Elliott Wave and Market Behavior

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Elliott Wave and Market Behavior Powered By Docstoc
					Elliott Wave Principle

           Steven W. Poser
           Managing Director, Research
           New York Stock Exchange
          Today’s Objectives
   Review fundamentals of the Elliott
    Wave Principle (EWP)

   Preparation for CMT II&III

   Text: Elliott Wave Principle: Key to
    Market Behavior (A.J. Frost, Robert
    Prechter Jr.)
   EWP’s primary value is as a description of
    how markets behave.

   Provides context for market analysis.

   Prechter and Frost state EWP “is not
    primarily a forecasting tool”

   EWP patterns also visible in economic data
    and in general human behavior
                  Basic Tenets
   EWP is governed by man’s social nature,
    which is expressed in repetitive form.

   In markets, this is shown as progressions
    of five waves, followed by three waves.

   Three rules
    • Wave-2 never moves beyond start of wave-1
    • Wave-3 never the shortest
    • Wave-4 never overlaps wave-1, except in a
      diagonal triangle

      Elliott Wave Theory Basics
•   Developed by Ralph Nelson Elliott, mostly
    in the 1930s

•   Related specific price patterns in the stock
    market as being nature’s law – in essence,
    price patterns were deterministic

•   Although most reasonable Elliotticians
    would not call EW deterministic, it does
    give us deep insight into market behavior
     Elliott Wave Theory Basics
•   Classic patterns are based deeply in
    market psychology

•   Each wave and sub-wave has a
    characteristic market psyche
    attached to it

•   This improves forecasting capability
The Basic Wave Pattern

             4       A


           Elliott Wave Basics
•   Wave modes
    • Motive waves – subdivide into five waves
    • Corrective waves – subdivide into a three wave
      structure or a triangle

•   A complete cycle is eight waves:
    • Five wave motive (1-2-3-4-5)
    • Three wave corrective (a-b-c)

•   Even numbered waves are also corrective
    within a motive move
              Elliott Wave Basics
•   Waves are fractal
    • Wave-1 breaks into five smaller waves
    • Wave-2 subdivides into a three wave move, etc.
    • Wave-a is motive against the trend of one larger degree

•   Any cycle of five waves forms a larger cycle of one degree
    higher than the individual waves. Degree is based on form,
    not price and time (despite nomenclature discussed later).

•   Even numbered waves are also corrective within a motive

•   Five wave moves have nothing to do with bull or bear
    markets: they can be in either direction. Action in the same
    direction as the larger trend is five waves, and countertrend
    action develops in three waves.
           Elliott Wave Basics
•   Actionary moves are motive cycles that
    are not diagonal triangles (no overlapping
    between wave-1 and wave-4). Also known
    as impulse moves.

•   A diagonal triangle is also known as a
    wedge in classic TA and usually shows up
    in wave-5 or wave-C, rarely wave-1.

              Elliott Wave Notation
•   Elliott created names for cycles of varying sizes and time. Frost
    and Prechter revised the names and notations
    1.    Supermillenium       1                A
    2.    Millenium            (1)              (A)
    3.    Submillenium         1                A
    4.    Grand Supercycle     I                a
    5.    Supercycle           (I)              (a)
    6.    Cycle                I                a
    7.    Primary              1                A
    8.    Intermediate         (1)              (A)
    9.    Minor                1                A
    10.   Minute               i                a
    11.   Minuette             (i)              (a)
    12.   Subminuette          i                a
    13.   Micro                1                A
    14.   Submicro             (1)              (A)
    15.   Miniscule            1                A

•   Usually, one wave in an impulse move extends
    – breaks into a larger five wave move. This is
    typically the third wave in the stock market and
    is often the fifth wave in the commodity
•   A full five wave impulse therefore breaks into a
    nine leg cycle. For example: (1)-(2)-1-2-3-4-
    5(3)-4-5 where wave-(3) extended into 1-2-3-
•   Extensions can extend as well: 1-2-3-4-(1)-(2)-
    •   The circled waves are primary, the ones in parentheses
        are intermediate and the last are minor degree.
•   More commonly known as failures,
    but Frost/Prechter changed the name
    to truncation.

•   When the fifth wave does not move
    beyond the end of the third wave.

•   Motive, but not actionary (impulsive)

•   Each leg is three waves. One exception is that a diagonal
    can appear in wave-a of a zigzag or wave-1 of an impulse.
    In those cases, the subdivisions can – but do not have to –
    develop as 5-3-5-3-5.

•   Third wave still never the shortest

•   Usually in fifth and sometimes in c-wave. If in a double
    three, can only be in wave-c of the second of the doubles.

•   Looks like wedge, with 5th sometimes over shooting,
    sometimes undershooting. Frost/Prechter mentions one
    case of expanding diagonal.

•   Fifth wave extensions, truncated fifths and ending
    diagonals often result in dramatic reversals.
        Corrections - Categories
•   Three basic types:
    • Zig-zags – 5-3-5 pattern. Also double zig-zag and triple
      zig-zag, which represent multiple zig-zag patterns joined
      together. These are usually the sharpest corrections.
    • Flats – 3-3-5 pattern. Includes regular, expanded
      (Frost/Prechter term for irregular) and running. These
      corrections are usually horizontal.
    • Triangle – Actually have five legs (3-3-3-3-3). Divided
      into symmetrical, ascending, descending and expanding
      (reverse symmetrical). Always in last correction of an
      actionary wave of one larger degree (but can also be
      part of a combination). Frost/Prechter then says in very
      rare cases it can be a second wave, but usually as part
      of combination.
    • Combination – Double or triple, combining flats, zig-zags
      and triangles
           Corrections – Labeling
•   If you see a five wave move after a motive cycle, then
    there will be another five wave move to come, forming a
    correction (ie, a zig-zag). Five wave moves never stand

•   Labels for a zig-zag or flat are of the A-B-C variety.

•   For combinations (double three and triple three), each
    individual “three” is labeled as W, then Y and then Z. The
    overall labeling then would be: a-b-c(W), a-b-c(X), a-b-
    c(Y), a-b-c(X), a-b-c(Z). The waves between the W,Y and Z
    are called X-waves and can be any kind of corrective
    pattern, but it is usually a zig-zag.

•   If part of a combination is a triangle, that is labeled a-b-c-
    d-e instead of a-b-c.

           Corrections – Zig-Zags
•   Both waves are 5-wave motive moves.

•   Wave-A is rarely a diagonal triangle.

•   Wave-B can be a triangle, or any other type of correction.

•   Wave-C is often like wave-3, very powerful, but can occasionally
    be a diagonal triangle.

•   Zig-zags are usually faster and correct more price territory than

•   You should look for a double zig-zag if a zig-zag completes that
    has ended too quickly and more importantly has not retraced
    enough price territory.

•   A zig-zag can appear, usually as a Y or Z as part of a combination.

           Corrections – Flats
•   Usually retraces less ground than a zig-

•   If a flat ends too quickly, although much
    of the price retracement may have taken
    place, look for a double-three or triple-
    three to allow for more time (range

•   Wave-B can retrace more than 100% of
    wave-A. This is known as an expanded flat
    (Elliott called it an “irregular”, and that
    term is used by many Elliotticians).
      Corrections – Flats (con’t)
•   Wave-C typically ends near the end of

•   In expanded flats, wave-C may end well
    beyond the end of wave-A.

•   In a running flat, wave-B ends far beyond
    the start of wave-A. This implies strength
    in the trend of one larger degree. Wave-C
    usually ends well before the end of wave-
    A in these cases. These types of
    corrections are very rare!

         Corrections – Triangles
•   Possibly the single most important thing you can
    learn from triangles is that the classic technical
    analysis books have triangles all wrong:
    • You can always predict which direction a triangle will
    • Although an ascending triangle is more likely to appear
      as a correction in an up trend, the direction it breaks is
      based on the prior wave pattern. They are not inherently
      bullish. The same is true of descending triangles.

•   Triangles, in this terminology are always
    corrective. If a triangle appears elsewhere in a
    trend, in Elliott terms, it is something different,
    even if classic technicians call it a triangle. In all
    likelihood, these triangles are less perfect
    triangles in standard TA terms.
    Corrections – Triangles (con’t)
•   Triangles are virtually never in wave-2.

•   Running triangle – When wave-b of the
    triangle moves past the starting point of

•   Fifth waves after triangles are usually fast
    and the reversals are sharp. The size of
    wave-5 is then often about the same as
    the width of the triangle (similar to the
    classic TA projection measure).

•   Frost/Prechter state that stocks are
    directionally progressive. That is, that the
    general direction of stock prices is higher.

•   In other words, stocks are upwardly
    directional, due to man’s general

•   Waves denoted by numbers are called
    cardinal waves. Waves denoted by letters
    are called consonant or sub-cardinal. We
    can always says we are in a cardinal wave
    of whatever is the current largest degree.
                    Irregular Tops
•   Frost/Prechter disagree with Elliott’s irregular top idea.

•   Elliott stated that major cycle highs were often irregular.
    This would result in a tiny wave-a and an enormous wave-

•   The authors state this is because Elliott favored extended
    fifth waves, leaving an extra leg at the end of the cycle.
    Frost and Prechter prefer using an extended third wave,
    which often removes this requirement.

•   They note that the Elliott counting often had a strange
    second wave which combined an expanded flat with a short
    c-wave. (See figure 1-50 in Frost/Prechter).

•   This is not a rule, but it is a strong tendency.

•   It states that wave-2 and wave-4 do not usually develop in
    a similar fashion. The definition is vague, but examples
    may include:
    •   Flat versus zig-zag
    •   Expanded versus regular flat
    •   Combination versus triangle
    •   Fast versus slow
    •   Deep versus shallow retracement

•   In other words, alternation may be in any dimension: size,
    time or form.

•   Alternation also exists in corrections
    • If wave-a is a flat, expect a zig-zag for wave-b
    • If wave-a is simple, wave-b may be complex and wave-c even
      more complex.                                             24
            Depth of Correction
•   Fourth waves usually end near the terminus of
    the fourth wave of the prior wave of one lesser
    degree, especially if the current corrective wave
    is a fourth wave itself.

•   For example, wave-4 will typically terminate near
    the end of the fourth wave of the just completed

•   When wave-5 extends, the next correction will
    often end near the end of the second wave of
    wave-5, though it could end as far as the end of
    the prior fourth wave.

•   In an impulse move, the two non-extended waves tend to
    be about equal in size.

•   The best measurement tool for equality, for all but very
    minor cycles (ie, above minor) is percentage, not price

•   If equality does not happen, a Fibonacci ration between the
    two (say wave-5 = 61.8% of wave-1) often occurs.

•   The extended wave will tend to be at least 1.618 times the
    size of the non-extended waves.

•   Note: The book talks about how you cannot use intraday
    highs and lows in the Dow. This is no longer true, although
    it was correct at the time the book was first published.

•   A whole impulse cycle often develops in a channel.

•   Alternately, you may be able to draw a channel by
    connecting the lows of waves 2&4 and projecting from the
    extreme of wave-3 to provide you with a fifth wave target

•   If a fifth wave approaches its resistance line on lower
    volume, it may fail to reach that resistance line.

•   A move above the resistance line in wave-5, known as a
    throw over, is often preceded by a throw under for wave-4.
    A throw under is when wave-4 briefly falls below channel

•   If volume in a fifth of less than Primary degree is seen, you
    are probably in a fifth wave extension.

•   Volume tends to be higher if fifths of Primary degree and
    higher (capitulation or blow-off in classic TA terms of major27
            Wave Characteristics
   Wave-1 (I am writing this from the perspective of
    a bullish first wave. It can also be bearish, just
    reverse bull for bear and bear for bull in all
    •   Start of bull move
    •   Almost everybody still bearish
    •   Rally seen as selling opportunity
    •   Volume may not be very high, but usually there is a
        small increase in volume and improved market breadth.
    •   About half of first waves have very deep retracements.
    •   Fundamental news probably still bad
    •   In futures, open interest might fall
    •   In stocks, A/D line may have already been improving
        before bottom.

         Wave Characteristics
   Wave-2
     Correction of first leg of bull move
     Fundamentals still mostly negative

     Drop seen as resumption of bear trend

     Bears tell bulls, “I told you so!”

     But, volume weaker on drop

     In futures, open interest falls

     Most sentiment surveys still bearish

A Diversion: Behavioral Finance
   Studies how human emotion and
    crowd psychology can cause
    inefficiencies in the markets

   Can be used to support both
    fundamental and technical analysis
    as being able to offer positive alpha

          Behavioral Finance
   Some academics in behavioral
    finance have embraced technical
    analysis as a tool in their cadre.

   Two examples are be Blake LeBaron
    (Brandeis) and Andrew Lo (MIT)

          Back to Elliott – Wave-3
   Elliotticians dream of third waves (they don’t
    have much of a life, do they?)
   Usually most powerful and largest price move
   The public jumps on board during this move
   High volume, momentum confirms
   Typically at least 1.618 times as large as wave-1
   Fundamentals (finally) confirm the positive price
   Breakouts, continuation gaps are common.
   Excellent market breadth with Dow Theory
    confirmation for higher degree stock market bull

Wave-3 and Behavioral Finance
   Sentiment should be at highest level
    during this move
   Forecasts should show revisions to extend
    earlier expectations
   Recognition that this is a bull market is
   While should be easy to get in, some will
    want to wait for a pull back to get a
    bargain, and they will miss the boat

          Wave-4 Characteristics
   Often the most difficult wave to trade

   Trend is still up

   Extended range trading possible, and irregulars very

   Seen as buying opportunity.

   Forms first support in head and shoulders neckline

   Preferably, trend line drawn from start of wave-1 through
    bottom of wave-2 is not breached

        Wave-5 Characteristics
   Everybody is bullish; it is a true bull
    love fest
   Bears are regularly ridiculed in the
    financial media
   The news is all good
   Prices make new highs

          Wave-5 Characteristics
   Volume probably lower than at end of third wave, except in
    Primary degree and higher where there can be a blow-off
    type situation. Also, volume is high in a fifth wave

   Open interest (in futures) might not confirm gains

   Usually see momentum divergences

   COT reports may show growing short positions held by

   Optimism is extreme. The bull market will never end!

       Wave-5 Behavioral Clues
   Forecast targets extended to allow for new

   Your friendly neighborhood plumber is talking
    about the investment

   Cover stories in mass media magazines such as
    Time and Newsweek

   Nobody will talk to all of the famous bearish
    gurus, except to ridicule them. Remember how
    technical analysts were treated in early 2000 by
    the mainstream financial media?
       Wave-A Characteristics
   At the start of the bear market,
    people still think they should be
    buying dips.
   Sentiment is still bullish.
   If Wave-A is five waves, it means
    that the bear market will be a zig-

         Wave-B Characteristics
   A wolf in sheep’s clothing.
   Market participants still following the bullish
    mantra and see the just completed wave-A as
   Everything is going to be okay.
   But, volume probably not very strong (except in
    Primary Degree and higher) and market breadth
    is poor even if sentiment is still strong and
    fundamentals, which tend to be trailing, still look
   Wave-B is the right shoulder of the classic head
    and shoulders reversal pattern.
        Wave-C Characteristics
   Cousins of third waves.
   Usually impulsive, but can be diagonal
   High volume as end of wave is reached (at
    the end of a bear, this would be termed a
   Everybody finally buys into the bear
   However, as the end approaches, there
    might even be some technical lights at the
    end of the tunnel (which are not an
    oncoming train).
        Waves D&E (Triangles)
   Wave-D might see higher volume in non-
    expanding triangles.
   This may be due to the fact that they
    follow c-waves and can be initially
    believed to be the start of the next cycle
    and the end of the correction.
   E-waves look like the resumption of the
    bear market and news can be very
    negative. They often break below triangle
    support. But, they are a fake-out as the
    market is then ripe for a return to the
    prior up trend.
                     Da Rules!
   It is not worth going through all of the guidelines
    and rules noted in the 2005 edition on pages 86-
    91, but you should be familiar with most of them.
   Note that most of these guidelines have been
    discussed in prior slides.
   Here are a few of the less obvious but more
    important rules and guidelines:
    • Usually, only one motive wave extends, but two might in
      Cycle or Supercycle degree.
    • When wave-5 extends, it is typically in a Fibonacci
      proportion to the distance traveled by waves 1-3
    • Wave-4 usually ends in the area of the fourth of wave-3
    • Wave-4 often subdivides the entire impulse in a
      Fibonacci price or time proportion

              Da Rules! (con’t)
   An ending diagonal always appears as wave-5 of
    an impulse or wave-c of a zig-zag or flat.
   A leading diagonal always appears as wave-1 of
    an impulse or wave-A of a zig-zag or flat.
   All waves of an ending diagonal and waves 2&4
    of a leading diagonal always divide into a zig-zag.
   Wave-4 of a diagonal always overlaps wave-1.
   Diagonals look like classic TA wedges.
   Wave-3 is still never the shortest wave and in an
    expanding diagonal wave-5 always ends beyond
    the terminus of wave-3.
   Waves 2&4 usually retrace 66% to 81% of the
    prior wave.
                 Da Rules! (con’t)
   In an impulse, a diagonal is unlikely unless wave-3 is
   In a zig-zag, wave-B never retraces more than 100% of
   If wave-B is a running triangle, it will typically retrace 10-
    40% of wave-A
   Wave-B usually retraces 38-79% of wave-A if it isn’t a
    running triangle.
   If wave-B is a zig-zag, it typically retraces 50-70% of
   Wave-A is never a triangle in a flat (or a zig-zag).
   Wave-B always retraces at least 90% of wave-A and
    usually retraces 100-138% of wave-A in a flat.
   In a flat, wave-C is typically 100-162% of wave-A.
   Wave-C usually ends beyond the end of wave-A in a flat.

                 Da Rules! (con’t)
   An expanded flat is when wave-B is more than 105% of
    wave-A and wave-C ends beyond the end of wave-A.
   If wave-B is more than 100% of wave-A, but wave-C does
    not move past the end of wave-A, then the flat is called a
    running flat.
   In a contracting triangle, at least four of the waves must
    divide into a zig-zag or a zig-zag combination.
   Except for wave-E, a wave in a contracting triangle never
    retraces more than 100% of the prior wave.
   A triangle never has more than one complex wave and if it
    does, it is either a zig-zag combination or a triangle itself.
   About 60% of the time, wave-B does not end beyond the
    end of wave-A. This is a running triangle.
   Wave-5 following a triangle is typically either brief or an
    exceptionally long extension.

                Da Rules! (con’t)
   In an expanding triangle, waves c,d and e retrace at least
    100%, but not more than 150% of the prior subwave. They
    usually retrace 105-125% of the previous subwave.
   Combinations are formed by two or three corrective
    patterns separated by corrective pattern(s) in the opposite
   A double three flat is either a zig-zag&flat, a flat&zig-zag,
    two flats, a zig-zag and triangle or a flat&triangle.
   A triple three flat comprises three flats.
   Double and triple zig-zags take the place of zig-zags while
    double and triple threes stand in for flats or triangles.
   An expanding triangle has never been seen as part of a

         Determining Your Count
   You should consider all factors discussed to this point in
    developing a wave count.
   More than one count may be possible. Frost&Prechter
    recommend always having an alternate count. Alternates
    must also abide by these rules and guidelines.
   Never forget that wave form is more important than
    volume, exact timing, price target calculations of non-Elliott
    indicators, be they technical or fundamental in developing
    your count.
   In the next section, we will cover in greater detail Fibonacci
    ratios to help you more closely compute potential time and
    price targets. However, these calculations remain less
    important than wave form.
   Despite these admonitions, if several methods provide you
    with a good price target (such as equality between wave-1
    and wave-5, a trend line, a day count, plus volume and
    indicators), the probability of your being correct is better.
        Fibonacci - Introduction
   Based on the work of the mathematician
    Leonardo da Pisa (later known as Fibonacci).
   Many waves relate to prior subwaves and
    degrees based on comparisons using Fibonacci-
    based ratios.
   Ratios based on the series of numbers where S n
    = Sn-1 + Sn-2
    • Example: 1,1,2,3,5,8,13,21,34
    • Example: 6,11,17,28,45,73,118
   The ratio of number n in the series, to number n-
    1, quickly approaches 1.618.
   The inverse of this is 0.618 and is known by the
    Greek letter phi (Φ).

          Fibonacci - Introduction
   There is a whole lot of numerology involved with Φ, which
    is not all that relevant to Elliott.
   What is relevant are the main ratios and retracements that
    Elliotticians use:
    •   0.382 (Sn/Sn-2)              1.618
    •   0.618                        2.618 = 1.618*1.618
    •   0.236 (Sn/Sn-3)              4.236 = 1.6183
    •   0.764 (1-0.236) or 0.786 (Φ0.5)
   The Golden Mean (or Golden Ratio) is 0.618 or 1.618
    according to Frost/Prechter.
   The Golden Section: The point on a line where the ratio
    between the smaller part of the line and the larger part of
    the line equals the ratio between the larger part of the line
    and the whole line. This is at the 0.618 point.
   The book covers the Golden Rectangle and Golden Spiral.

              Using Fibonacci
   Some basic tendencies were discussed in “Da
    Rules” earlier.
   You can use Fibonacci ratios for determining
    possible targets for retracements and for current
    and later wave termini.
   You can also use Fibonacci numbers and ratios to
    help you time when waves might end.
   On their own, a dependence on Fib numbers can
    be dangerous, but when combined with the
    principals of channeling as well as by using
    volume and momentum, plus an understanding
    of Crowd Behavior, you can learn to apply Elliott
    Wave in a profitable and easy-to-understand
         Using Fibonacci (con’t)
   When wave-3 extends, wave-1 and wave-5 end
    to be equal in size.
   When wave-5 extends, it tends to travel about
    1.618 times the distance traveled by waves 1-3
   When wave-1 extends, it will often travel 1.618
    times the distance of waves 3-5.
   Wave-4 often divides a whole move into the
    Golden mean (ie, wave-5 is 38.2% or 61.8% of
    the distance from the start of wave-1 to the
    bottom of wave-4).
   In a contracting triangle each alternate wave
    tends to be 0.618 times the preceding alternate
    wave (ie, wave-e = 0.618 times wave-a)

         Using Fibonacci (con’t)
   You can also use Fibonacci numbers to look for
    timing targets.
   Waves will often take Fib ratios in terms of time
    as well. For example, if wave-1 takes eight days,
    wave-2 might take five, and wave-3 13.
   I have often found that daily cycles tend take
    Fibonacci numbers of days.
   My work has also shown that trading days works
    better than calendar days. However, neither this
    or the previous point is noted in Prechter/Frost.
   Frost/Prechter notes the Benner-Fibonacci cycle.
    Although I doubt it will be on the exam, this 20-
    18-16 year cycle has done a very good job of
    forecasting panics and blow-offs.
              Using Fibonacci
   When wave-3 extends, wave-1 and wave-5 end
    to be equal in size.
   When wave-5 extends, it tends to travel about
    1.618 times the distance traveled by waves 1-3
   When wave-1 extends, it will often travel 1.618
    times the distance of waves 3-5.
   Wave-4 often divides a whole move into the
    Golden mean (ie, wave-5 is 38.2% or 61.8% of
    the distance from the start of wave-1 to the
    bottom of wave-4).
   In a contracting triangle each alternate wave
    tends to be 0.618 times the preceding alternate
    wave (ie, wave-e = 0.618 times wave-a)

            Some Final Thoughts
   Frost and Prechter note that wave theory is applicable to
    business activity. Prechter has extended this to the new
    science of Socioconomics. Socioconomics is not mentioned
    in the book, and is not likely to be tested on, but the Elliott
    Wave Principle is its basis.
   Note that this ties us back into the idea of Behavior
    Finance. It is not the news that counts, but how the market
    (or stock, or commodity) reacts to the news. In terms of
    Elliott, it is how that reaction is represented in wave forms.
   Dow Theory has some minor overlaps with Elliott. They
    both recognize the behavioral and psychological differences
    between bull and bear cycles.
   Dow Theory divergences (Industrials at new high,
    Transports not) couples well with momentum divergences
    often noted at the top of fifth waves.
   Dow bull and bear markets are not directly tied to any
    specific degree and Elliott does not have a true bull or bear.
Charts to Discuss

Charts to Discuss

Charts to Discuss

    Further Readings and Sources
   Robert Prechter Jr.’s site:
   R.N. Elliott’s Masterworks (edited by Robert
    Prechter Jr.)
   Applying Elliott Wave Theory Profitably (by
    Steven W. Poser) – Note that my book does not
    exactly follow Frost/Prechter. It should be useful
    when you get beyond the exam and wish to start
    applying Elliott Wave in the real world.
   Pioneering Studies in Socioconomics&The Wave
    Principle of Human Social Behavior (by Robert
    Prechter Jr.)