The Elliott Wave Principle
"The universe is ruled by law. Without law it is self-evident there would be chaos, and where chaos is, there is nothing"
The quote above is from Elliott's first book "The Wave Principle", which was published in August 1938. With Elliott's discovery that laws reflect the human behavior govern the financial markets, we have finally been given a prober roadmap with which to read the financial markets.
Elliott's finding shows that a full cycle consists of a five wave move; A numbered phase, followed by a three wave correction, the lettered phase. Three of the five waves that forms any completed movment, will be in direction of the trend and two of the waves will be in the opporsite direction of the trend. Elliott numbered the movment from 1 to 5, where waves 1,3 and 5 are impulsive waves, while waves 2 and 4 are corrective waves. Once a five wave movment is complete, it will be followed by a corrective phase, which Elliott lettered from A to C.
A complete five wave movment from 1 to 5 (coloured)
A complete cycle numbered and lettered is shown below
As can be seen from the two figures above, the three impulsive waves (1,3 and 5) are in direction of the trend and is themself made up by five smaller waves. The two corrective waves (2 and 4) are in the opporsite direction of the trend and only consists of three smaller waves.
Wave 2 corrects wave 1, while wave 4 corrects wave 3. However, once the entire five wave movement from the start of wave 1 to the top of wave 5 is over, a bigger correction, than both wave 2 and 4 will take place (the lettered phase). This correction will be bigger in both time and price.
A complete five-wave movement followed by a three wave correction, completes the first and the second waves of the next higher degree. Elliott classified nine degrees of waves, which he named in the following order.
- Super Cycle
- Grand Super Cycle
The labeling of the different degrees is not overly important in the day to day counting of waves. However in regard to the very long term counts it is very important whether we just ended a primary degree of trend or it was a cycle degree of trend. Remember that any following correction will be of the same degree.
There are just three simple rules to remember in a five wave movment.
- Wave 2 can never exceed the starting point of wave 1
- Wave 3 can never be the shortest of the impulsive waves
- Wave 4 is not allowed to trade into the price territory of wave 1 (The only exception is when a diagonal triangle is developing).
Rule no. 1: Wave 2 clearly exceeds the starting point of wave 1, which makes the below count wrong.
Rule no 2 and Rule no. 3: Wave 3 is the shortest of the three impulsive waves, but wave 4 also clearly overlaps the price territory of wave 1, which makes this count wrong.
The correct way to count the rally is shown below, where both rule no. 2 and rule no. 3 is observed.
The First Wave
The first wave of a new bull market starts from a significant low. Ideally the absolute final part of a correction has been identified and a small five wave rally can be counted from this significant low, in order to confirm that a new impulsive rally is developing. This first minor five wave rally will make it past the reflex point (likely the wave four high of the prior decline). Once the reflex point is broken and a five wave rally can be counted. Then look for a corretion towards the 50% -61.8% area of this first five wave rally. This area will represent the safest entry area to buy into this new uptrend. As wave 2 is not allowed to break below the starting point of wave 1, stops should be placed just below the starting point of wave 1, in order to attain the optimal risk/reward situation.
As can be seen in the chart above, once the reflex point was broken, we had the first indication that a significant low was in place and a new rally might be developing. If we had looked at a smaller time frame it would have shown that the rally was in five small waves, and the correction after this first five wave rally was almost exactly 61.8%, representing a low risk entry point, with a stop just below wave i.
The above chart shows EUR/GBP reaching a significant low and that the first small five wave rally breaks above the reflex point. The following correction of wave 1 corrects slightly more than 61.8% of the first rally and makes an excellent entry point with a low risk stop.
The first wave in any new trend is often not a clear wave, as the battle between buyers and sellers still is almost equal. In a new uptrend the sellers sees this new rally as a new selling opportunity, while the buyers sees a possible new opportunity to buy.
From a significant top, look for a small five-wave decline below the reflex point. This should then be followed by a correction towards the 50% - 61.8% corrective target area before entering a short position, with a stop just above the start of the first wave.
The chart above shows USD/CHF and after a break below the reflex point a correction slightly larger than the 61.8% corrective target is seen in wave 2 before wave 3 lower takes over.
The Third Wave
This is where things really get interesting. Third waves are wonders to behold. Prices takes off in a powerful way, and if it is a market where gaps are seen, this is the wave where they most often will be seen. Elliott said that it is usual for at least one of the impulsive waves to extend. An extended wave is a wave that travels longer than would normally be expected. The third wave is normally the wave among the impulsive waves that does extend. Unfortunately there is no way to tell in advance if a wave will extend, but it would be wise to expect an extension in wave three.
If wave three does extend, it will at least become 161.8% the length of wave one, but often it can travel even longer and become 200%, 261.8%, 300%, 361.8 or even 423.6% of the length of wave one.
USD/JPY - The chart above clearly shows that wave 3 becomes a very powerful and extended wave. It can be seen that wave 3 becomes almost exactly 300% longer than wave 1. Looking at the chart it can also be seen that we had a minor pull-back from the 200% and the 261.8% targets, but they are far to small to be counted as a possible correction of wave 3. The pullback from the 300% target is, however, clearly more in line with what should be expected.
The Fifth Wave
Wave five is usually less strong than wave three and if wave three became an extended wave, then the first possible target for wave five would be where wave five equals wave one in length. There are however two other possible targets should always be calculated; The 38.2% of the distance traveled from the bottom of wave one to the top of wave three, then add the result to the bottom of wave four. Do the same calculation with the 61.8% of the distance traveled from the bottom of wave one to the top of wave three. Each of this possible targets for wave five, could be the top. However, the internal wave structure of wave five should be examined for additional targets where the final wave five target may be.
As mentioned before wave five tends to be less strong than wave three and that will show itself in form of "divergence" on a momentum indicator. Divergence is when price makes a new high but this new high is not seen on the momentum indicator. Divergence between price and the momentum indicator is a warning of a possible top, however a possible divergence can develop over many hours, days, weeks and even months depending on the degree of the trend.
USD/JPY - In the chart above it can be seen that wave five perfectly reached the first target, where wave five is equal in length to wave one. At the same time a clear divergence between the price and the momentum indicator (in this case the RSI) is seen. All pointing towards a possible top for wave five being in place.
Knowing where the possible top of wave five could be located is important. As said earlier once a five wave rally has been seen it will be followed by a correction bigger in both price and time than both wave two and four. The reason why this correction is going to be bigger is because it corrects the entire rally since the low of wave one and therefore is one degree larger than both wave two and four.
Dealing with corrective waves is where the Elliott Wave Principle gets really complex. It is not because there is an overwhelming amount of corrective waves, as there are only four main types of corrective waves, but the different corrective wave can merge together in ever more complex corrections., which can make them hard if not impossible to read at times.
As said there are only four main catagories of corrective waves and they are: Zig-zags (5-3-5); Flats (3-3-5); Expanding flats (3-3-5) and finally triangles (3-3-3-3-3).
The zig-zag correction is the simplest of the corrective patterns. It is made up of a five-wave move as wave "A" followed by a three-wave counter move as wave "B". This B wave will normally not correct more than 61.8% of wave A. Once the B wave is over another five-wave move in the same direction as wave A will occur, this wave is wave "C". Wave C will normally be equal in length to wave A, but it can be an Fibonnaci relation as 61.8%; 161.8%; 200 and even 261.8% of wave A.
EUR/GBP - Both wave ii and wave 2 became a zig-zag correction. Notice how wave 2 became much larger than both wave ii and iv because it was of one degree larger. It should also be noticed that wave a and c of wave ii was close to being equal in length, while wave C of wave 2 was 200% of wave A.
Wave 2 is often a deep simple zig-zag correction as the fight between bulls and bears is almost equal. Ideally wave 2 correctes 61.8% of wave 1, but wave 2 is allowed to correct 100% of wave 1. However, due to rule no. 1 wave 2 can not break below the starting point of wave 1.
This type of corrections is a sideways correction, where wave "B" ends at or very close to the starting point of wave "A" and wave "C" normally ends slightly below the ending point of wave "A". It is characteristic for this type of correction that wave "A" and "B" are made up of three smaller waves, while wave "C" is an implsive five-wave move; therefore they are often mentioned as a (3-3-5) correction.
Dow Jones Industrial Index - Wave 2 was a simple deep zig-zag correction, while wave 4 alternated and became a flat correction. It should be expected that wave 2 and 4 will be different in shape. Elliott called this "Alternation". It is valuable information, if wave two was a zig-zag correction, then wave four will become either a flat, an expanding flat or a triangle correction.
This corrective pattern is a variation of the flat correction. However, in an expanded flat correction wave "B" exceeds the starting point of wave "A" and wave "C" ends below the ending point of wave "A". Normally wave B and C will relate to wave A with a Fibonnaci expansion relationship. The most common relationship is that wave B becomes 138.2% of the lenght of wave A, but it can extend to 161.8 the length of wave A, while wave C normally becomes 161.8% of wave A.
Dow Jones Industrial Index - An expanded flat correction where wave B ends well beyond the starting point of wave A and wave C ends well below the ending point of wave A. Wave c becomes a massive 300% of wave A.
These are easy to recognize as they draw to an end, but they can be a bit of a pain while unfolding. Especially expanding triangles can be very hard to recognize. However, triangles only unfold as wave 4 of an impulsive wave or wave B of a corrective wave. This is very valuable information, as it is already known that once the next wave in the direction of the trend will be last, then the trend will revers.
Another clue triangles offer is that where the two converging lines, that forms the triangle, meet (the Apex) will often be the close to the top or bottom of the move.
USD/JPY - A major 12-year triangle was seen as wave 4 of the major impulsive decline, while a smaller wave iv of A triangle was seen during the rally from 2011. Notice how close the final low came to the triangle Apex.
All waves within a triangle will be made up of three-wave moves. One of the waves within the triangle will normally be more complex than the others. Expect wave C within the triangle to be the complex wave. Wave E of the triangle can itself become a triangle. At the same time wave E can be a very small wave as everybody knows it is a triangle by now, but there is no way of telling how wave E will unfold other than it will be in three waves.
There are two types of diagonal triangles. The first is an ending diagonal. As the name says it will only be found in wave 5 of C and show hesitation of the trend. An ending diagonal is made up of five waves, but they are all in three waves only, where wave one and four likely overlap, which normally is not allowed (remember rule nor. 3), but diagonal triangles are the exceptions.
Once an ending diagonal terminates, the trend normally reverses quickly and tend to move back to the starting point of the ending diagonal triangle.
USD/JPY - The final wave 5 after the triangle became an ending diagonal triangle and once wave 5 terminated the trend reversal was quick.
The other type of Diagonal Triangle is the Leading Diagonal triangle. The leading diagonal triangle is the only imuplsive wave, where overlapping waves between wave one and four is allowed. Leading diagonals is only found as wave one or wave "A" of corrections. The leading diagonal is different from the ending diagonal. As the sub-waves will show it consists of 5-3-5-3-5 as any other impulsive waves does.
EUR/GBP - A nice Leading Diagonal Triangle is seen as wave 1 out of the 0.7763 low. After a brief wave 2 the powerful wave 3 higher was seen.
The above description of the Elliott Wave Principle covers the basics, but it is strongly recommended to read Frost and Prechter's "Key to Stock Market Profits". This book does an excellent job providing a more in debth knowledge of the Elliott Wave Principle.