February 2004

Trading Tip:

The theory is named after Ralph Elliott who observed and identified repetitive patterns in the stock market and in nature.  He believed all human activities were influenced by these identifiable wave series.   He published several articles in 1939 in the 'Financial World' magazine.   After his death, others such as Hamilton Bolton (1960) and Robert Prechter (1978) advanced Elliott's work through books and newsletters.

Underlying forces in the market are constantly contending in a kind of tug-of-war.  Every move or thrust is followed by a corrective response.  This creates the basic concepts of the Elliott Wave Theory:

1. Action is followed by reaction.   Ie. a trend is followed by a retracement.
2. The main trend will contain 5 waves, followed by three corrective waves.
3. This 5-wave and 3-wave cycles are two legs of the next higher order wave.

For the sake of illustration, a trend or thrust will be indicated by the letter 'T', and a corrective reaction or retracement by the letter 'R'.   The 5 waves in the main trend wave would be the represented by  T-R-T-R-T.  Thus the main trend is made up of 3 T-waves and 2 R-waves.   The convention is to label these 5 waves with the numbers 1, 2, 3, 4, and 5.

The 3 waves in a correction or retracement would be the pattern  T-R-T and labeled on the chart with the lower case letters a, b, and c.  The correction is always a move in a direction opposite the 1-5 move's direction.

Elliott Wave Theory says that each wave within a wave contains a 5-3 wave count of a smaller cycle.  Thus, in a big T wave will be found 5 smaller waves in the T-R-T-R-T pattern.   And in the big R wave which is the reaction to the big T wave will be found the 3 smaller waves in the T-R-T pattern.

Elliott Wave practitioners seek to predict the future by determining where the market is in the unfolding wave pattern.   They often use Fibonacci price and time relationships found in the wave formations to predict both the time and price of future wave completions.  The primary weakness of Elliott Wave Theory is the determination of the wave count.  When the market creates a wave pattern that is at odds with the current wave count, practitioners reevaluate their wave counts and relabel the waves.

What is Elliott Wave?   Elliott Wave is a pattern.  Nothing more, nothing less.  It has rules, as any pattern has.  Those rules are also related to the Fibonacci proportions.

Rules:   Markets move in Impulsive mode and Corrective mode.  Impulsive mode has 5 waves: 1, 2, 3, 4, 5.  The 5 waves in Impulse mode should not overlap.  Non-overlapping waves should be labeled with numbers as shown below.  A characteristic of impulsive mode is the non-overlapping waves, as in this drawing where the bottom of wave 4 and top of wave 1 do not overlap.  Corrective waves do overlap.  Typically the Corrective mode has 3 waves which are labeled:  a, b, c.

Wave 3 cannot be the smallest one.  Either wave 3 or wave 5 will be the longest.  Waves 1, 3, 5, a and c are impulsive.   Waves 2, 4, and b are corrective.

Why learn Elliott Wave?   Because it helps keep track of market direction, as close as possible.

Do I trade using Elliott Wave?   Yes, every day.  I combine Elliott Wave with other patterns to find entries with a smaller stop loss than the one I would get by just playing the wave.  The trades I play are where the Elliott Wave articulates from wave 2 to 3, from wave 3 to 4, and from wave 4 to 5.

What do I do when I am watching the market move?   I use Ensign's formations tool to know if we are in an a-b-c corrective pattern or in an 1-5 impulsive pattern.   My formations tool is set up where c=100% and 3=162%.  If the market goes past the 100% line then I know we are in an impulsive mode.  Doing this is as fast and clear as they come.

Before 100% I do not know if I am getting an impulsive or corrective pattern.  I do not yet know if I should label the waves 1 or a, 2 or b, 3 or c, because they can become either one.

In a typical Gartley pattern, wave 3 is not a 3, it is a C.  A wave 3 does not have the right proportions.  The whole thing reaches only 78% retracement.

Gartley patterns happen most in a corrective market.  Elliott 5 wave patterns happen most in Impulsive markets.  This is how we have been going up since the low of 2003, Gartley after Gartley, because the market, although is going up, is in a bear trend.  Yes it is.

How do I trade?   Here are two days that are a perfect example of the mix between Elliott Wave patterns and Gartley-Butterfly patterns.  The market made a triangle, which broke to the downside in a beautiful five wave structure.   All Fibonacci proportions fit.

A corrective pattern is developing on the right going upward.  This corrective pattern is forming a wedge, which is more easily seen in the next image.

Do you need to know Fibonacci to do this?   Yes.  Not only to know it, but to be able to draw targets very fast once you get a sense of where you are within the unfolding pattern.

Is Fibonacci enough?  Not for me.  Many times Elliott doesn't give me precise entries and I need to go to a lower time frame chart to look for a more precise entry with a small stop loss.  I also like it when I have other patterns that confirm the five wave structure or the retracement pattern.  I watch for gaps, wedges, channels, etc.

The pattern being traded here is the Lower High (LH) with divergence on the MACD study.   HH stands for Higher High.  LL stands for Lower Low.

I had drawn the lower boundaries of a possible head and shoulder.  When the market did its five waves down I was expecting it would break the neck with the 5th wave and give a nice short opportunity.  But it didn't.  What did it do?  It failed, and what happened when it failed?   It went up like a bubble of air in the water.  That's what failures of patterns do.  They change direction.

The formation marked with the circle was a perfect 1-2-3 lower bottom - or 2B with a nice MACD divergence to sustain it.

All of this happens fast.  You cannot pretend to do this if you do not perfectly know proportions and the rules of at least the patterns shown in this article.   You also need Ensign tools ready to do the work.  Elliott Wave comes slowly.  First you learn the proportions and rules and then you start recognizing the shape of waves and those shapes tell you about counts, and counts will tell you about proportions.

Why not use ONLY Elliott Wave?  Because the stops are too wide.  Why not use ONLY the entry systems based on oscillators?  Because I love the targets I get with Fibonacci relationships.  I also love Elliott Wave.  I really like the shapes.  I like to guess when they appear.  I like to count the waves.  I like the alternatives that Elliott Wave theory gives about market movement.

(Editor's Note:   Mary patronizes the B-Line chat room and frequently posts her excellent charts with current Elliott Wave counts labeled to the www.dacharts.com web site.)