Ralph Nelson Elliott (1871-1948), an accountant, began a systematic study of 75 years of stock market data in the early 1930’s. Whilst others believed that markets appear to move in random and unpredictable directions, he found that they actually moved in predictable patterns that tended to follow natural laws and Fibonacci ratios. He first published a book on his studies titled The Wave Principle in 1938 which was followed up in 1946 with his most comprehensive work titled Nature’s Laws: The Secret of the Universe.
ELLIOTT WAVE ANALYSIS, AN EXTENSION TO TRADITIONAL TECHNICAL ANALYSIS
The core belief of traditional technical analysts is that by applying various methodologies to the price action displayed on charts of stocks/indices/sectors etc, it is possible to gain an insight into possible future price action.
Trend lines, channels, levels of support/resistance, and a number of recognisable patterns such as Head and Shoulder, Cup and Handle, Double/Triple Tops/Bottoms, Pennants, Flags, etc form part of the tool kit available to the analyst. Complementing these direct price action tools are a large number of technical indicators such as RSI, MACD, Stochastic, Bollinger Bands, Moving Averages, etc, that have been developed over time to measure some of the so called ‘under the bonnet’ aspects of the market price action.
By combining one or more of these technical tools, analysts are able to make decisions on the likely future price action of the stock/index under consideration.
We can see from the above that pattern recognition has always been one of the most important tools used in analysing the market. It is my view that Elliott Wave (EW) analysis takes pattern recognition to a new level. EW analysis observes all market price action as a series of contiguous recognisable patterns strung together to form the entire market action price action picture. These same recognisable patterns occur in every time frame thus making it a useful tool for anyone from a day trader to a long term investor.
THE BUILDING BLOCK OF ELLIOTT WAVE ANALYSIS
When traders/investors are exposed to charts for the first time the first observation that they make is that prices (in the majority of cases) do not travel in straight lines. Instead they appear to travel in a haphazard fashion between different price levels. Through his studies R N Elliott discovered that the price action found in share market charts travelled in what he termed “waves” and that these waves fell into two categories, namely impulsive and corrective patterns.
Elliott found that the basic building block of patterns found in the share market was a simple 8 wave pattern. The first fives waves of this building block formed the impulsive portion of the pattern whilst the following 3 waves formed the corrective portion of the pattern. To differentiate between the impulsive portion and the corrective portion he labelled the former with numbers and the latter with alphabetic characters. Refer to Figure 1 below.
The key to successful Elliott Wave (EW) analysis is the identification of the correct level of pattern under examination. EW patterns occur at every level of share market price action.
For example the pattern in Figure 1 (left) could be a subset of a larger pattern and at the same time the analyst could drill down into the individual legs of that pattern and discover that these are made up of other patterns.
Refer to diagram below.
Note that the above diagram drills into the individual legs of the previous pattern. We can also see that the encircled pattern is another 8 wave pattern consisting of an impulsive component and corrective component. So we can see from the above diagram how the basic EW pattern can be repeated at every level of share market price action.
The above diagram also clearly shows that the impulsive component of the 8 wave pattern is made up 3 legs (waves 1, 3 and 5) which are impulsive and 2 legs (waves 2 and 4) which are corrective.
The following diagram shows how the appearance of two levels of pattern will make a 5 wave impulsive pattern look as though it has a total of 9 waves. This is an illusion that is brought about by the appearance of a lower level pattern (shown in red) within the 3rd wave of the original impulse pattern. This is also sometimes called an extended impulse pattern. This most often occurs in the 3rd wave of an impulse pattern but also often occurs in the 5th wave especially in commodity charts. When two extensions occur, the pattern will appear to look like a 13 wave impulse pattern.
Share market charts inevitably display 2 or more different levels of patterns on the same chart. Inability to differentiate between these levels can often lead to what I call “level confusion”.
As both impulse patterns and corrective patterns at one level are made up of a mix lower level impulse and corrective wave patterns this mixture can often confuse analysts as to where one higher level pattern finishes off and another one starts.
Corrective patterns can often be made up of a mixture of 2 or 3 higher level corrective patterns. This can lead to some very complicated corrective patterns which can be very difficult to identify until almost complete. I would advise newcomers as well as advanced EW practitioners under these circumstances to either cease trading on these occasions or use other methodologies to analyse the market until such time as the next impulse pattern appears.
Whilst the basic EW pattern is simple, EW analysis becomes complicated for the following reasons.
Rules for Impulse Waves
There are 3 main rules relating to pure impulse waves. These are:
* Wave 2 cannot fall below the starting point of wave 1
* Wave 3 is not the shortest wave by price movement when compared to waves 1 and 5.
* Wave 4 cannot fall into the price range of wave 1.
It should be emphasised that whilst wave 3 cannot be the shortest of waves 1, 3 and 5 that does not mean that it must be the longest. More often than not it is the longest but it does not have to be. In commodities for example wave 5 is quite often the longest of the motive waves.
We also sometimes develop a similar pattern in wave 5 of an impulsive pattern or the third wave of a corrective pattern. In this case because it is the last impulsive pattern in a higher level pattern it is called an ending diagonal.
Impulsive patterns move market pricing in the direction of the main trend. Because these patterns move in the direction of the trend they often tend to move quite aggressively, especially in the third wave of the pattern.
There are 3 basic impulsive patterns. The first is an impulse wave and these obey the abovementioned rules and generally look like the pattern in the above diagram. Sometimes in wave 1 of an impulse or corrective pattern the market will form an impulsive pattern known as a leading diagonal.
Like the standard impulse wave, they are a 5 wave pattern. The main difference between the leading diagonal and the standard impulse wave is that wave 4 almost always will fall into the price range of wave 1.
As can be seen from the above two patterns, they appear to be identical. There are however subtle differences. First of all, a leading diagonal can only be the first pattern in an impulse or corrective wave. An ending diagonal can only be the last pattern in an impulse wave or corrective wave. The other differences are in the format of the individual legs of the patterns. These formats of the individual legs of the pattern are defined below:
Impulse wave: impulsive-corrective-impulsive-corrective-impulsive. Also defined in terms of the number of legs in each pattern, ie 5-corrective-5-corrective-5. We don’t nominate the number of legs in the corrective legs because they can be either 3 or 5.
Leading diagonal: imp-cor-imp-cor-imp or 5-cor-5-cor-5.
Ending diagonal: cor-cor-cor-cor-cor
As implied by the name, corrective patterns move in the opposite direction to the main trend. As these patterns are moving against the tide of the market their patterns can be quite tortuous and complex. Because of this whilst there are only three impulsive patterns, there are a much larger number of corrective patterns. As this is only an introduction to Elliott Wave analysis I will only discuss the most common corrective pattern which is a 3 wave pattern.
The two most common 3 wave corrective patterns are the Flat and Zigzag patterns. The most aggressive of these two pattern types is the Zigzag. The individual legs have the format imp-cor-imp or 5-cor-5 as can be seen in the diagram below.
As can be seen in the above diagram, this pattern moves the price action significantly from the point of origin to the termination point.
Unlike the Zigzag the Flat pattern, in spite of moving through reasonably significant ranges in the individual legs, has a termination point which is not all that far from the point of origin of the corrective pattern. Whist there is only one basic form of Zigzag pattern, there are three basic forms of Flat patterns. These are shown in the following diagram.
The format of all 3 Flat patterns is cor-cor-imp or cor-cor-5. Note that in both the Zigzag and Flat pattern the last pattern is impulsive.
Furthermore since the last leg of an impulsive pattern is also always impulsive we can say that the last leg of all EW patterns (both impulsive and corrective) at some level is always impulsive.
Why is this important? It is because from this fact we know that when looking for the end of a pattern, we should always be looking for an impulsive pattern at either the level of the observed pattern or one level down.
Remember I said earlier in this article that one of the problems EW analysts have is determining where one pattern ends and another starts. Now we know what pattern we should be looking for when attempting to identify the end of a pattern.
Copyright: Rudy Dumas, 2011
An Introduction to Elliott Waves