Chapter 10 - Elliott Wave Theory

Question 1

What is a cycle wave?

Answer 1

In Elliott Wave Theory, the longest-term
wave; a bull market is one cycle wave and a
bear market is one cycle wave.

Question 2

What is a double three?

Answer 2

In Elliott Wave Theory, a correction
formation that consists of two other
correction patterns.

Question 3

What is an extension?

Answer 3

In Elliott Wave Theory, an extended
impulse wave.

Question 4

What is a failed fifth?

Answer 4

In Elliott Wave Theory, an impulse wave 5
that fails to peak above impulse wave 3.

Question 5

What is a flat correction?

Answer 5

In Elliott Wave Theory, a three-wave
correction; the first and second waves can
be broken down into three smaller waves,
while the third wave can be broken down
into five waves.

Question 6

What is an impulse wave?

Answer 6

Waves 1, 3, and 5 in the Elliot Wave Theory that take prices in the direction of
the main trend.

Question 7

What is an intermediate wave?

Answer 7

In Elliott Wave Theory, the second level of
waves; a bull market has 21 intermediate
waves and a bear market has 13
intermediate waves.

Question 8

What is a minor wave?

Answer 8

In Elliott Wave Theory, the first level of
waves; a bull market has 89 minor waves
and a bear market has 55 minor waves.

Question 9

What is a primary wave?

Answer 9

In Elliott Wave Theory, the third level of
waves; a bull market has five primary waves
and a bear market has three primary waves.

Question 10

What is a triangle correction?

Answer 10

In Elliott Wave Theory, a correction that
consists of five overlapping waves, with
each wave subdividing into three smaller
waves.

Question 11

What is a triple three?

Answer 11

In Elliott Wave Theory, a correction
formation that consists of three other
correction patterns.

Question 12

What is a zigzag correction?

Answer 12

A zigzag correction is a straightforward three wave A-B-C pattern. Each of waves A and C
subdivides into five waves, while wave B subdivides into three waves, therefore a 5-3-5 pattern.
The B wave rally ends well below the start of wave A in a bull market correction (see Figure 10.8).In a bear market, the B wave pullback ends well above the start of wave A (see Figure 10.9).
A 5-3-5 zigzag is formed during trends of modest strength in which the counter-trend pressure is
stronger, allowing wave A to develop five sub-waves.On occasion, particularly when a zigzag falls short of a normal-sized retracement, a second or at
most a third zigzag is formed. Separated by an intervening “X” wave (not covered in this text),
which itself subdivides into three waves, this produces a double or triple zigzag.

Question 13

What is a fractal?

Answer 13

• A bullish fractal occurs when there is a low point with two higher low bars/candles on each side of it.
  
  • A bearish fractal occurs when there is a high point with two lower high bars/candles on each side of it.
  • Arrows are drawn above or below the middle bar (high or low point), even though the pattern is five bars. There is no way a trader could enter a trade at the arrow because the arrow only occurs if the next two bars create the pattern.
  • If someone were to trade fractal signals, the entry would be the open price of the third bar after the arrow.

Question 14

How was the Elliott Wave Theory developed?

Answer 14

• Ralph Nelson Elliott’s development of the Elliott Wave Theory was greatly influenced
  by his view of business cycles and his interest in the Dow Theory.
• He published his Wave Principle hypothesis after several years of studying empirical
  evidence.

Question 15

What are the basic assumptions of Elliott Wave Theory?

Answer 15

• The Elliott Wave Theory rests on a group of three basic assumptions:
  – The world is run according to law, and this law breeds order, which, by its nature of
  constancy, will recur in a predictive fashion.
  – Humans behave according to law, and hence their behaviour will repeat itself over
  time.
  – Market action is influenced by these laws because it is a psychological phenomenon
  reflecting human action.

Question 16

Describe the basic structure of price patterns.

Answer 16

• Price patterns can be categorized into impulse waves and corrective waves.
• Waves 1, 3 and 5 of a five-wave pattern are impulse waves, whereas waves 2 and 4 are
  counter-trend reactions.
• Each five-wave pattern is then corrected with a three-wave a-b-c sequence.
• When broken down further, waves 1, 3 and 5, and waves a and c can be subdivided into
  five waves of lower degree; waves 2, 4 and b can be subdivided into three waves of lower
  degree.
• This cycle of eight wave (five and three) form two subdivisions of the wave cycle of the
  next higher degree.
• Elliott married his analysis of cycles with Fibonacci numbers.

Question 17

What are impulse waves, extensions, and corrections?

Answer 17

• Impulse waves (waves 1, 3 and 5) are formed in the direction of the main trend.
• One, and only one, of the three impulse waves can be an extension, a move that is
  larger than the other two impulse waves.
• Corrections, which are formed in the direction opposite the main trend, are grouped
  into four categories: zigzag, flat, triangle, and double-three and triple-three structures.
• A zigzag correction is a three-wave pattern, with the first and third waves being further
  subdivided into five waves, and the second being subdivided into three waves.
• Zigzag corrections often form during trends of moderate strength, where the counter-
  trend pressure is strong.
• A flat correction is also a three-wave pattern, with the first and second waves being
  subdivided into three waves, and the third being subdivided into five waves; flat
  corrections can be categorized as “regular,” “irregular” and “running.”
• Flat corrections often form during strong trends, where the counter-trend pressure is
  modest.
• A triangle correction consists of five waves, with each wave being subdivided into
  three sub-waves; triangle corrections can be categorized as ascending, descending, and
  symmetrical.
• Double threes and triple threes combine two or three of the previously discussed
  corrections.

Question 18

How does Elliott Wave Theory fit into basic chart analysis?

Answer 18

• Many of the concepts in Elliott Wave Theory can aligned with chart patterns in classical
  technical analysis.
• Both have triangles that are interpreted the same way; flags and pennants are equivalent
  to zigzags and triangles; double tops and bottoms are generally failed fifths; head-and-
  shoulders patterns are typically waves 3 through 5 with a zigzag correction.

Question 19

In detail, describe Elliott’s assumptions.

Answer 19

1. The first set of assumptions assert that the world is run according to law:
   * “No truth meets more general acceptance that the universe is governed by law. Without
   law, there would be chaos, and where chaos is, nothing is.”
   * “Since the very character of law is order, or constancy, it follows that all that happens
   will repeat and can be predicted if we know the law.” All the sciences and arts are
   possible only because of such laws.
   * “Even though we may not understand the cause underlying a particular phenomenon,
   we can, by observation, predict that phenomenon’s recurrence.” For many thousands
   of years before the reason for the change in seasons was known, the knowledge of this
   change was used by mankind the world over.
2. The second set of assumptions maintain that humans behave also according to law:
   * “Man is no less a natural object than the sun or the moon, and his actions, too, in
   their metrical occurrence, are subject to analysis.” It follows that “calculations having
   to do with his activities can be projected far in the future” and, particularly with the
   increasing amount of data related to these activities, can be done so “with a justification
   and certainty heretofore unattainable.”
   * “Very extensive research in connection with what may be termed human activities
   indicates that practically all developments which results from our social-economic
   processes follow a law that causes them to repeat themselves in similar and constantly
   recurring serials of waves or impulses of definite number and pattern. It is likewise
   indicated that in their intensity, these waves or impulses bear a consistent relation to
   one another and to the passage of time.”
3. The third set of assumptions applies these laws to behaviour in the stock market. Elliott
   prefaces his comments on this by stating that “… there is no other field in which
   prediction as been essayed with such great intensity and with so little result.” In spite of the
   development of “a definite profession with market forecasting as its objective,” the crash of
   1929 caught almost all investors, investment institutions and forecasters, by surprise. For
   Elliott, the reasons are clear:
   * “… those who have attempted to deal with the market’s movements have failed to
   recognize the extent to which the market is a psychological phenomenon … the stock
   market is a creation of man and therefore reflects human idiosyncrasy.”
   * Stock market forecasters generally “… have not grasped the fact that there is a regularity
   underlying the fluctuations of the market, or, stated otherwise, that price movements in
   stocks are subject to rhythms, or an ordered sequence.” The result is that “[their] market
   predictions … have lacked certainty or value of any but an accidental kind.”

Question 20

Impulse waves can form extensions
that enhance the analysis of sub-waves by providing additional guidelines and clues. What are they?

Answer 20

• An extension can appear in any one of the three impulse waves, but never in more than
  one.11
• In the stock market, wave 3 is the one that normally extends, whereas in commodities, the
  tendency is for wave 5 to extend.
• The knowledge that only one wave extends and the other two tend to be of the same length
  provides a method for estimating remaining wave lengths. For example, if wave 3 extends,
  wave 5 can be expected to approximate wave 1 in length.
• On occasion, the waves are so equal that a nine-wave sequence is formed (see Figure 10.4).
  These are treated the same as a five-wave sequence.
• An extension deepens the degrees of sub-waves present.

Question 21

A second set of three variations deals specifically with the fifth wave. What are they?

Answer 21

1. A wave 5 extension leaves prices quite over-extended (overbought), with the following
   correction usually falling to at least the level of the sub-wave 2 bottom (see Figure 10.5).
2. Failed fifths, or truncated wave 5s, peak below or at the previous wave 3 high (see
   Figure 10.6). In a bull move, they warn of underlying weakness and are often preceded by
   an unusually deep wave 4. In a bear market, a wave 5 that bottoms above the preceding
   wave 3 down is a sign of emerging strength.
3. Diagonal triangles (discussed in the next section) are generally formed from rising
   converging lines, primarily when the market has gone too far too fast, and typically lead to a
   sharp correction back to the beginning of this formation (see Figure 10.7).

Question 22

What are the rules and guidelines of wave analysis?

Answer 22

To bring rigour into wave analysis, three rules and a number of guidelines have been developed
(refer to Figures 10.1 and 10.2):
* Wave 2 can never retrace more than the beginning of wave 1. If this occurs, the impulse
move has been broken and the previous correction is continuing.
* Th e bottom of the wave 4 correction cannot overlap the top of wave 1 and remain an
impulse pattern. If such an overlap occurs, what was developing as an impulse pattern is
transformed into a corrective one. (A few more recent wave theorists are willing to allow a
bit of overlap, particularly in commodities.)
* Wave 3 can never be the shortest of the impulse waves (it is often the longest one).
The following guidelines provide clear tendencies but are not as absolute as the rules above:
ALTERNATION
Just as bull and bear markets, and impulse and corrective waves alternate, so too do their kind
of corrective waves. For example, if wave 2 was a more simple pattern such as a zigzag, then
wave 4 would tend to be a more complex pattern such as a triangle, and vice versa. In general,
wave 2s tend to be simple but strong zigzag corrections, followed by wave 4s which tend to be
more sideways consolidations such as flats and triangles. Also, a double three will consist of two
different kinds of patterns separated by an intervening corrective X wave (not covered in this
text).
DEPTH OF CORRECTIVE WAVES
The maximum retracement of a normal bear market correction will be to within the range of the
previous wave 4 correction of one lesser degree. A retracement that continues beyond this level
typically will create a five-wave impulse pattern down, and will have greater difficulty generating
another bull market.
WAVE EQUALITY
Two of the three impulse waves will tend to be equal in time and magnitude. If equality is
lacking, then a Fibonacci 0.618 multiple is the next most likely relationship. If the measurement
is on the weekly chart, the price relationships usually must be stated in percentage terms, which
allows the strength of wave movements to be compared, regardless of the different price levels at
which they occur.