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Discover the basics of elliott wave theory, a popular technical analysis approach used to forecast stock market price movements. Learn about the theory's history, wave structures, and applications, as well as its connection to fibonacci numbers. This quick start guide also includes tips for profitable elliott wave analysis.
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Learning about the Stock Market for Beginners & How to Start Day Trading - Successfully!
Traders Day Trading .com
TradersDayTrading.com – Learning about the Stock Market for Beginners
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Preface
This eBook is an original publication from
TradersDayTrading.com
A trader’s guide to
Learning about the Stock Market for Beginners & How to Start Day Trading – Successfully!
Visit us at our website to learn more about Elliott Wave Theory and much more.
Copyright
© Copyright 2010: The content of this eBook is copyrighted material and is protected under the US Copyright Act of 1976 and all other applicable international, federal, state and local laws.
All rights are reserved.
You may freely distribute this eBook, provided all content including text, author credits, active links and the copyright note remain intact.
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An Introduction to Elliott Wave Theory
Elliott Wave Theory is a commonly used form of technical analysis that is applied to stock market charts for the purposes of forecasting the future direction of prices.
The Elliott Wave Principle is founded upon the concept that stock market price movements are not a result of the latest news headline, but are in fact a direct product of the mass psyche of the market participants.
How many times do we see the market drop on supposedly ‘good’ news , or a stock’s price rise on the announcement of some pretty disastrous results? Of course, the talking heads will always find an angle to explain away these discrepancies, ‘results were not as bad as expected’ or something similar, that is their job after all.
For a technical analyst it is not the news that matters, or even the numbers in those results, it is the market’s reaction to them that is the only thing that matters. Applying Elliott Wave theory is the study of the stock markets price data in the search for recognisable patterns in the behavior of the markets prices. These price patterns can enable an Elliott Wave analyst to assess whether prices are likely to rise or fall - ahead of the event.
All technical analysis is based upon these cycles of mass human behaviour that is reflected in the movements of a stock’s price. Elliott Wave analysis is unlike most other forms of analysis in that it is possible for an analyst to understand exactly where prices are within that cycle at any given point in time.
This knowledge is invaluable to traders and investors, as using other forms of technical analysis such as traditional support and resistance methods can tell traders where support is, but how do they know whether to expect that support to hold or break? Proper application of Elliott Wave Theory can help them substantially increase successful trade results by helping them to assess the probabilities of that support holding or breaking.
Successful trading is about limiting risk and reducing losses incurred from bad trades. By understanding where prices are in the Elliott Wave cycle, traders have a unique tool available to them in their efforts to find low risk and high yielding entry and exit points for their trading.
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The Origins of the Elliott Wave Principle
The Wave Principle was developed in the 1930’s by Ralph Nelson Elliott who had the view that:
“Because, man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable.”
A distinguished accountant to trade, Elliott suffered from periods of ill health and at a time of historical stock market activity, spent much of his time studying the movements of the stock market to occupy his mind. He observed that the markets often appeared to move in recurring and recognisable patterns.
Elliott studied the charts of a number of stock market indexes spanning 75 years at various degrees of time, from Yearly down to 30mins. What he discovered was that these patterns were repetitive and took the form of interlinking ‘waves’. These waves then went on to develop into larger waves with similar patterns.
RN Elliott’s work remained relatively unknown until the 1970s when A.J. Frost and Robert Prechter Jr. published Elliott Wave Principle which is now widely regarded as the definitive guide to Elliott Wave Theory. It has since become one of the most popular and commonly used technical analysis tools.
Robert Prechter Jr. then went on to create the world’s largest stock market forecasting service, Elliott Wave International (EWI).
Elliott Wave International’s team of analysts provide forecasts for every major market in the world and through their free to join, Club EWI membership, offer an impressive range of very good quality educational materials such as videos, special reports, webinars...etc. Club EWI membership also gives you access to a free Elliott Wave basics tutorial (50 pages) which covers all the basics in more detail than we can in this “ Elliott Wave Theory – Quick Start Guide” eBook.
Robert Prechter Jr
R.N. Elliott
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Impulse Waves
Impulse Waves
Impulse waves are powerful moves composed of 5 sub waves that drive the market in the direction of the larger trend. Within the larger impulse wave, the 5 waves subdivide into 5,3,5,3,5 formations and are labelled 1,2,3,4,5.
Waves 1,3 and 5 are the impulse waves and are powerful, driving moves which are interrupted by the waves 2 and 4 which are corrective and consolidating phases, creating the wave like structure.
An impulse wave itself, always subdivides into 5 waves to a lesser degree, so the important factor for an Elliott Wave analyst in recognising that the trend has reversed, is to be able to count 5 waves in the internal sub divisions of the move.
Wave construction is always the most important factor in wave recognition so let’s have a closer look at the subdivisions within an impulse wave.....
Wave 1 (Impulse)
First waves subdivide into 5 smaller waves and can be either, slow and steady, grinding away and relentlessly moving against the trader convinced the previous trend is still underway, or they can be sharp and decisive blowing those traders out of the water.
First waves can also take the form of a Leading Diagonal which involves an overlap of waves 2 and 4 but these must still subdivide into 5,3,5,3,5 structures.
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Impulse Waves
Wave 2 (Corrective)
Second waves subdivide into 3 smaller waves and are often sharp and deep , retracing much of the gains of wave 1.
Within second waves, many traders are still convinced that the previous trend is still in effect. Generally speaking, second waves will be very deep and are most likely to retrace much of the first wave if that was a slow grinding move. Very sharp and powerful first waves can lead to a very shallow wave 2.
Wave 2s never retrace more than 100% of wave 1. If prices move beyond the origin of wave 1, it is a clear signal to the Elliott Wave analyst that his analysis is wrong.
Wave 3 (Impulse)
Third waves subdivide into 5 smaller waves and are typically the largest and most powerful wave. These waves occur on high volume and are broad ranging with mass participation as the new trend becomes clear. Wave 3s are never the shortest impulse wave and are the most likely to extend.
Wave 4 (Corrective)
Fourth waves subdivide into 3 smaller waves and are often very complex moves. These tend to be sideways and range bound moves frustrating bulls and bears.
Wave 5 (Impulse)
Fifth waves subdivide into 5 smaller waves and are distribution phases. These usually display a weakening of the trend in prices, breadth and volume. They can be long and drawn out phases as the market tops or bottoms, but at times they can be very sharp ‘spike’ like moves.
Fifth waves can take the form of an Ending Diagonal and involves the overlap of waves 2 and 4 but they differ from a Leading Diagonal which can appear in the wave 1 position, in that they subdivide into a 3,3,3,3,3 construction.
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Elliott Wave Triangles
Elliott Wave Triangles
As with all Elliott Wave identification, the internal wave formation is the most important factor in identifying Triangles in Elliott Wave Theory. Triangles subdivide into 3,3,3,3,3 and are labelled a,b,c,d,e. In other words, each internal wave subdivides into a 3.
It is important to remember that Elliott Wave triangles are not determined by shape, contracting price action in a converging triangular shape does not necessarily mean that it is an Elliott Wave Triangle.
A very common mistake we have found is that most of the formations that we see purported by analysts to be an Elliott Wave Triangle are not actually valid. We believe that this is through wishful thinking rather than through reasoned analysis.
An Elliott Wave Theory Triangle is a particularly special feature as they can only appear at certain points in the cycle. This means that they can be extremely good guide in confirming to the technical analyst where we are at that particular point in the cycle. The reliability offered by the price action following these patterns can lure to the analyst to see what he wants to see rather than what is actually there.
“What we see depends mainly on what we look for.” (John Lubbock)
Triangle Positioning in Elliott Wave Theory
A genuine Elliott Wave Triangle will only appear in the charts in certain positions within the cycle. They always occur in a position prior to the final wave in a move or as the final wave within a combination as mentioned earlier.
Wave 4 B wave X wave (final X wave in a Triple 3) Final wave in a Combination
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Elliott Wave Theory and Fibonacci
Fibonacci number Series
R.N Elliott himself wrote that "The Fibonacci Summation Series is the basis of The Wave Principle."
So what is the Fibonacci Series, the series is 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.....
Each number is the sum of the previous two numbers. E.g. 1+2=3, 3+2=5, 5+3=8...etc... If you compare the number sequence and refer back to the chart on page 6 of this eBook, you will start to get an idea of the relevance of Fibonacci within Elliott Wave Theory.
Fibonacci Ratios
Fibonacci ratios are derived from the sequence of numbers and the most important one is of course the Golden Ratio which is 0.618. The Golden ratio appears in many forms throughout the natural world and the importance of the Fibonacci ratios within stock analysis is very clear to see too.
There are many ways to apply Fibonacci studies to technical analysis and we also look for Fibonacci ratio relationships between the related waves in a cycle. Here are some common ratios to look for....
Wave 3 to wave 1 – 1, 1.618, 2.618, 4.236... Wave 5 to wave 1 – 0.5, 0.618, 1, 1.27, 1.382, 1.618...
When one of the impulse waves extend, there are some common relationships to look for and an example of this can be seen in these charts.
Common retrace ratios for corrections are
Wave 2 – 0.616, 0. Wave 4 – 0.382, 0. B waves – 0.5, 0.618, 1.00, 1.
Wave 2s are often sharp and deep. In an ideal world they would retrace 0.618 or 0.786 most of the time. Wave 4s tend toward a shallower retrace and will often find support at the 0.382 level of wave 3.
B waves are generally less consistent and tend to vary in length more.
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Test Your Knowledge – Elliott Wave Theory
Q1. How many waves does an impulse wave subdivide into?
A1.
Q2. What is the maximum retracement level for a wave 2?
A2.
Q3. Who is considered to be the leading authority on Elliott Wave Theory?
A3.
Q4. What is the most important Fibonacci ratio?
A4.
Q5. How does a triangle subdivide?
A5.
Q6. What is the most important factor in wave recognition?
A6.
Q7. What is the next number in this Fibonacci sequence 5, 8, 13, 21,?
A7.
Q8. Which impulse wave is never the shortest?
A8.
Q9. How do we label a 3 wave zigzag?
A9.
Q10. Could a wave 2 be a triangle?
A10.
How did you do? Check your answers to see how well you did at the Traders Day Trading .com Elliott Wave Theory answers page.
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Learn More about Elliott Wave Theory
This eBook is an original publication from Traders Day Trading.com and is part of a series of educational eBooks that we have produced for the purposes of
Learning about the Stock Market for Beginners & How to Start Day Trading – Successfully!
Visit us at our website to learn more about Elliott Wave Theory and much more.
Elliott Wave International is widely considered to be the leading authority on Elliott Wave Theory.
Elliott Wave International’s team of analysts provide forecasts for every major market in the world and through their free to join, Club EWI membership, offer an impressive range of very good quality educational materials such as tutorials, videos, special reports, webinars...etc.
Visit the Elliott Wave International website to learn more about Elliott Wave Theory and access their extensive library of educational materials including a 10 lesson tutorial over 50 pages.
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