Elliot_Wave_Analysis

Elliot Wave Analysis was developed by Ralph Nelson Elliott* in the early 1930's, following what remains the most devastating market decline in U.S. history - the Crash of 1929.

1929 was a terrible year for Elliott.  Like many others, he suffered major losses in the market crash.  To make matters worse, he had contracted a parasite during one of his trips to Latin America, infecting him with a life-threatening anemia.  In 1930, he moved to California, where, to occupy his time as he recovered from his illness, he took to studying charts of the major market indices.  Part of his motivation was a book on the market theory of Charles Dow (creator of the Dow Jones Industrial Average); the other part was an intense desire to understand the mechanics that led to the Crash of '29.  

Training his meticulous eye on decades of market charts, he discovered a persistent and recurring pattern that operated between market tops and bottoms.  He theorized that these patterns, which he called "waves," were a collective expression of investor sentiment, giving the market a distinct form and behavior.  Through a use of measurements that he called "wave counting," an analyst could forecast market turns with a high degree of accuracy.  After testing his theory over four years, Elliott organized his research into an essay that he titled "The Wave Principle," which was published in book form in 1935 with the assistance of Charles Collins, a respected newsletter publisher who helped popularize Elliott Wave analysis in its early years.

The Wave Pattern

Elliott's main discovery was that market behavior could be identified and measured through a repeating eight wave sequence, consisting of 5 waves that he called "impulsive," followed by a 3-wave "corrective" sequence.  Impulse waves are labeled numerically 1 through 5, corrective waves are labeled A, B and C, as per the following example:

Below, the pattern is illustrated in a chart of the Dow Jones Industrial Average from 1921 to 1932:

The above chart also illustrates another of Elliott's key discoveries, namely that wave patterns themselves subdivide into smaller patterns that trend in the same direction as the wave of one larger size, or, as Elliott termed it, "degree."  In this example, the encircled wave numbers are labeled as Primary waves.  The Primary waves subdivide into a five-wave sequence of Intermediate degree waves, which, in turn, subdivide into a sequence of five Minor degree waves.  A three-wave "corrective" sequence then begins from the 1929 market top and ends in July 1932, well below the start of the bull market, a loss of about 90% in the Dow's value.  

Extended Impulse Waves

The above chart of the Dow also illustrates the concept of "extended" waves, which holds that one of the three impulse waves in an Elliott sequence will always be "extended" or longer than the other two, regardless of degree.  In Elliott's original work, he noted that 5th waves were more frequently the extended wave in a sequence.  Frost and Prechter in their 1978 book "Elliott Wave Principle," revised this view to suggest that 3rd waves were more commonly extended, and their view has come to dominate wave labeling.  Each of these tendencies is seen in the above chart.  Both at Primary and Intermediate degree, the 5th wave extends from 1926-29, and 1928-29, respectively.  At the Minor degree level (1928-29) wave 3 is clearly the extended wave.  Correctly identifying the extended wave is important in forecasting the depth of the correction to follow.

Differences Between Internal Wave Structures

Frost and Prechter classify internal wave structures as being one of two modes -"motive" or corrective.  They use the term "motive" to describe those waves that "impel" the market.  Internally, motive waves are always 5-wave structures; corrective waves are always 3-wave structures.  In the impulse sequence, therefore, Waves 1, 3 and 5 are motive; Waves 2 and 4 are corrective.  This should not be confused with the ABC corrective pattern (discussed below) whose internal waves may subdivide as motive or corrective, depending on the type of correction taking place.

Corrective Wave Patterns

Elliott, Frost and Prechter classified 21 corrective patterns, from simple forms to more complex structures and combinations.  Three of the simple patterns, and those which form the building blocks of the more complex structures, are illustrated below.  These are corrective patterns following an uptrend.  The patterns would be inverted following a downtrend.

Zigzag:  Zigzag patterns are sharp declines (or advances in a bear rally) that substantially correct the price level of the previous impulse sequence.  Often wave B (the counter-trend wave of the ABC pattern) is the shortest relative to A and C.  In zigzag patterns, the sequence may double or triple up until the price correction target is achieved.  Zigzags internally subdivide 5-3-5 as follows: Wave A (5-waves, motive), Wave B (3-waves, corrective), Wave C (5-waves, motive).

Flats: Flats are triangular structures that tend to move the market in a what Elliott called a "sidewise" (sideways) pattern.  The ABC waves also tend to be equivalent in length.  In the flat pattern, wave B will often undo the work of A and frequently tops in the area of the previous wave 5.  Because of this action, wave B's tend to fake-out traders who think the correction is over. Wave C then undoes the work of wave B.  There are also variations on the flat correction pattern, which include "expanded" flats (Elliott described them as "irregular") in which wave B tops well beyond the start of wave A, and wave C is substantially larger than A, generally by 1.618 or 2.618 the length.  In a "running" flat, waves A & B are similar to an expanded flat, but wave C is shorter than wave A.  Flats internally subdivide 3-3-5 as follows: Wave A (3-waves, corrective), Wave B (3-waves, corrective), Wave C (5-waves, motive).

Triangles: Elliott described two distinct types of triangles: Diagonal and Horizontal.  Diagonal triangles are part of ending sequences in a wave pattern, and therefore can occur within a wave 5 or a wave C.  According to Elliott, diagonal triangles form when market action has moved "too far, too fast" and represent exhaustion of the trend.  The 5th wave of the diagonal will frequently spike sharply above the upper trendline of the triangle in what Elliott called a "throw-over." A trader should be alert to a diagonal triangle formation, as it signals an impending and sharp trend reversal.  Horizontal triangles, on the other hand, are corrective structures.  Also called "wedges," horizontal triangles are identified by drawing parallel trend lines along the peaks and troughs of the wave labels.  D and E labels are added to fill out the sequence.  In heavily corrective and choppy markets, there can be as many as 11 to 15 waves within the overall horizontal triangle structure.  In all cases, the completion of a triangle pattern is normally followed by a sharp "thrust."  The direction of the thrust is determined by the wave pattern in progress.  One unique type of triangle, that is related to the family of "irregular flats" is the "Running Triangle," which was described by Frost and Prechter as one in which Wave B of the triangle exceeds the start of Wave (A).  Since Running Triangles are cousins to both flats and horizontal triangles, they are most common to fourth waves and other corrective wave patterns.   

Internally, all subwaves in a triangle are "threes", which tend to overlap. The only exception is a structure identified by Frost and Prechter (though not originally by Elliott) called a "leading diagonal" triangle, which occurs in the first wave position and subdivides 5-3-5-3-5 (like an impulse wave).  Unlike an ending diagonal, this structure implies a continuation of the trend.  They caution, however, against confusing this with a progression of first and second waves, which is far more common.

Corrective Combination Patterns

In forming more complex corrections, the basic corrective patterns may, and often do, combine to extend the corrective process.  Most common is a doubling of the pattern, and less frequently, a tripling.  These result in the following types of combinations:

1. Double Zigzags and Triple Zigzags (self-explanatory)

2. Double-Three:  The components of a double-three include...

• • Flats-Flat

  • Flat-Triangle

  • Zigzag-Flat

  • Zigzag-Triangle

3. Triple-Three:  The components of a triple-three include...

• • Flat-Flat-Flat

  • Flat-Flat-Triangle

  • Zigzag-Flat-Triangle

  • Zigzag-Flat-Flat

To help clarify the labeling when these combinations occur, Frost and Prechter devised the labels W, X and Y to identify the main sections of a double combination, and W, X, Y and Z for triple combinations.

Rules of Wave Labeling

Correctly labeling waves is at the heart of wave analysis.  Incorrect labeling can prove very costly to a trader, and so it is important to observe the rules of labeling.  Elliott established three simple rules that, if not observed, will invalidate a wave count:

• 1. Wave 3 can never be the shortest impulse wave.

  2. Wave 2 can never exceed the start of Wave 1.

  3. Wave 4 can never overlap Wave 1 (i.e., cross into the same price area).  

In addition to these rules, there are guidelines that aid in labeling waves.  They are not as inviolate as the rules, and they help in telling you what to look out for.  Three of these guidelines include:

Alternation:  If Wave 2 is a sharp correction, expect Wave 4 to be a sideways correction.  Conversely, if Wave 2 is sideways, expect Wave 4 to be sharp.  More often than not, Wave 4 is sideways, subdividing as either a flat or triangle.  In corrections, if Wave A is a simple structure, expect Wave B to be more complex.  Wave C may or may not be more complex relative to A.

Depth of Correction: Generally, following impulse wave sequences where Wave 3 is the extended wave (the most common scenario) the subsequent Wave A correction should terminate in the area of Wave 4.  

In cases where Wave 5 is the extended wave, either Wave A alone, or the entire correction, will be sharp, and bottom in the area of a Wave 2 of lesser degree.  We see an example in the Dow chart above.  Note that Primary Wave A terminates right at the area of Minor Wave 2.  Wave C may bottom here as well, or just as often in either the Wave 4 area from where the extension began, or it can also erase the entire impulsive rise, as also seen in the above chart of the Dow. 

Wave Relationships: Two of the non-extended impulse waves (generally waves 1 & 5) will tend to be equivalent in length and time of formation, or will be related by a Fibonacci ratio (more on that in the next section).  Waves 2 & 4 are also similarly related, as are Waves A & C.

There are other guidelines identified by Elliott, Frost and Prechter, and it is important to note that all rules and guidelines operate at all wave degrees, whether intraday or over longer time-spans.

Wave Labels & Degrees

Since all waves subdivide into smaller waves, there is a hierarchy that is used to label wave movement that covers everything from broad expanses of time, to hourly market movement.  Elliott developed a labeling method that was slightly revised by Frost and Prechter in their 1978 book.  Most important are the wave degrees under study, which include, in descending order:

At the top of the pyramid are the family of Cycle waves, which can take decades to complete.  Primary and Intermediate waves cover shorter periods of years and months.  Minor waves and lower reflect daily and intraday market action.  In describing a wave pattern, an Elliottician might say, for example, "the S&P is tracing out a Minor Wave 5 down within an Intermediate Wave (A)."  What this would tell the analyst is that the subwaves of Intermediate Wave (A) are about to complete their sequence, and that an Intermediate Wave (B) up (a good, tradable market rally) will begin once (A) bottoms.  A series of price targets for a bottom will normally be included in the analysis.