When
investors and traders first discover the Wave Principle …..
When
investors and traders first discover the Wave Principle, there are several
reactions:
- Disbelief – that markets are patterned and largely predictable by
technical analysis alone.
- Joyous “irrational
exuberance” – at having found a “crystal ball” to foretell the future.
- And finally the correct, and
useful response – “Wow, here is a valuable new tool I should learn to
use.”
Just like
any system or structure found in nature, the closer you look at wave patterns,
the more structured complexity you see. It is structured, because nature’s patterns build on themselves,
creating similar forms at
progressively larger sizes. You can see these fractal patterns in botany, geography, physiology, and
the things humans create, like roads, residential subdivisions… and – as recent
discoveries have confirmed – in market prices.
Natural
systems, including Elliott wave patterns in market charts, “grow” through time,
and their forms are defined by interruptions to that growth.
Here's
what I mean by that. When your hands formed in the womb, they first looked like
round paddles growing equally in all directions. Then, in the places between
your fingers, cells ceased growing or died, and growth was directed to the five
digits. This structured progress and regress is essential to all forms of
growth. That this “punctuated growth” appears in the financial markets is only
natural. As Bob Prechter, the world's foremost
Elliott wave expert, says, “Everything that thrives must have setbacks.”
The first
step in Elliott wave analysis is identifying patterns in market prices. At
their core, wave patterns are simple; there are only two of them: “impulse
waves,” and “corrective waves.” Impulse
waves are composed of five sub-waves
and move in the same
direction as the trend of the next larger size. A corrective wave follows, composed of three sub-waves, and it moves against the trend of the next
larger size. As the picture below shows, these two patterns form similar
structures of larger sizes, or “degrees,” as R.N. Elliott, the discoverer of
the Wave Principle, called them:
The above
pattern begins with waves 1, 2, 3, 4 and 5 that together form wave (1) – a
five-wave, impulsive structure that tells us that the trend at the next larger
degree is also upward. If you were reading this in real-time, and the rest of
the pattern was not visible, it would also warn you to watch for a three-wave
correction.
Corrective
wave (2) in the chart above is followed by waves (3), (4), and (5), to complete
an impulsive sequence one degree larger – labeled 1 circled, sometime written
as ((1)). This is followed by a three-wave correction of the same degree; wave
((2)).
One way
to think about corrective waves is that because they move against the next larger trend, they
lack the strength to unfold into a full five-wave move. Whatever the reason,
the fact that they are weaker than the impulse waves creates that necessary
"interruption" I mentioned earlier and causes the progress and
regress that defines nature’s growth structure.
Have a
look at this next chart of an actual market, the U.S. Dollar Index. (See
this chart fully labeled in the February 18 Short Term Update; online now).
Well,
that's the gist of it. Congratulations, you've begun learning the basics of
Elliott wave analysis! Stay tuned for the Part II article in this five-part
series, where we'll address the labeling of wave patterns in real time and show
you how to use this valuable tool in your trading.
In the first article of this series, you learned the
basics of Elliott wave patterns. Now let’s take a look at how we can (or can't)
identify completed wave structures in order to see where the market is within a
larger pattern (or trend). Then we’ll use the Three Rules of Elliott to decide
where it is likely to go, and use "alternate counts" to order the
probabilities.
Impulse
waves are the most readily identifiable waveform. Like the main current in a
river, they are relatively smooth and laminar. But corrective waves are more
like eddies along a riverbank, complex and tricky, swirling back against the
current.
Below is
a chart of an impulsive five-wave move up that completes a
larger-degree impulse wave (1). It is followed by a three-wave move down
within what is probably a larger
corrective wave (2). This is our "working," or
preferred count – the scenario most likely to be correct.
We know
that wave (1) is complete. How? Because we see that a) its internal structure
shows clear five waves of a smaller wave degree, and b) it is followed by a
three-wave correction. But do we know that the corrective wave labeled (2) is
complete?
The fact
is we are not certain. But we
can assign various probabilities
to whether or not it's complete. That’s what Elliotticians
call alternate wave counts,
shown at the bottom as Alternate (A) and (B). Alternate counts are essential to
using the Wave Principle properly. They are not "failed predictions,"
or "bad" pattern interpretations. Alternate counts allow you to
narrow down the infinite number of ways the market can move to just two or three AND rank these probabilities from highest
to lowest. That makes your trading or investment decisions a whole lot easier.
So, now
that we see in the chart above that corrective-looking three-wave decline
labeled ABC (that comprise the larger-degree wave 2), here are the three most
likely possibilities – ranked in order of highest to lowest:
Most
Likely: Wave
(2) has ended and wave (3) is about to begin a strong upward move.
Less
Likely: Wave
(2) has not ended, and could develop into a more complex three-wave structure
(which would still not change the preferred count).
Least
likely: If
Wave (2) continues much lower, retracing all of wave (1), the alternate count
will become preferred: Waves (1) and (2) are then most likely waves (A) and (B)
of an upward correction within a larger impulsive downtrend. That's what the
labeled "Alternate (A) and (B)" count in the above chart shows.
Despite
this seeming uncertainty, you will like the next part. Although the three
alternate counts describe different scenarios, the implication of each – if you
think about it – is the same: The larger trend is higher, so the market is
likely to move upward! So, as you can see, a careful look at your alternate
wave counts can quickly lead you to an actionable trading strategy.
You
should always remember that only time can reveal the exact wave pattern. There
can never be 100% certainty about the position of the market, but Elliott’s
three specific rules limit the
probabilities to a number you can work with – so you know when your
primary count is valid, and when you should change to your alternate. The rules
are:
Rule One: Wave 2 can never retrace more than 100% of wave 1.
Rule Two: Wave 3 is often the longest and never
the shortest among waves 1, 3 and 5.
Rule Three: Wave 4 can never end in the price territory of
wave 1.
The Three Rules of Elliott give you specific boundaries
for any wave count. In the chart above, for example, if wave (2) continues
below the start of wave (1), thus violating Rule #1, then your originally
preferred count would be instantly
invalidated, and one of the alternates becomes preferred. These rules help
eliminate subjectivity, define your strategy, reduce your risk – and give you
an instant edge in the markets.
In Part
III, we will look at how Fibonacci ratios help you forecast the markets. In the
meantime, our website is full of educational material: check out our Education,
Traders and Free Stuff pages.
In the first article of this series, you learned about
the basics of Elliott wave patterns. The second article introduced you to
"alternate counts" and ways to identify the market position in the
wave pattern. This article is about the Fibonacci sequence and the ratios
within the sequence that guide the shape of Elliott waves. These ratios help
traders establish support, resistance, and other price targets in the market.
Leonardo
Fibonacci of
The
Fibonacci sequence begins with 1 and 1 (two love struck rabbits) and then
progresses by adding each number to the one before it: 1, 1, 2, 3, 5, 8, 13,
21, 34, 55, 89 – and so on. What is important to us as Elliott wave students is
not so much the numbers themselves as the ratios between them.
As the
Fibonacci sequence progresses, the ratios between adjacent numbers approach
closer and closer to .618 – or its inverse, 1.618 (depending on which of two
adjacent numbers you divide by). The ratios between alternate numbers in the
sequence are approximately .382, and 2.618. In fact, the nature of this
additive sequence is such that you can start the sequence with any two numbers,
and the ratios will rapidly approach .618. Try these examples with a
calculator. For a fascinating list of phenomena relating to the Fibonacci
sequence, consult chapter 3 of Prechter & Frost's
Elliott Wave Principle – Key To Market Behavior
(EWP)*.
Phi
(.618034…; don't confuse with Pi) is an irrational number called the Golden
Ratio. This ratio exists throughout nature – in population growth patterns, in
the DNA helix, in plants, in the structure of the human brain, and in spiral
structures from seashells to galaxies. R. N. Elliott's stunning discovery (made
in the 1930s, without a computer) was that this universal growth pattern found
also shows up in stock market chart patterns. To Elliott, this could only mean
that, "man's collectively expressed emotions are keyed to this
mathematical law of nature." (EWP)
R. N.
Elliott was the first person to use Fibonacci analysis in financial markets.
The correct usage of it can only be done within a valid Elliot wave
interpretation. Many non-Elliott analysts try to find Fibonacci proportions
between market moves that are unrelated to each other in any way, making the
approach appear far less valuable than it is when you view the markets through
the Elliott wave prism.
Elliott
had two main observations about Fibonacci relationships within waves.
One:
Corrective
waves tend to retrace a Fibonacci proportion of impulse waves of the same
degree. Frequent relationships between these waves are 38%, 50%, and 62%.
(See the
chart from the previous article.)
Two: Impulse waves of the same degree
within a larger impulse sequence tend to be related to each other in Fibonacci
proportion. (See the chart below.) At large degrees of trend these
relationships usually occur in percentage terms. At small degrees, the number
of points in each impulse wave reveals the ratios.
These Fibonacci
relationships occur in numerous ways in wave patterns, from the numbers of
waves in a pattern, to their relationships to each other – and even, in some
cases, the relationship between time-spans of waves.
That
wraps up a brief introduction to the fascinating world of Fibonacci. Stay tuned
for Part IV of the series, where we'll show you how to establish investment
strategy and reduce risk in your trading using Elliott wave analysis. In the
meantime, you can help yourself by studying the Prechter
& Frost's classic text, Elliott Wave
Principle*.
In Part
I of this series, you learned about the basics of Elliott wave patterns. Part
II introduced you to "alternate counts" and ways to identify the
market position in the wave pattern. Part
III talked about the Fibonacci sequence and the ratios within the sequence
that guide the shape of Elliott waves. Part IV showed you how to use Elliott to
establish investment strategy and reduce risk.
This is
the last article in the series, and it covers the ways you can take advantage
of the Wave Principle in trading.
If you
remember, in this real-time coffee chart that you saw in Part IV, we expected
wave 2 to retrace one
of these common Fibonacci ratios of wave 1
(in order of probability): approximately 5300 (62%; most probable), 5500 (32%)
and 5400 (50%). That would be the preferred Elliott wave count; after reaching
one of those targets, you would expect wave 2 to end.
Once the
price stalled near a Fibonacci point and started to reverse, you could decide
that wave 2 is ending
and wave 3 to the
upside is about to start – a nice bullish opportunity. The most likely entry
point would be near the end of wave 2
– of course, only after you've observed five waves up in 1 and three waves down in 2, the definition of a completed
Elliott wave sequence.
But what
if the price falls substantially below the 62% point at 5300? Then probability
shifts away from the preferred, bullish wave count. The good news is that you
know that wave 2
cannot go past the beginning of wave 1
(just under 5000) – the First Rule of Elliott says that wave 2 cannot retrace more than 100% of
wave 1, remember?
That’s the point where you know
that your bullish “one-two” wave interpretation is wrong and it’s time to
switch to an alternate count (we covered those in Part II) – if you haven't
already done so.
There are
several other ways for you to take advantage of the Three Rules of Elliott and
Fibonacci retracements. If you're a shorter-term investor, you might decide to
take advantage of each of the sub-waves
of waves 1 and 2. For example, as you watch wave 1 top, you know a 38% retracement
is the most likely minimum
downside potential for wave 2.
You could short the market accordingly, watch for an acceptable a-b-c pattern
unfold to the downside and signal the end of wave 2, close the short position and
prepare to catch the expected rally in wave 3.
The chart
below zooms in on an even shorter time frame and shows the action in the same
Coffee that followed the “one-two” preferred count we’ve been working with. You
can clearly see the reversal at the wave 2
low and the impulsive action that followed. From the end of wave 2, you could have confidence to
expect a rally in wave 3
– well beyond the top of wave 1:
I’d like
to leave you with one last thought. Because Elliott waves develop exactly the
same way in bull and bear markets, if you “flip” upside down every chart you’ve
seen in these series of articles, you would be looking at the same
opportunities, but to the downside. Neat, eh?
That
wraps up this series, a brief introduction to trading and investing with the
Wave Principle. Once you learn this discipline, you will learn to establish a
coherent investment strategy and reduce risk in your trading. To continue your
studies, there are several good options. The best one is Prechter
& Frost's classic text, Elliott Wave
Principle – Key To Market Behavior*.