. • Despite these admonitions, if several methods provide you with a good price target (such as equality between wave-1 and wave-5, a trend line, a day count, plus volume and indicators), the probability of your being correct is better.

  48. Fibonacci - Introduction • Based on the work of the mathematician Leonardo da Pisa (later known as Fibonacci). • Many waves relate to prior subwaves and degrees based on comparisons using Fibonacci-based ratios. • Ratios based on the series of numbers where Sn = Sn-1 + Sn-2 • Example: 1,1,2,3,5,8,13,21,34 • Example: 6,11,17,28,45,73,118 • The ratio of number n in the series, to number n-1, quickly approaches 1.618. • The inverse of this is 0.618 and is known by the Greek letter phi (Φ).

  49. Fibonacci - Introduction • There is a whole lot of numerology involved with Φ, which is not all that relevant to Elliott. • What is relevant are the main ratios and retracements that Elliotticians use: • 0.382 (Sn/Sn-2) 1.618 • 0.618 2.618 = 1.618*1.618 • 0.236 (Sn/Sn-3) 4.236 = 1.6183 • 0.764 (1-0.236) or 0.786 (Φ0.5) • The Golden Mean (or Golden Ratio) is 0.618 or 1.618 according to Frost/Prechter. • The Golden Section: The point on a line where the ratio between the smaller part of the line and the larger part of the line equals the ratio between the larger part of the line and the whole line. This is at the 0.618 point. • The book covers the Golden Rectangle and Golden Spiral.

  50. Using Fibonacci • Some basic tendencies were discussed in “Da Rules” earlier. • You can use Fibonacci ratios for determining possible targets for retracements and for current and later wave termini. • You can also use Fibonacci numbers and ratios to help you time when waves might end. • On their own, a dependence on Fib numbers can be dangerous, but when combined with the principals of channeling as well as by using volume and momentum, plus an understanding of Crowd Behavior, you can learn to apply Elliott Wave in a profitable and easy-to-understand manner.