Elliott Wave Theory
"... markets act paradoxically from what novices typically expect." -- Robert Prechter
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The financial markets have bullish and bearish trends, exhibiting waves, up and down. This is a fractal fact of life. The trick in measurement is to detect a pattern and use it to solve a problem. So you need an approach -- a model, or way of seeing, a guide. But that's not easy to get. To be able to see, you need ideas to let you focus, and that calls for learning, which is inherently creative, a jump from "I don't see." to "Ah, I see!" That's especially true for Elliott Wave Theory.
The Wave Model
Originally propounded as Dow theory, wave theory was developed by R N Elliott and also interpreted by Glenn Neely and Robert Fischer. Accordingly, the markets define trends that depend on a cyclical or up/down mood of the public, reflecting optimism or pessimism. This means investor psychology moves the market, with help from the merchandisers, who feed on the moods.
Market Trends
Trends appear in various time spans. The most familiar trends are the primary, intermediate, and short-term trends. But these are only loosely defined segments of more formally recognized trends, which range in time from centuries to seconds and which identify Elliott wave pattern degrees. Among them are: Supercycle, Cycle, Primary, Intermediate, and Minor
The Social Dynamics
To use the words of Robert R Prechter:
The wave principle presents a profound truth [that] sometimes the dynamics of social psychology are impelling the mass mood toward optimism, and sometimes toward pessimism, regardless of all news. At most, events serve as a background for the rationalization of opinion. The key to anticipating markets is recognizing extremes in psychology, which requires knowing the patterns. ... When wave five ends, it's time for a reversal, regardless of all other possible considerations.
The dynamics of the social (skills) environment is the concern of my doctoral thesis, my book, and this Web site, particularly the market modeling section. My primary concern is with the measurement problem, which is to find out how markets perform -- how they are moving and how far they will go. The dynamics are very nonlinear, highly interactive phenomena and identify what traders can and can't do. Elliott theory expresses the dynamics by means of price waves.
Wave Properties
The wave phenomenon has two stages, consisting of an impulsive stage and a corrective stage. A typical wave has five steps: three up and two down.
The five steps are identified as waves 1 through 5. The completion of these steps leads to a corrective phase, which consists of three waves: a, b, and c -- two down and one up (zig zag zig). I use this theory as the main tool in reading the gold producer stocks and any other pattern as support, but mainly candlestick theory.
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Elliott says that bull markets (impulse waves) have five major waves, labeled 1 through 5, in temporal order, and bear markets (downward corrective waves) have three major waves, labeled A, B, and C.
Impulse waves have three waves (1, 3, and 5) that move in the direction of the impulse and two waves (2 and 4) that go against it. In an overall bull trend, the five waves usually form an upward channel. Each of the major waves 1, 3, and 5 subdivides into five sub-waves, and they in turn subdivide. Similar comments can be made for bear market waves A and C.
The language gets tricky (if not entirely confusing), because you have to contend with trends at different levels -- i.e., different time scales -- and different labels are needed to identify the waves at the various levels. Because of the multiple levels, you can get expressions like 'the fifth of the fifth,' or 'the third of the third of the extended fifth,' or 'the fourth of the third,' and so on, each expression referring to waves within waves.
Wave pattern recognition depends on being able to isolate waves of the same degree. Sub-divisions add to wave complexity and complicate the counting. There are also extensions that add more waves of the same degree to the starting five -- like playing an overtime basketball game. A major task of the measurement problem is to determine the level of the waves. Finding the beginning and end of a wave structure is no picnic!
To identify a wave pattern, you have to identify the starting point, or recognize common signs (landmarks) of waves. For example, wave 3 is never the shortest wave of the 5 wave. Waves 1, 3, or 5 can be extended waves -- i.e., containing additional same-level waves. Also, the structure of wave 4 alternates with the shape of wave 2. Waves must also have the correct appearance, otherwise they are suspect.
Complicating the identification is that patterns can morph into something you may not have anticipated as a probable construction. The market is always in the NOW. It begins anew at every moment. You always have to start fresh and continually update your views. And the NOW "thickness" changes, depending on your trading time frame -- thinner for shorter time intervals, thicker for longer. To grasp this stuff you have to read, and read again, and study charts, and read again, and again. While doing that, you might want to follow what I see in the Gold market. But don't ignore other indicators.
Corrective Wave Divisions
According to Elliott, the corrective waves in a bull phase (i.e., waves 2 and 4) alternate in pattern, so that, if one of the two corrective waves is simple, the other one will be complex, and vice versa. Among the possible corrective patterns, Prechter includes zigzags, flats, and contracting and expanding triangles, shapes that can be recognized from technical analysis.
Wave Extensions
As the term indicates, extensions are waves of similar ilk that increase the number of one-less degree waves in a wave. So you may get 5, 7, or even 9 sub-waves in a wave. The extensions may appear in any one of the three impulse waves 1, 3, or 5, but never in more than one. They
If extensions occur in wave 3, double tracing will be achieved by waves 4 and 5.
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The first rule of forecasting (measuring) is to wait to the end of a 5-wave move, because three waves in the opposite direction can be expected. Using Fibonacci thinking, a reasonable expectation for the correction is a retracement of about two-thirds of the prior advance. So, if P1 and P5 are the prices for the stock at, respectively, the beginning and end of waves 1 through 5, the expected price PC after the end of corrective waves A through C will be:
PC = P5 - .618(P5 - P1)
This requires patience, as well as recognition of the completion of the five waves, particularly since an extension can appear in the fifth wave. The fraction, .618, is identified as a Fibonacci ratio. And the price retracement to PC, is called a Fibonacci retracement.
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If you wait for signs of the end of wave 5, you can apply the Fibonacci ratio to help you identify the endpoint. You can also expect to see the formation of something like a head and shoulders top. First, though, you must determine whether a wave has actually occurred, a wave being defined as a continuous surge in one direction, up or down.
To get a more precise wave count, base it on the number of consecutive moves of the price bar, either to the upside or the downside. The Gann format, for example, identifies minor, intermediate, and main trend indicator charts, respectively, in terms of one-, two, and three-bar movements, for a presumed trading time interval.
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According to Robert Fischer, the Fibonacci ratio is best used in correction targets. But it is also used to analyze price targets on extensions. Corrections and extensions are seen as the special characteristics of wave patterns of prices.
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