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Elliott Wave Theory

The theories of self-appointed stock market experts come and go; however, the theories of pioneering market analysis with the gift of timeless trade strategy development remain over the course of centuries. Among those with the pioneering gift was R.N. Elliott, whose assertions in regard to market movements and a diversity of other components of stock trading have remained as an invaluable contribution to economic and financial theory. Elliott presented that the stock market “is like a river: customized by well defined borders of uniform width; becomes blocked by barriers from time to time; and majestically escapes the barriers…narrow channels mean greater speed of flow and the river curves according to encountered resistance”. Today, market analysts across the globe use Elliott’s Wave theory and stock market charts to predict future price direction. Further, the Elliott Wave International (EWI) was formed in Elliott’s honor and as a source knowledge and applications of the tenets of his pioneering Wave Principle. This paper will present a historical illustration of historical accountant and trade analyst Ralph Elliott, and the fundamental tenets of his theory in regard to its applications to stock price movements.

1) About Ralph Elliott

            Ralph Nelson Elliott was born in 1871, in Marysville Kansas and began to research stock market behavior later on in life after retirement at the age of 58. As a youth, he was gainfully employed as a telegraph operator; train dispatcher; railroad lineman; a stenographer and an accountant. However, between 1929 and 1934, Elliott’s extensive domestic and international travels and his studies of the stock market indices and market behavior expanded and eventually surfaced publicly through his sharing of his interests and findings with Charles Collins.

            Elliott’s theory evolved at a critical time in economic and financial market history, as the stock market crash from 1929 to 1932 and the Dow Jones 1935 decline increased trader skepticism and disinterest in new strategic ideas. Further, chronic illness plagued the theorist’s ambitions and his ability to aggressively partake in the authorship of his the trading theories.

Nonetheless, Elliott’s literary contributions of stock market trading include The Wave Principle (1938), The Financial World Articles (1939), The Fibonacci Summation of Series of Dynamic Symmetry (1940, and Nature’s Law - The Secret of the Universe (1946). In the final years of his life, Elliott served as a financial advisor to many that called upon him to tap into his knowledge of short term trading approaches that reduce risk.

2) Elliott Wave Theory Explained

            After 75 years of investigation into the stock market indices, Elliott concluded that human emotions, which drive their decision making mechanisms, are rhythmic; and thus, predictable. The personality of the wave reflects the mass psychology that impacts the market. In this light, Elliott theorized that the markets move in recurring and identifiable patterns or waves. (Kotick, 1996) presented that the primary factors that underpin Elliott’s Wave Theory are trends in crowd behavior and recognizable, consistent pattern reversals. The predictable wave movements may be applied to the Dow Jones, individual stocks, and a diversity of commodity markets (Pretcher, 1980).

            Elliott (1938) theorized that stock price movements are not significantly impacted by current news; but rather are direct outcomes of the mass psyche of the market participants. Subsequently, he developed a 5-3 wave pattern that is the fundamental unit of several wave patterns that extend from the 5-3. The Elliott wave patterns may be identified in financial markets that exhibit sufficient liquidity and volume.

            A fundamental focus of Elliott Wave Theory is pattern recognition that may be used to forecast price movement trends. The price movement predictions were to be based upon the existing price trends. Cyclical patterns of mass psychology are presented in 5 upward waves and 3 downward waves for a total of 8 waves. Based upon this pattern, after 5 waves upward, the price could be forecasted to fall by 3 waves. Each wave consists of a combination of smaller waves. In reference to time, the wave pattern may last for durations that span from hours to days, months, or years.

            A complete cycle, or dimension consists of 5 waves which are fractal, or may be divided into segments that exhibit self-similarity.  (Pretcher, 1980) proposed that Elliott selected the number 5 as a result of its significance as the number of completion in the context of social movement. (Kotick, 1996) contributed that the financial markets progress in sequences of 5 waves in both bull and bear markets. Nonetheless, trending movements in the market are depicted as a 5-3 pattern. The first pattern is a 5 wave pattern that is referred to as the impulse wave. The final pattern is a 3 wave pattern that is referred to as corrective waves. The 5-3 wave pattern is divided into motive waves 1, 3, and 5; and corrective waves 2 and 4. The rules that support the Elliott wave theory are:

Rule number 1: Wave 2 cannot extend beyond the initial point of wave 1.

Rule number 2: Wave 3 cannot be the shortest impulse wave in the pattern.

Rule number 3: Wave 4  cannot extend into the price range of wave 1.

The labeling of the wave pattern trends are based upon sizes from the Grand Supercycle to the subminuette (see table 1, Appendix A). The wave principles are applicable within all time frames and are useful in the identification of the direction of market trends; peaks in buying and selling; and the location of overall pattern unfolding of the pattern for capital decisions in regard to whether market opportunities are available.

2.1) Impulse Waves

            The 5 wave impulse pattern consists of all of the phases of one dimension is characterized by strong downward trends that interrupt the growth of the pattern. In any time frame, the impulse wave is depicted in the same direction as the primary trend. The 1, 3 and 5 impulse waves drive movements that are interrupted by waves 2 and 4; which create the complete wave pattern. Common types of impulse waves include the diagonal wave, ending diagonal, and leading diagonal. Figure 1 shows the 5 sub waves of the impulse wave:

Elliot Wave Theory

Figure 1. Elliott Impulse Wave

During wave 1, the stock moves upward due to a large number of investors entering the market and driving the price upwards. Wave 2 is characterized by investors taking profits and driving the stock price downward. Wave 3 is the strongest and the longest wave in the pattern, as the mass public becomes aware and buys in, reversing the downward trend and driving the price upward. In wave 4, the investors resume taking profits and is characterized by bullish trends. Wave 5 reflects movements by the masses and the stock is overpriced. The stock becomes shorted by some, which initiates the A,B,C pattern. One of waves 1, 3 and 5 is continuously extended, producing one wave in the diagram that is longer than the others. Typically, the extended wave will be wave 3 or 5. Instances in which wave 5 fails to extend beyond the end point of wave 3 are referred to as truncation.

2.1.1) Extensions

            Often times, the impulse wave will exhibit extensions to their normal patterns. Elliott theorized that when the extension occurs in wave 5 of an upward trend, an irregular top will typically carry the market into a new, higher territory beyond the peak of the 5th wave. Therefore, the extensions within the wave are highly significant and are also based upon rules:

         The extension occurs within new territory of current cycles.

         The extension is never the end of the movement.

         The extension is retraced in two instances.

         The first retracement occurs immediately in 3 waves at the onset of the extension.

         The second extension occurs during the progress of the market and move beyond the extension.

         When extensions occur, wave c consists of 5 downward waves and complies with the rules of double retracement.

2.2) Corrective Waves

            Market movements against trends of a higher degree prevents the wave pattern from traditional impulse wave movements and toward movements that reflect a higher degree of variation. These occurrences are depicted as corrective waves. Elliott’s corrective waves are depicted by trends that may be simple or complex; sharp or sideways.  The theory supports that the 5 wave trend is “corrected” by the 3 wave countertrend. Elliott proposed 21 corrective “ABC” patterns that vary in terms of complexity.

            Market movements occur in upward or downward movements in which the corrective wave is typically exhibited as a decline in price. The correction wave is reflected by movement in the opposition direction from the impulse; which equates to a countertrend that is comprised of 3 waves. Figure 2 shows the 5 waves of the corrective wave during an uptrend and a downtrend:

 Elliot wave theory 2

Figure 2. Elliott Corrective Wave

The corrective waves are labelled as A,B,C and retrace segments of prior trends. The correction waves fall in 4 general movements; and that in its formation, the wave pattern may be difficult to predict. When a movement travels between 2 points for a second time, it is referred to as retracement. Some corrective patterns include the 5-3-5, a,b,c zig-zag; 3-3-5, a,b,c flat formations; and the 3-3-3-3-3, a,b,c,d,e triangle formations. The impulse and the corrective waves combine to produce a complete market cycle.

2.2.1) Elliott Wave Triangles

            The triangle patterns are corrective, horizontal or diagonal patterns; and are either bound by trend lines that converge or trend lines that diverge. All of the waves in the triangles move in one direction. The horizontal triangle pattern is also comprised of 5 waves that move in opposition to the trend and consist of 3-3-3-3-3, a-b-c-d-e sequencing. The triangle wave occurs in specified positions within cycles in the stock chart. The position is prior to the final wave or as the final wave in a movement within the combination. The diagonal wave only occurs within the fifth wave. Further, the triangle wave may be ascending, descending, symmetrical or expanding.

            The price action that follows a triangle wave count is rapid and intense, and produces spike movements toward the target price. The price target is determined by the point on the deepest segment of the triangle along with the breakout point from the line of the converging trend between b and d. In the event that the targeted price is realized, the prices move back to the apex of the triangle.

2.2.2) Combination Waves

            The combination wave reflects the complexity of market behaviors that may not be depicted in simple wave patterns. The combination wave occurs when the corrective wave has not hit the targeted price and a time extension is required and reflects the corrective wave movements as sideways extensions. The combination wave may be in the form of double or triple 3s that are depicted by zig-zag or flat formations.  The double combination may be depicted as W-X-Y, and the triple combination may be depicted as X-Y-X-Z. Figure 3 shows the Elliott corrective flat, zig-zag, triangle and expanded flat wave patterns:

Elliot wave theory 3

Figure 3. Flat; Zig-Zag; Triangle & Expanded Flat Waves

The flat wave consists of 3 waves that are labeled A-B-C with a sub-wave sequence of 3-3-5. Wave B is an impulse wave; while waves A and C are corrective. The flat wave pattern is characterized by sideways movements and may be reflected in the 4th wave within the impulse wave. Expanded flat correction waves occur when wave B terminates beyond the onset of wave A and wave C terminates beyond the onset of wave B. The running flat occurs when wave B terminates beyond the onset of wave A, but wave C does not reach the onset of wave A.

            The single zig-zag correction wave consists of 3 waves that are labeled A-B-C with a sub-wave sequence of 5-3-5. Wave B is corrective; while waves A and C are impulse waves. The zig-zag is characterized by sharp corrections and typically is reflected in the second wave position of the impulse wave. Figure 4 shows zig-zag and flat corrective waves on a stock chart:

Elliot Wave theory 4

Figure 4. Zig-zag and Flat Corrective Waves on a Stock Chart

The corrections are depicted by numbers, and all but the triangle have a Wave C with 5 waves. Wave B has 3 waves in all phases.All but the zig-zag exhibit a Wave A with 3 waves. Further, the corrective waves depict upward slopes on the stock chart that reflect against the dominating market trends.

2.4) Fibonacci Summation

            The Fibonacci ratio is a natural constant that was developed based upon theory of the association between numerical series in nature and mathematical laws that are similar to Elliott’s perceptions of natural laws. The critical values of 0.618 and 1.618 may be used to project the end of an upward price trend. The 3 levels of the Fibonacci retracement levels are 38%, 50% and 62% regions with reversal points that are highly reversible. Elliott presented that “all human activity is characterized by 3 unique features of time, ratio and pattern; all o f which are in observance of the Fibonacci summation series”.

            The degree to which the Fibonacci Summation is embedded in Elliott’s Wave theory is evidenced in the mechanisms that factor into a diversity of wave patterns. Waves 2 and 4 often reflect off of the Fibonacci retracement levels. In instances of the 3 wave pattern, the peak of wave 5 may be calculated as .618 times higher than the total movement from the peak of wave 1 to the peak of wave 3. When the stock price moves continuously in one direction, the movement is referred to as a swing. When the swing size is defined, the price targets may be calculated using the Fibonacci ratios. The quotient dampened swings that surround the 1.618 or 0.618 values in the Fibonacci series may be identified in the higher and lower values of Elliott’s Wave Principle.

3) Applications of Elliott’s Wave Theory

            The applicability of Elliott’s Wave Principle lies in the use of the theory as a guide to make decisions in regard to long versus short trades. The fact that the Elliott Wave may be used across all time frames makes the Wave extremely useful as a supportive tool for market trading in terms of probability.  The most basic application is the identification of market price patterns through the wave size and movements on the stock chart; and more specifically, the identification of the 5-3 wave pattern. Guidelines to include Channeling; Scale; Depth; Alternation; and Equality are used to apply the Elliott Wave Theory to market analysis. The number of possible valid interpretations of the wave patterns are minimized by Elliott’s rules and the corresponding trading strategy guidelines.

            The Elliott Wave may be applied to foreign exchange markets, fixed income, commodity and equity trading. Some support that the use of candlestick signals with the Elliott Wave theory provides the most recent trend direction. Forex traders benefit from using the Elliott Wave Theory to maximize profits through the identification of market trend directions. In regard to bull trends, the Wave provide a method for identification of current market position and predictions of the direction in which it is heading.

            The conclusions to which Elliott arrived through challenges of illness and age, and during a period that was absent of computer technology had to be, at best, painstaking and consuming. Several books have been published that attempt to explain the essence of the Wave theory in practical terms. The Elliott Wave International (EWI)  technical analysis firm was created by Pretcher & Frost in order to introduce the tenets of the Wave theory to a wide audience. The EWI (2016) founder, Robert Pretcher asserted that the Elliott Wave Principle is a statistical exercise and a “measurement of investor psychology, which is a representation of actual engine behind the markets”. (Kotick, 1996) described Elliott’s Wave Theory as “ahead of its time”. Although some of the concepts of the Wave Theory become complex and require some degree of high level comprehension and practice; in essence, the Elliott Wave Theory has made an invaluable contribution to financial market analysis and economic theory.

References

Elliott, R. 1938. The Wave Principle. In (eds) Pretcher, R. 180-1994. R.N. Elliott’s Masterworks - The Definitive Collection. Gainesville, Georgia: New Classics Library.

EWI. 2016. Introduction to the Wave Principle. Elliott Wave International. Retrieved from http://www.elliottwave.com/Free-Reports/Introduction-to-the-Wave-Principle

Forex Abode. 2016. Elliott Wave Theory. Retrieved from http://www.forexabode.com/forex-school/technical-indicators/elliott-wave-theory/abc-correction/

Kotick, J. An Introduction to the Elliott Wave Principle. The London Bullion Market Association. Alchemist, 40, 1996.

Pretcher, R. 1980. The Major Works of R.N. Elliott. New Classics Library, Inc.

Rosenbloom, C. 2016. Elliott Wave Theory. Afraid to Trade. Retrieved from http://blog.afraidtotrade.com/elliott-wave-quick-cheat-sheets/

Appendix A

Elliott Wave Pattern Trend Labelling

Elliot wave theory 5

Table 1. Elliott Wave Pattern Trend Labelling


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