Technical Analysis - Menu
1.
Technical Analysis - Elliott Wave, Gann and
Chart Patterns
2. Elliott Wave Introduction
3.
Secrets of Price Bars
4.
Fibonacci Number Sequence
5.
Market Cycles and Fibonacci
Elliott Wave Introduction – How Markets Move in
Recognisable Patterns
Ralph Nelson Elliott discovered that stock market charts move in a series of
recognisable patterns back in the 1950’s, publishing his findings in his book, The
Wave Principle. Elliott believed that the patterns reflected mass market psychology, (made
up of hundreds of thousands of collective investors’ opinions) and was a barometer of
man’s valuation of productive capability.
He described 13 patterns, or waves, that recur and are repetitive, whereby the
structures link together to form larger versions of the same patterns.
As the patterns repeat, the waves have a predictive quality, although I prefer to use
them to label what situation a market is in, rather than use them as a
predictive tool.
I use Elliott as a way of anticipating probable ensuing formations. And I mainly
focus on using my other techniques to trade the markets and ride trends.
Elliott Waves help to avoid trading some false signals and corrective, reactionary
waves and congestion areas. And I believe it is a great help to have some idea why a
market is moving how it is, in a pattern that you can label.
The Basic Wave Formation
The basic Elliott Wave formation is made up of 5 sub-waves that propel the market in
a trending direction – called a Motive Wave.
Every one of the 5 sub-waves serves one of two functions: action or reaction.
Actionary Wave: Promotes the cause of the wave of a larger degree.
Reactionary Wave: Interrupts the progress of the wave of one larger degree.
The 5-pulse, motive wave is labelled with numbers (1, 2, 3, 4 and 5), with the
actionary waves being labelled with odd numbers, 1, 3 and 5; and the reactionary waves
being labelled with even numbers 2 and 4.
Figure 56: Basic 5-wave structure that propels the market in the direction of the
trend. Sub-waves 1, 3 and 5 are actionary waves. Sub-waves 2 and 4 are reactionary waves.
These 5 sub-waves complete ONE wave of a larger degree.
This 5-wave structure completes the movement that advances the trend. We can label the
whole Motive Wave pattern above as Wave (1) of a larger degree.
It is then followed by a Corrective Wave, which most often takes the form of 3
sub-waves. It is labelled with letters a, b and c. This 3-wave pattern, we can label as
Wave (2) of a larger degree.
Figure 57: After a 5-wave move in the direction of the main trend – Wave (1) of a
larger degree – the wave is corrected by what is usually a 3 wave pattern, which is
labelled with letters: a, b, and c. This 3-wave correction forms a complete formation that
we can label Wave (2) of a larger degree. Therefore, the diagram above now shows 8
sub-waves that form Wave (1) and Wave (2) of a larger degree.
This complete 8 sub-wave pattern is what typically makes up the Elliott Wave structure.
It is important to realise that the pattern can be ascending (a bull market) or descending
(a bear market). If the main trend is up – then we will see 5 waves moving up,
followed by 3 waves moving down. If the main trend is down, we will see 5 waves moving
down, followed by 3 waves moving up – correcting the main trend.
I have spoken of the complete pattern forming one or two waves of a LARGER DEGREE. This
is another important point of Elliott Wave Principle:
That the main pattern is prevalent in all markets of all time frames…
If the chart above was a based on a daily price chart, then one could zoom in on the
market and look at, say, an hourly or 30-minute chart and see the same patterns (5’s
and 3’s) of a smaller degree.
For example:
Figure 58: Zooming in on the same chart on a smaller time frame, one can see the same
5’s and 3’s formations making up each wave with sub-waves of a smaller degree.
You will notice that once the 3 wave structure (a, b, c) shows sub-waves of a 5, 3, 5
formation in the correction. This is because, on the pattern of a smaller degree, the
trend is now downwards. Waves a and c propel the market in the direction of the main
trend – downwards in the smaller degree – and wave b corrects this down trend by
moving upwards in a "3".
Another point to note is the number of sub-waves involved to make each pattern:
Figure 59: Sub-wave counts of the entire pattern.
SIZE="5">
Waves (1) and (2) = 2 waves of the largest degree
SIZE="5">
Waves 1, 2, 3, 4, 5, a, b, c = 8 waves, one
degree smaller
Waves 1, 2, 3, 4, 5, a, b, c, 1, 2, 3, 4, 5, a, b, c, 1, 2, 3, 4, 5 and 1, 2, 3, 4, 5,
a, b, c, 1 , 2, 3, 4, 5 = 34 waves, two degrees smaller.
If one looked at the same market on a longer-term time scale, such as weekly or
monthly data, then waves (1) and (2) would form only sub-waves in the larger pattern. I.e.
they would probably be followed by another 5-wave advance making Wave (3), a 3-wave, abc
decline making Wave (4) and a final 5-wave advance making Wave (5).
If one zoomed in on the same market on a smaller time scale, such as 15 minute
or 5 minute data, then each of the smallest waves labelled above (that make up 34
sub-waves) would be seen to divide in the same 5 sub-waves and 3 sub-waves formations.
The table below illustrates the amount of sub waves in each degree:
Largest Waves = 1 + 1 = 2
Largest Sub Divisions = 5 + 3 = 8
Next Sub Divisions = 21 + 13 = 34
Next Sub Divisions = 89 + 55 = 144
This process continues indefinitely: Each eight-wave cycle completes 2 waves of a
larger degree and, as long as the process continues, the process of building to a larger
degree continues. The process of sub-dividing to a smaller degree also continues to
infinity as well.
The general categories of Elliott Degrees are shown below. I have also given some
possible examples where one might be able to count the Elliott Wave formations:
Grand Supercycle
(Example: Market data from as far back as records allow. Some market data is available
from the 1600’s)
Supercycle
(Example: The Dow Jones from the 1800’s)
Cycle
(Example: monthly charts of the Dow Jones with; Wave 1 from 1932-1937, Wave 2 from
1937-1942, Wave 3 1942-1966, Wave 4 1966-1974, Wave 5 1974-2000?)
Primary
(Example: Dow Jones weekly charts)
Intermediate
(Example: Dow Jones daily charts)
Minor
(Example: Dow Jones 30-minute charts)
Minute
(Example: Dow Jones 15-minute charts)
Minuette
(Example: Dow Jones 5-minute charts)
Elliott Wave Trading Rules
Motive Waves
Motive Waves are made up of 5 sub-waves. They are very common, they follow the
direction of the main trend and easy to interpret.
The basic tenets of trading a Motive Wave are:
Wave 2 can never retrace more than 100% of Wave 1.
Figure 60: Wave (2) can never retrace more than 100% - i.e. the entire length – of
Wave (1). I.e. the bottom of Wave (1) is the maximum low for Wave (2). The diagram above
shows Wave (2) retracing around two-thirds of Wave (1).
2. Wave 4 can never retrace more than 100% of Wave 3.
Figure 61: Wave (4) never penetrates more than 100% of Wave (3). I.e. the bottom of
Wave (3) is the maximum low for Wave (4). To illustrate this point, the diagram above
shows almost a flat, zero retracement in Wave (2).
3. More importantly, Wave 4 can never move below the peak of Wave 1.
Figure 62: Wave 4 can never penetrate the peak of Wave 1.
(This last rule is true for non-leveraged cash markets. Futures markets, with their
high degree of leverage can "bend" these rules slightly, but this is rare.)
Elliott Wave Guidelines
The 3 points above are rules that must me obeyed when labelling Elliott
Wave formations. What follows below are guidelines that will help with labelling the waves
and trading them.
Guideline 1: Wave 3 can NEVER be the shortest of the actionary waves (1, 3 and 5).
Figure 63: Correct labelling because Wave 3 is longer than Wave 1 and Wave 5, i.e. Wave
3 is not the shortest.
Figure 64: Incorrect labelling because Wave 3 is shorter than Wave 1 and Wave 5.
Figure 65: This is what would probably happen in Figure 64. I have drawn the likely
outcome of the pattern shown in Figure 64 with grey lines. I have relabelled the start of
the wave as an extending third wave. This is explained below.
Guideline 2. Extensions
Most Motive Waves contain one actionary wave (1, 3 or 5) that extends longer the
others.
In rare cases, it will be the first wave that extends…
Most often, it is Wave 3 that will extend…
Occasionally, it will be the 5th wave that extends.
Quite often, Wave 3 and Wave 5 will extend.
It can sometimes be difficult – especially for newcomers to Elliott – to
count the sub-waves correctly.
There is one method that can often help to count any extending, actionary waves:
With one of the actionary waves extending – one usually extends - the total count
of sub-waves will be 9.
Here are some examples of different possible wave counts on one single chart’s
extending wave. (The same chart is used in all diagrams. The labelling is different, but
the final outcome is the same):
Figure 66: Extending First Wave. If you count all the sub-waves, there are 9 of them.
Figure 67: The same formation labelled with an extending third wave. Again, this could
be a correct count and if you count the individual sub-waves, there are 9. As wave 3 is
the one that usually extends, this is the most common labelling used by Elliotticians.
Figure 68: The same formation labelled with the fifth wave extending. Again, this could
be a correct count and if you count the individual sub-waves, there are 9.
There are a few ways that help me to decipher whether the market is still moving in a
certain wave. Much of the time, it is a visual thing – all of the actionary or
reactionary sub waves will be of a similar size.
Guideline 3: Wave 4 often retraces to the previous actionary wave’s Wave 4
area.
I have mentioned that the peak of Wave 1 provides strong support for a Wave 4 to fall
to. In the previous part of the course, I also said that I look for previous support and
resistance points to forecast market tops and bottoms.
Therefore, it makes sense that other support and resistance points, created by previous
Elliott waves in the formations will also provide likely targets for any reactionary waves
to retrace to.
One common support point is that of an actionary Wave 3’s fourth sub-wave, which
will provide strong support for a reactionary Wave 4.
For example:
Figure 72: Wave 4 commonly retraces to the support area of Wave (iv) of Wave 3.
Figure 73: Wave 4 retracing to the resistance of Wave (iv) of 3 in a bear market.
