Elliot Wave theory

Market Analysis

Elliot Wave

The patterns link to form five and three-wave structures which themselves underlie self-similar wave structures of increasing size or higher "degree." Note the lower most of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of the wave one degree higher is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold according the five and three-wave structure which it underlies one degree higher.

The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves.

Each degree of a pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree—numbers for motive waves, letters for corrective waves (shown in the highest of the three idealized series of wave structures or degrees). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.

The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

• Grand supercycle: multi-century
• Supercycle: multi-decade (about 40-70 years)
• Cycle: one year to several years (or even several decades under an Elliott Extension)
• Primary: a few months to a couple of years
• Intermediate: weeks to months
• Minor: weeks
• Minute: days
• Minuette: hours
• Subminuette: minutes

Elliott wave "personality" and behavioral characteristics

Elliott described each wave as exhibiting a characteristic volume behavior and a "personality" in terms of attendant momentum and investor sentiment. The "personality" of a wave reflects the psychology of the moment. Understanding how and why the waves develop is key to the application of the Wave Principle and confirms a correct wave count.

That understanding includes recognizing the characteristics described below:

These wave characteristics assume a bull market in equities. The characteristics apply in reverse in bear markets.

Five wave pattern (dominant trend)

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern.

Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, the most distinguishing feature of fourth waves is that they often prove very difficult to count.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high, the indicator does not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

Three wave pattern (corrective trend)

Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.

Pattern recognition and fractals

Elliott's market model relies heavily on looking at price charts. Practitioners study developing price moves to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition.

The structures Elliott described also meet the common definition of a fractal (self-similar patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order."

Elliott waves rules and guidelines for correct wave counts

In counting Elliott waves there are three rules that can never be broken in a correct count: Rule 1: Wave 2 cannot go below the low of wave 1., Rule 2: Of the three impulse waves—1,3 and 5—wave 3 can never be the shortest. Rule 3: Wave 4 can't end in the area of wave 1, except in the rare case of a diagonal triangle. A violation of these rules implies that the operative wave count is incorrect.

Elliott also noted additional technical aspects of waves to be used a guidelines to correct wave counts: "Most motive waves take the form of an impulse, i.e., a five wave pattern (as shown in the above chart) in which subwave 4 does not overlap subwave 1 and subwave 3 is not the shortest subwave. One motive wave in an impulse i.e., 1,3 or 5 is typically extended, i.e., much longer than the other two. There are two rare motive variations called diagonal triangles, which are wedge shaped patterns that appear in one case at the start(wave 1 or A and in the other case only at the end( wave 5 or C of larger forms.

Corrective waves have numerous variations. The main ones are named zigzag, flat and triangle... These three simple corrective patterns can string together to form more complex corrections..... In impulses waves 2 and 4 nearly always alternate in form, where one correction is typically of the zigzag family and the other is not. Corrections usually terminate within the span of wave 4 of the preceding impulse of the same degree.