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An Introduction to Elliott Waves

by

Rudy Dumas

THE BEGINNINGS

Ralph Nelson Elliott (1871-1948), an accountant, began a systematic study of 75 years of stock market data in the early 1930’s.
Whilst others believed that markets appear to move in random and unpredictable directions, he found that they actually moved in
predictable patterns that tended to follow natural laws and Fibonacci ratios. He first published a book on his studies titled The
Wave Principle in 1938 which was followed up in 1946 with his most comprehensive work titled Nature’s Laws: The Secret of the
Universe.

ELLIOTT WAVE ANALYSIS, AN EXTENSION TO TRADITIONAL TECHNICAL ANALYSIS

The core belief of traditional technical analysts is that by applying various methodologies to the price action displayed on charts of
stocks/indices/sectors etc, it is possible to gain an insight into possible future price action.

Trend lines, channels, levels of support/resistance, and a number of recognisable patterns such as Head and Shoulder, Cup and
Handle, Double/Triple Tops/Bottoms, Pennants, Flags, etc form part of the tool kit available to the analyst. Complementing these
direct price action tools are a large number of technical indicators such as RSI, MACD, Stochastic, Bollinger Bands, Moving
Averages, etc, that have been developed over time to measure some of the so called ‘under the bonnet’ aspects of the market price
action.
By combining one or more of these technical tools, analysts are able to make decisions on the likely future price action of the
stock/index under consideration.

We can see from the above that pattern recognition has always been one of the most important tools used in analysing the market.
It is my view that Elliott Wave (EW) analysis takes pattern recognition to a new level. EW analysis observes all market price action
as a series of contiguous recognisable patterns strung together to form the entire market action price action picture. These same
recognisable patterns occur in every time frame thus making it a useful tool for anyone from a day trader to a long term investor.

THE BUILDING BLOCK OF ELLIOTT WAVE ANALYSIS

When traders/investors are exposed to charts for the first time the first observation that they make is that prices (in the majority
of cases) do not travel in straight lines. Instead they appear to travel in a haphazard fashion between different price levels.
Through his studies R N Elliott discovered that the price action found in share market charts travelled in what he termed “waves”
and that these waves fell into two categories, namely impulsive and corrective patterns.

Elliott found that the basic building block of patterns found in the share market was a simple 8 wave pattern. The first fives waves
of this building block formed the impulsive portion of the pattern whilst the following 3 waves formed the corrective portion of the
pattern. To differentiate between the impulsive portion and the corrective portion he labelled the former with numbers and the
latter with alphabetic characters. Refer to Figure 1 below.

The key to successful Elliott Wave (EW) analysis is the identification


of the correct level of pattern under examination. EW patterns occur
at every level of share market price action.

For example the pattern in Figure 1 (left) could be a subset of a


larger pattern and at the same time the analyst could drill down into
the individual legs of that pattern and discover that these are made
up of other patterns.

Refer to diagram below.

Note that the above diagram drills into the individual legs of the previous pattern. We can also see that the encircled pattern is
another 8 wave pattern consisting of an impulsive component and corrective component. So we can see from the above diagram
how the basic EW pattern can be repeated at every level of share market price action.

The above diagram also clearly shows that the impulsive component of the 8 wave pattern is made up 3 legs (waves 1, 3 and 5)
which are impulsive and 2 legs (waves 2 and 4) which are corrective.

Whilst the basic EW pattern is simple, EW


analysis becomes complicated for the following
reasons.
• Share market charts inevitably display
2 or more different levels of patterns
on the same chart. Inability to
differentiate between these levels can
often lead to what I call “level
confusion”.

• As both impulse patterns and corrective


patterns at one level are made up of a
mix lower level impulse and corrective
wave patterns this mixture can often
confuse analysts as to where one
higher level pattern finishes off and
another one starts.

• Corrective patterns can often be made


up of a mixture of 2 or 3 higher level
corrective patterns. This can lead to
some very complicated corrective
patterns which can be very difficult to
identify until almost complete. I would
advise newcomers as well as advanced
EW practitioners under these
circumstances to either cease trading
on these occasions or use other
methodologies to analyse the market
until such time as the next impulse
pattern appears.

The following diagram shows how the appearance of two levels of pattern will make a 5 wave impulsive pattern look as though it
has a total of 9 waves. This is an illusion that is brought about by the appearance of a lower level pattern (shown in red) within the
3rd wave of the original impulse pattern. This is also sometimes called an extended impulse pattern. This most often occurs in the
3rd wave of an impulse pattern but also often occurs in the 5th wave especially in commodity charts. When two extensions occur,
the pattern will appear to look like a 13 wave impulse pattern.

Rules for Impulse Waves

There are 3 main rules relating to pure impulse waves. These are:

* Wave 2 cannot fall below the starting point of wave 1


* Wave 3 is not the shortest wave by price movement when compared to waves 1 and 5.
* Wave 4 cannot fall into the price range of wave 1.

It should be emphasised that whilst wave 3 cannot be the shortest of waves 1, 3 and 5 that does not mean that it must be the
longest. More often than not it is the longest but it does not have to be. In commodities for example wave 5 is quite often the
longest of the motive waves.

Impulsive Patterns

Impulsive patterns move market pricing in the direction


of the main trend. Because these patterns move in the
direction of the trend they often tend to move quite
aggressively, especially in the third wave of the
pattern.

There are 3 basic impulsive patterns. The first is an


impulse wave and these obey the abovementioned
rules and generally look like the pattern in the above
diagram. Sometimes in wave 1 of an impulse or
corrective pattern the market will form an impulsive
pattern known as a leading diagonal.

Like the standard impulse wave, they are a 5 wave


pattern. The main difference between the leading
diagonal and the standard impulse wave is that wave 4
almost always will fall into the price range of wave 1.

We also sometimes develop a similar pattern in wave 5 of


an impulsive pattern or the third wave of a corrective
pattern. In this case because it is the last impulsive
pattern in a higher level pattern it is called an ending
diagonal.

As can be seen from the above two patterns, they appear to be identical. There are however subtle differences. First of all, a leading
diagonal can only be the first pattern in an impulse or corrective wave. An ending diagonal can only be the last pattern in an impulse
wave or corrective wave. The other differences are in the format of the individual legs of the patterns. These formats of the
individual legs of the pattern are defined below:
Impulse wave: impulsive-corrective-impulsive-corrective-impulsive. Also defined in terms of the number of legs in each pattern, ie 5-
corrective-5-corrective-5. We don’t nominate the number of legs in the corrective legs because they can be either 3 or 5.

Leading diagonal: imp-cor-imp-cor-imp or 5-cor-5-cor-5.

Ending diagonal: cor-cor-cor-cor-cor

Corrective Patterns

As implied by the name, corrective patterns move in the opposite direction to the main trend. As these patterns are moving against
the tide of the market their patterns can be quite tortuous and complex. Because of this whilst there are only three impulsive
patterns, there are a much larger number of corrective patterns. As this is only an introduction to Elliott Wave analysis I will only
discuss the most common corrective pattern which is a 3 wave pattern.

The two most common 3 wave corrective patterns are the Flat and Zigzag patterns. The most aggressive of these two pattern types
is the Zigzag. The individual legs have the format imp-cor-imp or 5-cor-5 as can be seen in the diagram below.

As can be seen in the above diagram, this pattern moves the price action significantly from the point of origin to the termination
point.

Flat Patterns

Unlike the Zigzag the Flat pattern, in spite of moving through reasonably significant ranges in the individual legs, has a termination
point which is not all that far from the point of origin of the corrective pattern. Whist there is only one basic form of Zigzag pattern,
there are three basic forms of Flat patterns. These are shown in the following diagram.

The format of all 3 Flat patterns is cor-cor-imp or cor-cor-5. Note that in both the Zigzag and Flat pattern the last pattern is
impulsive.

Furthermore since the last leg of an impulsive pattern is also always impulsive we can say that the last leg of all EW patterns (both
impulsive and corrective) at some level is always impulsive.

Why is this important? It is because from this fact we know that when looking for the end of a pattern, we should always be looking
for an impulsive pattern at either the level of the observed pattern or one level down.

Remember I said earlier in this article that one of the problems EW analysts have is determining where one pattern ends and
another starts. Now we know what pattern we should be looking for when attempting to identify the end of a pattern.

Copyright: Rudy Dumas, 2011

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