The Elliott Wave Principle enables traders to formulate a suitable trading strategy as the market progresses. It provides a tool to effectively monitor the position of the market relative to the trend and the probable target of the market’s movements.
The wave principle works better if it is applied to market averages and blue-chip stocks that are supported by active turnover. Generally, it is not practical to apply wave analysis to thinly traded stocks or penny stocks if such stocks have no transactions or supporting volume. When turnover starts to dwindle to practically zero and prices stay dormant for weeks, there is no possible way to do any counting because no transactions are being done and there will only be a horizontal line. It is not practical to get bogged down in detailing every small wave or in pinpointing each of the corrective counts. It is a common mistake to try to count every move, which not only overcomplicates the matter, but may lead to deep confusion.
When reviewing the count of waves, count the broadest swings first. If the counts total 5, 9, or 13, the pattern is an impulse wave pattern. Then dissect the waves to see if a fit can be made. If the broad swings total 3, 7, or 11, the pattern is a corrective wave pattern.
An Elliott Wave pattern is easier to understand if seen as a set comprising an impulse swing of five waves and a corrective swing of three waves. Each pattern can be a part of another cycle or can form part of an expanded cycle.
Figure 4.31
shows the basic pattern.
FIGURE 4.31
A rudimentary cycle pattern of Elliott Waves, comprising an impulse pattern of five waves, 1-2-3-4-5, and an A-B-C correction running counter to the impulse waves. In the impulse pattern, there are two corrections, or countertrend waves, Wave 2 and Wave 4, and in the correction pattern, there is one countertrend wave, Wave B.
Wave analysis often becomes complicated when it comes to analyzing the corrective patterns of Wave 2, Wave 4, or Wave B, especially if such patterns are of a complex nature, consisting of more than three waves. The difficulty arises in determining whether the market is in a trend or in a corrective mode, and whether the corrections are completed.
There is a guideline generally used to determine when a market is making a correction. If the market is making an A-B-C correction, prices will often make attempts to overlap the prior
section as illustrated in Figure 4.32
. Prices move to new levels beyond A and retrace their movements to overlap into the prior range of Wave A. If prices move beyond the extreme of Wave B, that will be a confirmation that the correction should be complete and prices should continue their prior trend. As corrections are countertrends, the prior trend in a downward correction will be an upward trend, and in an upward correction, the prior trend will continue in a downward trend. (See
Figure 4.32 .)
FIGURE 4.32
Two typical A-B-C corrective patterns. In a downward correction, prices make a new low below Wave A and then reverse their movement upward to overlap into the range of Wave A. In an upward correction, prices make a new high above Wave A and then make a downturn to
overlap into the range of Wave A. If prices move beyond the extreme of Wave B, it indicates the correction should be complete.
The overlap guideline is a valuable clue to identifying price direction. It enables a trader to identify when the market is in a corrective phase, and combined with other trading tools, it may help plan a trading strategy so that when the correction is complete and the trend resumes, the trader is ready to enter the market. We would want to be in a trade when there is a trend.
Coupled with the application of Fibonacci Retracement and Fibonacci Projection, the guideline should give a good indication of the levels at which prices will find support and resistance, and where trade entries and exits could be considered.
CONCLUSION
The basic tenet of Elliott Wave Theory is that market movements are based on crowd behavior.
Market movements occur as a series of impulse and corrective waves, and these movements can occur in predictable cycles. A bullish swing will be corrected by a bearish swing. The bullish swing will consist of five waves, three waves up and two waves down, and the bearish swing will consist of three waves, two waves down and one wave up. The sum of the waves in the entire cycle will be eight waves. Impulse waves refer to the waves in the bullish swing, and are numbered as 1, 2, 3, 4, and 5. And corrective waves refer to the waves in the bearish swing, and are numbered as A, B, and C. Impulse waves are waves that move in the direction of the main trend, and corrective waves are waves that move in the opposite direction of the main trend.
Impulse waves can be further broken down into another set of minor impulse waves, and likewise, corrective waves can be further broken down into another set of minor corrective waves. The cycle can be repeated as it expands or contracts in accordance with different time frames. All such impulse and corrective waves adhere to the rules of the theory.
Elliott Wave Theory can be used effectively when applied, as described in this chapter, to a suitable trading strategy in which risk can be minimized. One difficulty is in identifying the count, and recognizing whether waves are impulse waves or corrective waves. Another problem is in determining which phase of the market the prices are moving in according to the theory, in order to predict the next probable direction and target. Counting every wave can be subjective, but if the trader can identify the direction of the primary wave, he can still make a profitable trade. Here are several guidelines that may help traders to count the waves.
The first guideline is for getting the counts right. Getting the right count may be made more difficult by a complex structure comprised of impulse waves and corrective waves of major waves, minute waves, and subwaves, and so on. Traders, therefore, should try to identify the counts on a best-effort basis. Traders should avoid getting bogged down in trying to identify every exact count and being too concerned about getting the wrong count. Wave counting has a high degree of subjectivity. The best approach to wave counting is to determine the primary count so as to get the bigger picture. Doing a wave count of the longer time frame, that is, weekly, is a good way to find out the state of the market. This will protect the trader’s position even if he gets the count wrong in the daily time frame.
The second guideline is for locating trades that have less risk in accordance with the primary trend, and avoiding trades that have greater risk. For example, picking trades at the end of the fifth impulse wave or the beginning of a corrective Wave C can lead to huge losses.
The third guideline is for learning to differentiate impulse waves from corrective waves.
Corrective waves frequently tend to overlap. In an A-B-C correction, Wave C will exceed the low of Wave A, and when Wave C moves back into the range of Wave A, it has made an overlap movement. When Wave C rallies beyond the peak of Wave B, the correction is deemed completed. In an impulse wave pattern, Wave 1, Wave 3, and Wave 5 should not overlap each other and should comply with these three rules:
1. Wave 2 cannot go below the beginning of impulse Wave 1.
2. Wave 3 cannot be the shortest wave of the three waves.
3. Wave 4 should not overlap impulse Wave 1.
If Wave 2 goes below Wave 1, then the uptrend is invalidated. And if the retracement of Wave 4 overlaps Wave 1, it also violates the rules of the impulse waves. Wave 3 can be equal to
Wave 1, or Wave 3 can be equal to Wave 5, but Wave 3 cannot be the shortest of the three waves. This rule is probably derived from the observation that, in a strong market move, the second upward wave (Impulse Wave 3) appears frequently to be the strongest of the three waves. But when Wave 1 is extended in a strong trend, Wave 3 will equate with Wave 5. And also when Wave 5 is extended in a strong trend, Wave 3 will equate with Wave 1. The understanding of these rules will help to distinguish trending waves from corrective waves.
The fourth guideline is for checking the slopes of the three impulse waves (Wave 1, 3, and 5).
They will generally be steeper than the slopes of the corrective waves (Wave 2 and 4). In a bearish reversal of a major market correction, A-B-C, the slopes of Wave A and Wave C will be steeper than that of Wave B. In their steep declines, Wave A and Wave C will also show strong impulse waves and Wave C will be the strongest of the three waves in the corrective waves. To distinguish the impulse waves from the corrective waves, it is helpful to look at the slope of the relative waves.
The fifth guideline is for looking at the overbought or oversold values of the Elliott Wave Oscillator (EWO), which is popularly used to check Wave 4. EWO is a 34-period price moving average subtracted from the 5-day price moving average. The difference is plotted as a histogram. The concept of EWO is that the highest/lowest point of the oscillator is related to the bullish/bearish Wave 3 of the swing. When price is in an upswing, Wave 3 should be reflected by the highest point of the oscillator, and when price is in a downswing, Wave 3 should be reflected by the lowest point of the oscillator. The correction of Wave 4 should be over when Wave 4 crosses above the zero line in an upswing, and the correction of Wave 4 should be over when Wave 4 crosses below the zero line in a downswing.
Lastly, in an impulse wave pattern, the patterns in Wave 2 and Wave 4 will alternate. That is, if Wave 2 has a simple pattern, then Wave 4 will probably have a complex pattern. This knowledge will help traders to locate Wave 2 and Wave 4. In Wave 1, Wave 2 should be greater in time and price than any correction within Wave 1. In Wave 3, Wave 4 will also be greater in time and price than any correction within Wave 3.
Since the publication of the Elliott Wave Theory in 1938, research and development of the theory has continued. The theory has also been expanded by the development of computerized programs that count the waves based on interrelated Fibonacci ratios. For example, it has been learned that both Wave 5 and Wave C can end in a diagonal triangle pattern or in an expanding triangle pattern. Whether or not a computerized count can do the job, the aim of the trader in using Elliott Wave Theory is find those waves that work best for him in his trading strategy.