ELLIOTT WAVE

WATCHING

An Introductory Course on the Elliott

Wave Methodology

Rev. 1 16th

July 2010

The following Introductory Course on the Elliott Wave Methodology was taken from the

posts by Rudy Dumas on the Incredible Charts website in the Elliott Wave Watching

thread. As suggested by the title it is meant to be an introduction to the Elliott Wave

methodology.

Hi Folks,

As mentioned in my postings on the Our Daily Bread thread I am starting this particular

thread for those who are genuinely interested in learning the Elliott Wave methodology

to enhance their study of the markets. Like all methodologies, EW analysis has it's own

strengths and weaknesses. I hope that through this thread you will get some idea of

what these strengths and weakness are and get a practical view of how to use the

methodology in your every day trading.

Perhaps it might be a good idea to just mention a few of these strengths and

weaknesses (as I see them) at the outset. Naturally enough anything that I say about

EW analysis on this thread are my thoughts alone and not necessarily those shared by

other EW analysts.

Strengths

Elliott Wave analysis is built around the concept that there are a number of patterns that

continually re-occur in the market cycle at every level of observation. These same

patterns are formed on every thing from intraday charts to multi-decade charts. These

patterns define every part of the market cycle. In other words, every price action

occurring on any chart should be definable in EW terms. That is to say that the EW

patterns define every move on a chart and not just individual patterns that may appear

on a specific chart as is the case in traditional TA patterns.

Of all of the methodologies that I have studied it has probably the most complete set of

recognisable patterns available to the technical analyst.

Traditional TA has it's own set of recognisable patterns. Examples of these would be

Head and Shoulders, Cup and Handle, Pennants, Flags, Double/Triple tops and bottoms,

etc. Anyone studying TA methodologies understand that these patterns don't always

work to perfection (sometimes they don't work out at all) but they do allow us to see a

particular market action in some context and gives us potential target levels for any

future price action. Note however that traditional TA patterns occur in isolation on

particular charts and only define one particular part of the price action on the charts.

EW patterns on the other hand always work in terms of their 'general pattern' however

attempting to identify the 'specific' pattern of the current pattern being analysed is not

so simple. What I mean by this is that even a simple 5 wave impulse wave obeys a

number of general rules that relate to an impulse wave but there can be hundreds of

individual 5 wave impulse patterns that are all different in spite of obeying all of the

rules. For example each wave length may have totally individual ranges and the

corrective waves associated with waves 2 and 4 may be entirely different.

These EW patterns are similar to say a specific type of tree. A pine tree for example has

a particular shape and distinctive features but every pine tree is different. Just like

humans all have similar features that differentiate them from say a horse however

everyone of these humans (though identifiable as belonging to the human species) is

different.

There is also the complication of a number of patterns that start out the same way in

their pattern formation but end up with a completely different final pattern. An example

would be a Zigzag wave and the first 3 waves of an impulse wave. When taken in

isolation and not in the context of the preceding pattern, there is no way of

differentiating these two patterns.

Of What Benefit is Pattern Recognition?

Whilst there are times when patterns can be quite complex, there are many times when

the patterns shine through clear as a bell. This can happen even with part patterns. For

example, if an EW analyst sees an impulse wave followed by a corrective wave then they

can be very confident that the next wave will be another impulsive move. Depending on

where that part pattern is within the context of the preceding pattern, the analyst can

determine if he is seeing the signs of an impulse wave. If so he can be assured with a

high degree of certainty that the next wave will be highly tradable and he will already

have some idea of the likely target range for that move. This greatly enhances his ability

to trade successfully.

Another example would be in a strong trend which has the look of an impulse wave

pattern, the EW analyst can have some idea of where the current pattern is within the

overall pattern. This can alert him/her if a turning point in the trend is close at hand

(such as in the 5th wave of an impulse wave).

Weaknesses

The two biggest weaknesses that I have discovered in the EW methodology revolve

around corrective waves and what I call level confusion.

In EW analysis there are two types of waves.....impulsive and corrective waves.

Impulsive waves are those waves that push the market in the direction of a trending

market. Corrective waves move in the opposite direction to a trending market.

As you can imagine, when going against the trend, the market has to struggle against

the 'flow' of the market. The act of doing this causes corrective waves to be much more

complicated than impulsive waves that flow with the market.

For this reason, there are far more corrective wave patterns than impulsive wave

patterns. In fact the corrective waves can often become very complex. At times they can

be so complex that attempting to define them becomes an act in futility and often in

these cases the final pattern cannot be determined until they are almost complete At

times like this it is best to stand aside and not trade the market. This in itself is useful

knowledge to have because often these sort of patterns not only have a great deal of

risk but they don't provide good ranges to trade anyway.

Apart from complex corrective waves the other problem area in EW analysis is what I call

level confusion. On any chart (regardless of the time frame) it is common to see at least

2 and sometimes 3 different levels of pattern.

For example a chart may show the following pattern.

When correctly labeled we may find that we are seeing two levels of labeling. the lower

level is labeled 12345ABC where as the higher level waves (1) and (2) also can be seen.

A slightly more complex pattern may show 3 levels as per the chart below. Without

labeling the different levels accurately the EW analyst would end up with a dogs

breakfast in terms of labels. Note how I have clearly identified the 3 different levels of

labeling below.

Correct labelling is probably one of the single most important aspects of EW analysis.

Unfortunately it is also probably one of the most boring aspects of EW analysis. If you

don't get it right, you'll never be able to get very far with EW analysis. For that reason

I'll spend a bit of time on it in the next post.

Labelling of Elliott Wave Patterns

In my first post I indicated that one of the most important facets of EW analysis was the

correct labelling of the wave patterns. The correct labelling of wave patterns reduces the

chances of the 'level confusion' problem that I mentioned in that post.

An analyst can adopt virtually any labelling convention however it is important that once

a convention is used then it should be rigidly adhered to. Robert Prechter in the book

Elliott Wave Principles (Frost and Prechter) adopted the following convention. You will

find that on most occasions I use this convention.

Note that impulsive wave are labelled using numerals whereas corrective waves are

labelled using alphas.

As an example in the standard 8 leg Elliott Wave pattern below we can see that the

lower level waves (12345ABC) are at the Minor level whereas the higher level waves

{(1)(2)} are at the Intermediate level.

Elliott Wave Methodology

As analysts new to the Elliott Wave methodology delve into the various known patterns it

quickly becomes apparent that many of the patterns start off with the same sort of sub

patterns. Remember that in its simplest form, the standard EW pattern comprises a 5

wave pattern for impulsive moves and a 3 wave pattern for a corrective move. For this

reason many patterns have similar structures.

I would like to just talk a little about pattern structure and the short hand methods of

describing them.

It should always be remembered that EW patterns occur at every observable level.

Hence when purely observing the standard 8 leg Elliott Wave it will look like the

following.

If we now drilled down into that simple structure so that we could also see the next level

down of wave pattern we would see the next structure.

So what we would see then is the make up of each higher level leg. We can see then

that in the diagram displayed we have a typical impulse wave pattern for the

impulsive leg and a typical 3 wave corrective pattern for the corrective leg.

Note that in the impulse pattern legs 1, 3 and 5 have a 5 leg subwave pattern and legs 2

and 4 have a 3 leg subwave pattern. We would therefore describe this pattern

structurally as having a 5-3-5-3-5 format.

Similarly the corrective phase pattern wold have a 3-3-5 format.

Please note that all impulsive patterns have a 5 wave structure but they may not

necessarily have a 5-3-5-3-5 format because the corrective waves (legs 2 and 4) could

also be triangles (5 wave pattern) or other complex corrective patterns rather than a

simple 3 wave pattern.

Okay, now that I have briefly covered the basic EW pattern structure I can repeat again

that many different patterns may start off with the same patterns for the early part of

their structure. For example the format of a Zigzag corrective wave is 5-3-5. This also

happens to be the structure of the first 3 waves of a simple Impulse wave.

For that reason the EW analysis methodology involves monitoring the early part of a

forming wave and coming up with the possible scenarios that are most likely to occur

based on that early pattern. Then, as the price action (and therefore the pattern)

continues to evolve, we can eliminate the invalid patterns until such time as we only

have one valid pattern left. It is at this time that we are truly in a position to predict the

future market action.

THE SIMPLE IMPULSE WAVE

We can see from the standard EW pattern that it comprises a 5 wave impulse wave and

a 3 wave corrective wave. We now look at the first part of the pattern, namely the 5

wave impulse wave.

We will see from the diagram below that even though it is called an impulse wave, it

actually is also made up of a mixture of impulsive patterns and corrective patterns. Note

that the diagram is drawn showing one level of pattern only.

Note that there are 3 legs with an impulsive pattern and 2 legs with a corrective pattern.

There are two modes of wave development, namely motive and corrective. The

motive waves cause the direction of trend whereas the corrective waves provide

retracements (pullbacks) or rest periods in that trend.

Rules for Impulse Waves

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

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

2) Wave 3 is not the shortest wave by price movement when compared to waves 1 and

5.

3) Wave 4 cannot fall into the price range of wave 1.

Note that the above rules are written in the context of a rising market.

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.

Impulse Waves with Extensions

Whilst the simple impulse wave always has a total of 5 waves there are many

occasions when more than one level of wave pattern can be seen on a chart. This

causes the illusion that an impulse wave has more than 5 waves. The most common

cases are that impulse waves will appear to have either 5, 9 or 13 waves in its pattern.

The following diagram show what happens.

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Leading and Ending Diagonals

There are two types of impulsive moves that are a bit different to the normal Impulse

wave. These are the leading and ending diagonals. In both of these patterns we have

a breach of rule 3) for the normal Impulse wave. In both these patterns wave 4 will

often fall into the price range of wave 1.

The leading diagonal when it occurs will always occur as wave 1 of an impulse wave.

It cannot occur in wave 3 or wave 5. A leading diagonal will often develop as a result

of a market that has been moved dramatically in some corrective move (such as a bear

market plunge) and a new impulse wave is developing. Because of the dramatic move in

the previous corrective move the market takes time to gain confidence in the new

impulse pattern. So it is basically a weak beginning to a new impulsive move.

It has the basic form shown in the diagram below.

An ending diagonal looks very much like a leading diagonal but only ever forms as

wave 5 of an impulse wave pattern. The ending diagonal is once again a weaker pattern

than a normal Impulse wave. It normally forms when a market has moved too fast in

waves 1 and 3 and is therefore weakening in this part of the market cycle.

It can never be a wave 1 or wave 3. It has the basic shape shown in the chart below.

We can see from the above diagrams of the leading and ending diagonals that both of

them look identical. It is only thier position within a standard Impulse wave and their

internal structure that differentiates them. Capping their positions within an standard

Impulse wave again for emphasis. Leading diagonals are found as a wave 1 only and

ending diagonals are only found as wave 5 in an Impulse wave.

The internal structures have the following format.

Leading diagonals have a Impulsive(Imp)-Corrective (Cor)-Imp-Cor-Imp or a Cor-Cor-

Cor-Cor-Cor structure.

Ending diagonals have a Cor-Cor-Cor-Cor-Cor structure.

The Cheat Sheet that I posted earlier only indicates one of the two structures for the

leading diagonal.