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Elliott Wave Theory

Elliott wave theory is one of the most popular theories used in technical analysis, that might be helpful in understanding the way that trends develop, and therefore in making more accurate prognoses.

Eric asks:

Eric, Jill and John are having a walk along the seaside.

Prof. Jill, the Investor

Prof. Jill, the Investor

Oh, I just love the sound of waves, it’s so tranquilizing.
John, the Trader

John, the Trader

Yeah, that plan to spend the weekend at the sea was such a great idea!
Eric, the Beginner

Eric, the Beginner

Speaking of the waves reminds me that I read an interesting article – its author wrote about the next move in gold price that was – in his opinion – inevitable. He mentioned using something called Elliott Wave theory. I tried to delve a bit more into that but couldn’t figure this whole thing out. Besides, I had to pack my stuff for the trip. Thought you guys could help me out with that.
Read the whole discussion

It was created by Ralph Nelson Elliott in the late 1920s and described among others in his books The Wave Principle (1938) and Nature’s Law – The Secret of the Universe (1946).

The basic pattern

The most important part of the theory is the claim that markets move in a repetitive sequence of five wave advance followed by a three wave decline such as in the diagram below:

Elliott Wave Theory Basic 5-3 Pattern

Waves are classified into two groups: impulse waves which move in the direction of the larger degree wave and corrective waves which move against it. In the above diagram waves 1,3,5,a and c are impulsive and waves 2, 4 and b are corrective.

Fractal structure

Each wave can be further subdivided into smaller waves and is itself a part of a bigger one. There are many wave (or trend) degrees in the theory, ranging from Grand Supercycle, covering two hundred years, to Subminuette, lasting only several hours. But no matter which degree of trend is considered, the basic 5-3 pattern is always the same: impulse waves have the form of 5-wave sequence and corrective waves have the form of 3-wave sequence. In mathematics, objects with such a self-repeating structure are called fractals. This is why Elliott waves are said to be fractals.

The following diagram illustrates this idea:

Elliott Wave Theory Fractal Structure

For clarity’s sake waves forming a larger degree impulse wave are numbered from 1 to 5, while waves forming a larger degree correction wave are marked using letters a, b and c (just like on the diagram at the beginning). There are various labeling conventions (using parentheses, Roman numerals, capital letters, etc.) to distinguish between different degree waves.

As we can see, wave I is subdivided into 5 smaller waves numbered from 1 to 5, and each one of these waves is, in turn, split into yet smaller waves: waves 1, 3 and 5 – since they are impulse waves – are comprised of 5 ones, numbered (i) – (v), while waves 2 and 4 – being corrective waves – contain three lesser degree waves, labeled (a) – (c).

As wave II is a corrective one, it is subdivided into 3 smaller waves a – c, that are further subdivided into lesser degree waves. Since a and c are impulse waves (they move in the direction of wave 2 which is the higher degree wave in this case), they contain 5 waves each, numbered (i) – (v). Wave b, being a corrective one (it moves against the direction of wave 2) is split into three lesser degree waves, labeled (a) – (c).

As we have seen, counting waves is extremely important in Elliott Wave Theory. In order for it to yield meaningful prognoses, one needs to determine the current higher degree trend. What should be remembered is that – according to the theory – correction can never take place in five waves – if it does, it may be the beginning of the next larger degree move.

Important rules and guidelines

There are three very important rules that cannot be broken in the recognition of Elliott wave patterns and one regarding corrections:

  1. Wave 2 can never go beyond the start of Wave 1
  2. Wave 3 can never be the shortest impulse wave 
  3. Wave 4 cannot overlap Wave 1 
  4. Correction can never take place in five waves – this has already been stated before but is extremely important and should always be kept in mind when using Elliott Wave Theory. 

There is also one useful rule used in Elliott Wave Theory – the rule of alternation. It is not considered unbreakable like the three rules mentioned above, but it can be helpful in predicting the way the second correction will look like. The rule says that the market does not behave the same way two times in a row. So when the first correction was sharp, the second one will probably be relatively flat. And if the first one was flat, the second one should be relatively sharp.

Fibonacci sequence – the mathematical basis of Elliott Wave Theory

Fibonacci sequence is used to set price objectives in Elliott Wave Theory. Actually, it is not the sequence itself, but the ratios produced by it that are used the most, i.e. the golden ratio or phi (approx. 1.618) and its inverse (0.618).

Impulse waves number 3 and 5 can be projected using the golden ratio. Minimum price objective for wave three can be obtained by multiplying the length (i.e. the difference in price from the top to the bottom) of Wave 1 by 1.618 and adding it to the bottom of Wave 2.

Minimum and maximum price objective for Wave 5 is obtained by multiplying the length of Wave 1 by 3.236 (which is 2*1.618) and adding it either to the bottom or the top of Wave 1.

The most popular way to obtain price objectives for corrective waves is through the use of Fibonacci retracement levels. The most frequent ones are 38.2% (the square inverse of golden ratio), 50% and 61.8% (the inverse of golden ratio). So in a strong trend the price will usually retrace about 38.2% of the previous move and in a weak trend, the 61.8% retracement is more likely. An example of Fibonacci retracement levels “in action” can be seen below (charts courtesy of http://stockcharts.com/):

Elliott Wave Theory - Fibonacci Retrracements - and Silver

Individual Elliott Waves’ description

Let us now turn to describing individual Elliott Waves. We will begin with the 5-wave part of the 5-3 cycle that is presented on the diagram below (we will consider a bullish higher-degree wave, the description is analogous in the case of a bearish one).

Elliott Wave Theory - 5 Wave Part

Wave 1
The first wave of a higher degree one is always quite hard to spot. The situation on the general market or on the market of this particular stock/commodity is rather pessimistic as everybody still remembers the previous downtrend. Hence, this wave can be mistakenly taken as yet another correction. In order to be considered Wave 1, this wave needs to be significant, it should, for instance, exceed the previous low.

Wave 2
It is a correction wave. Price usually retraces up to 61.8% of Wave 1 length. According to one of the unbreakable rules mentioned before, it cannot exceed the Wave 1 low. The volume should be lower than in the first wave. Economic news is still pretty negative.

Wave 3
It is often the largest wave of all five waves in the major wave. It should have the length of approximately 1.618 times the length of Wave 1. The volume should be higher than in the previous waves and is quite often the highest of all five waves. At the beginning the news is still negative but it gradually becomes more and more optimistic and finally the stock exchange (or that particular market in the case of individual stocks/commodities) attracts the general public.

Wave 4
Another correction, retraces from 38.2% to 61.8% of the previous move but the fall is usually milder than in the case of Wave 2. This wave should not exceed the low of Wave 3 and the volume should be lower than in the third wave.

Wave 5
This is the final wave in an uptrend, quite often full of mass euphoria and the belief that prices will be rising forever. Yet many technical indicators finally start to show divergences and the volume is usually lower than in Wave 3

Now let us proceed to the A-B-C part of the 5-3 cycle. It is depicted in the following diagram (as we considered a bullish 5-wave part, we will focus on a bearish A-B-C one, but again – the description is analogous when it comes to bullish A-B-C pattern).

Elliott Wave Theory - 3 Wave Part

Wave A
This wave is quite hard to spot and is often erroneously interpreted as normal correction in an uptrend. The news is still very positive but the technical tools start showing signs of a turn in trend (such as the fact that volume is rising in the moves downwards and falling on the moves upwards or the above-mentioned divergences in technical indicators).

Wave B
This is a corrective wave seen by many as resumption of the previous trend, yet volume is lower than during Wave A and Wave B does not exceed Wave A.

Wave C
This is the final wave of the A-B-C pattern, often the largest of the three. Volume should be higher than in the previous two waves. By this time almost no one has any doubts regarding the presence of a downtrend.

Gold and Elliott Wave Theory

Elliott Wave Theory was – just as Dow Theory – originally applied to market averages. It may work on many markets but not necessarily on every one. We do not believe EWT is very useful in case of prices of gold, silver and mining stocks. It is quite easy to spot the 12345abc patterns in hindsight but there have been many cases when the prognoses formulated using EWT actually failed. These examples include April 2009 (prognoses for that correction went as far as $650 but gold did not fall below $865) or when gold broke through the $400 level, many Elliott Wave analysts predicted a fall to $200 that never took place (the price stopped at $372). We (Sunshine Profits) don’t put too much weight to EWT analyses, as it didn’t prove too useful (in our view that is) to precious metals investors during this bull market.

Conclusion

Elliott Wave Theory is one of the most popular theories striving to describe the behavior of the financial markets. It utilizes some interesting and useful ideas such as Fibonacci retracement levels (which are widely employed in practice and quite effective) or the idea of cyclicality and the shape that price movements sometimes take on, but it is definitely not infallible and that should be kept in mind when using this theory. It can serve as an addition to your technical analysis tools arsenal but you should not (as is the case with all other tools) rely solely on it. We personally don’t put too much weight to it.

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