Riding the Third Wave - A Closer look at Elliott Analysis
Based on his research that showed that financial markets bear a
striking resemblance to the basic harmony found in nature, Ralph Nelson
Elliott postulated that price movements in financial markets follow
patterns, but not necessarily in time or amplitude. Elliott developed
the Wave Principle on empirically derived rules for interpreting the
price action. He hypothesized that financial prices unfold according to
a basic rhythm or pattern: five waves in the direction of the trend and
three waves counter to the trend (figure 1). Elliott named the
five-wave upward movement an impulse wave, and the three-wave counter
trend a corrective wave. The most exciting and profitable impulse wave
is the third, and this analysis deals with methods of trading this
wave.
Figure 1. A bullish market breaks into a
five-wave/three-wave pattern for a complete market cycle of eight
waves. The five-wave bullish move is an impulse wave and the three-wave
counter trend is a corrective wave. The third impulse wave tends to be
the most exciting.
Main Picture
A more complete picture can be seen in figure 2, which shows the basic structure of the entire market cycle.
Figure 2. A complete market cycle
Waves (1), (3) and (5) are called impulse waves, and are
subdivided into five waves of smaller scale. The subwaves of impulse
sequences are labeled with numbers. Waves (2) and (4) are corrective waves,
and are subdivided into three smaller waves each. The subwaves of
corrections are labeled with letters. You can see the structure of the
five-wave bullish impulse wave in Figure 3.
Figure 3. The structure of the five-wave bullish impulse wave
Elliott's Rules of Interpretation
Elliott set up three essential rules of interpretation of his wave principle:
- Wave 2 may never retrace more than 100% of Wave 4.
- Wave 3 is never the shortest and most of the time is the longest.
- The range of Wave 4 can never overlap with the price range of Wave 1.
Figure 4 shows an example of the Elliott Wave analysis in USD/CAD.
Figure 4. An example of the Elliott Wave analysis in USD/CAD
The Place of Wave 3
Putting the waves in a context prior to Elliott, Charles Dow said
that the market has three stages: accumulation, run-up (uptrend) or
run-down (downtrend), and distribution.
Waves 1 and 2 are more difficult to identify. Wave 1, which is often
the shortest of the impulse waves, tends to look like a correction.
Meanwhile, wave 2 is identified by its three-subwave structure and
tends to retrace by about .618% of the first wave. These two waves form
Dow's accumulation phase and this is where some traders build large
positions.
Wave 3 is where the action is. Along with Wave 5 or many times all
by itself, Wave 3 is the run-up or run down-phase, which is when the
market trend is more obvious and traders of all levels jump on the
bandwagon. This wave tends to be the longest, and is never the
shortest. It provides a dynamic move, and once the market breaks above
the top of Wave 1, more traders jump in and fuel market. Volume tends
to be good and the fundamentals support the direction. Take a look at
Wave 3 in figure 5, which features USD/CAD. It's a downtrend for the
pair but naturally an uptrend for the Canadian dollar. Why did the
market like this low-yielding currency? Because Canada is very rich in
minerals and when the world economy is strong and the appetite for risk
is high, everybody wants that currency. More importantly, foreign
entities buy Canadian companies, and this M&A activity requires
Canadian dollars.
Figure 5. Wave 3 in USD/CAD
Trading Wave 3
Price trends are essential to technical analysts and traders, and
Wave 3 provides this trend. Simply put, the trend shows a direction of
the market that is likely to last several weeks to possibly a few
months.
To monitor the trend, simply draw a trendline. If the market provide
good peaks in an uptrend or lows in a downtrend, then you can draw a
channel line as well, which will be parallel to the trendline only
accidentally. If the specific market has only one significant top in an
uptrend or only one low in a downtrend, then just draw a parallel line
to the trendline that goes through that important price to get a
channel line. And if the channel you just drew is a large enough, then
bisect it to get more valuable crossovers with the prices.
The initial push higher in a rising market comes from the break
above the top of wave 1. If this was the highest high, then where is it
going from here?
One way to find targets is by using extensions. To do so, use the
standard Fibonacci ratios of .382 and .618, and probably some of Gann
ratios as well: .125, .25 and .5. A combination of these two sets of
ratios should provide accurate targets, the most common of which are
.25 and .382. To obtain these targets, multiply the range of wave 1
with each of these ratios and add it to the range of wave 1 measured
from its top.
Speaking of extensions, Elliott identified several extensions himself, but they are not easy to use.
In the five-wave sequence, one of the three impulse subwaves tends to generate an extension.
These subdivisions are of nearly the same amplitude and duration as the
larger-degree waves of the main impulse sequence, giving a total count
of nine waves of similar size rather than the normal count of five for
the main sequence.
Extensions can be useful guides to the lengths of future waves. Most
impulse sequences contain extensions in only one of their three
impulsive subwaves. Therefore, if the first and third waves have about
the same magnitude, the fifth wave will probably be extended.
Extensions may also occur within extensions. Although extended fifth
waves are not uncommon, extensions of extensions occur most often
within third waves. See figure 6.
Figure 6. Wave extensions in a bull market.
Meanwhile, stay with the trend, although this may be easier said
than done. Traders should consider moving averages as flexible support
and resistance lines. More often than not, a 20-day moving average will
act as a reliable trendline. The intersection between the market and
this moving average should provide good buy and sell signals in
trending markets.
Another reason to use moving averages is the overbought and oversold
signals that may occur when compared to the currency. If the currency
and the moving average are trailing too far away from each other, this
is a warning that the currency might change direction. But keep in mind
that a divergence on its own is a condition, not a signal, so use a
trigger from a different source, such as the break below a support or a
trendline. Figure 7 shows that a 20-day moving average acted as a
perfect resistance during the decline in wave 3. In two instances,
which are marked with blue arrows, USD/CAD was too far below the
average and the obvious divergence was corrected by the pair either
trading sideways (first arrow) or even climbing higher (second arrow).
Figure 7. The 20-day moving average acted as a
perfect resistance during the decline in wave 3. Notice the correction
of two bearish divergence instances (blue arrows).
The opposite is true for a downtrend.
Other waves
According to the rule of alternation, if wave 2 is complex, then wave 4 tends to have a simple pattern and vice versa.
Following this pause, which can be significant, the market gives the
currency a final move in the major direction of the trend. This is when
wave 5 comes to life.
This wave can be dynamic and extended. This is because everyone can
see the direction and knows the move is approaching the end, so they
will try to extract the last penny from the move.
Wave A can be difficult to spot through all the action, but its
five-subwave breakdown gives it away. Wave B may be of different
complexities and lengths since the last bulls are making their final
mark in a previously rising market and the bears are testing the waters
and starting to sell. Wave C confirms the end of the trend and in a
bullish market it will fall below the bottom of wave A.
Conclusion
Traders can use Elliott Waves even without using all the intricacies
of this complex analysis method. They can use the clear and rich
signals of all waves at macro scale. And they can use wave 3 as a
standalone trend, to which they apply standard trend analysis
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