CONNECTION BETWEEN ELLIOTT WAVE AND DOW THEORY

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CONNECTION BETWEEN ELLIOTT WAVE AND DOW THEORY

Let’s take a moment here to point out the obvious connection between Elliott’s idea of five advancing waves and Dow’s three advancing phases of a bull market. It seems clear that Elliott’s idea of three up waves, with two intervening corrections, fits nicely with the Dow Theory. While Elliott was no doubt influenced by Dow’s analysis, it also seems clear that Elliott believed

he had gone well beyond Dow’s theory and had in fact improved on it. It’s also interesting to note the influence of the sea on both men in the formulation of their theories. Dow compared the major, intermediate, and minor trends in the market with the tides, waves, and ripples on the ocean. Elliott referred to “ebbs and flows” in his writing and named his theory the “wave” principle.

CORRECTIVE WAVES

So far, we’ve talked mainly about the impulse waves in the direction of the major trend. Let’s turn our attention now to the corrective waves. In general, corrective waves are less clearly defined and, as a result, tend to be more difficult to identify and predict. One point that is clearly defined, however, is that corrective waves can never take place in five waves. Corrective waves are threes, never fives (with the exception of triangles). We’re going to look at three classifications of corrective waves—zig-zags, flats, and triangles.

Zig-Zags

A zig-zag is a three wave corrective pattern, against the major trend, which breaks down into a 5-3-5 sequence. Figures 13.4 and 13.5 show a bull market zig-zag correction, while a bear market rally is shown in Figures 13.6 and 13.7. Notice that the middle wave B falls short of the beginning of wave A and that wave C moves well beyond the end of wave A.

A less common variation of the zig-zag is the double zigzag shown in Figure 13.8. This variation sometimes occurs in larger corrective patterns. It is in effect two different 5-3-5 zig-zag patterns connected by an intervening a-bc pattern.

Figure 13.7 Bear Market Zig-Zag (5-3-5). (Frost and Prechter, p. 36

Flats

What distinguishes the flat correction from the zig-zag correction is that the flat follows a 3-3-5 pattern. Notice in Figures 13.10 and 13.12 that the A wave is a 3 instead of a 5. In general, the flat is more of a consolidation than a correction and is considered a sign of strength in a bull market. Figures 13.9- 13.12 show examples of normal flats. In a bull market, for example, wave B rallies all the way to the top of wave A, showing greater market strength. The final wave C terminates at or just below the bottom of wave A in contrast to a zig-zag, which moves well under that point.

There are two “irregular” variations of the normal flat correction. Figures 13.13-13.16 show the first type of variation. Notice in the bull market example (Figures 13.13 and 13.14) that the top of wave B exceeds the top of A and that wave C violates the bottom of A.

Another variation occurs when wave B reaches the top of A, but wave C fails to reach the bottom of A. Naturally, this last pattern denotes greater market strength in a bull market. This variation is shown in Figures 13.17- 13.20 for bull and bear markets.

Figure 13.14 Bull Market Flat (3-3-5), Irregular Correction. (Frost and

Triangles

Triangles usually occur in the fourth wave and precede the final move in the direction of the major trend. (They can also appear in the b wave of an a-b-c correction.) In an uptrend, therefore, it can be said that triangles are both bullish and bearish. They’re bullish in the sense that they indicate resumption of the uptrend. They’re bearish because they also indicate that after one more wave up, prices will probably peak. (See Figure 13.21.)

Elliott’s interpretation of the triangle parallels the classical use of the pattern, but with his usual added precision. Remember from Chapter 6 that the triangle is usually a continuation pattern, which is exactly what Elliott said. Elliott’s triangle is a sideways consolidation pattern that breaks down into five waves, each wave in turn having three waves of its own. Elliott also classifies four different kinds of triangles—ascending, descending, symmetrical, and expanding—all of which were seen in Chapter 6. Figure 13.21 shows the four varieties in both uptrends and downtrends.

Because chart patterns in commodity futures contracts sometimes don’t form as fully as they do in the stock market, it is not unusual for triangles in the futures markets to have only three waves instead of five. (Remember, however, that the minimum requirement for a triangle is still four points—two upper and two lower—to allow the drawing of two converging trendlines.) Elliott Wave Theory also holds that the fifth and last wave within the triangle sometimes breaks its trendline, giving a false signal, before beginning its “thrust” in the original direction.

Elliott’s measurement for the fifth and final wave after completion of the triangle is essentially the same as in classical charting—that is, the market is expected to move the distance that matches the widest part of the triangle (its height). There is another point worth noting here concerning the timing of the final top or bottom. According to Prechter, the apex of the triangle (the point where the two converging trendlines meet) often marks the timing for the completion of the final fifth wave.

THE RULE OF ALTERNATION

In its more general application, this rule or principle holds that the market usually doesn’t act the same way two times in a row. If a certain type of top or bottom occurred the last time around, it will probably not do so again this time. The rule of alternation doesn’t tell us exactly what will happen, but tells us what probably won’t. In its more specific application, it is most generally used to tell us what type of corrective pattern to expect. Corrective patterns tend to alternate. In other words, if corrective wave 2 was a simple a-b-c pattern, wave 4 will probably be a complex pattern, such as a triangle. Conversely, if wave 2 is complex, wave 4 will probably be simple. Figure 13.22 gives some examples.

CHANNELING

Another important aspect of wave theory is the use of price channels. You’ll recall that we covered trend channeling in Chapter 4. Elliott used price channels as a method of arriving at price objectives and also to help confirm the completion of wave counts. Once an uptrend has been established, an initial trend channel is constructed by drawing a basic up trendline along the bottoms of waves 1 and 2. A parallel channel line is then drawn over the top of wave 1 as shown in Figure 13.23. The entire uptrend will often stay within those two boundaries.

If wave 3 begins to accelerate to the point that it exceeds the upper channel line, the lines have to be redrawn along the top of wave 1 and the bottom of wave 2 as shown in Figure 13.23. The final channel is drawn under the two corrective waves—2 and 4—and usually above the top of wave 3 as shown in Figure 13.24. If wave 3 is unusually strong, or an extended wave, the upper line may have to be drawn over the top of wave 1. The fifth wave should come close to the upper channel line before terminating. For the drawing of channel lines on long term trends, it’s recommended that semilog charts be employed along with arithmetic charts.

WAVE 4 AS A SUPPORT AREA

In concluding our discussion of wave formations and guidelines, one important point remains to be mentioned, and that is the significance of wave 4 as a support area in subsequent bear markets. Once five up waves have been completed and a bear trend has begun, that bear market will usually not move below the previous fourth wave of one lesser degree; that is, the last fourth wave that was formed during the previous bull advance. There are exceptions to that rule, but usually the bottom of the fourth wave contains the bear market. This piece of information can prove very useful in arriving at a maximum downside price objective.

FIBONACCI NUMBERS AS THE BASIS OF THE WAVE PRINCIPLE

Elliott stated in Nature’s Law that the mathematical basis for his Wave Principle was a number sequence discovered by Leonardo Fibonacci in the thirteenth century. That number sequence has become identified with its discoverer and is commonly referred to as the Fibonacci numbers. The number sequence is 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and so on to

infinity.

The sequence has a number of interesting properties, not the least of which is an almost constant relationship between the numbers.

1. The sum of any two consecutive numbers equals the next higher number. For example, 3 and 5 equals 8, 5 and 8 equals 13, and so on.
1. The ratio of any number to its next higher number approaches .618, after the first four numbers. For example, 1/1 is 1.00, 1/2 is .50, 2/3 is .67, 3/5 is .60, 5/8 is .625, 8/13 is .615, 13/21 is .619, and so on. Notice how these early ratio values fluctuate above and below .618 in narrowing amplitude. Also, notice the values of 1.00, .50, .67. We’ll comment further on these values when we talk more about ratio analysis and percentage retracements.
1. The ratio of any number to its next lower number is approximately 1.618, or the inverse of .618. For example, 13/8 is 1.625, 21/13 is 1.615, 34/21 is 1.619. The higher the numbers become, the closer they come to the values of .618 and 1.618.
1. The ratios of alternate numbers approach 2.618 or its inverse, .382. For example, 13/34 is .382, 34/13 is 2.615.

FIBONACCI RATIOS AND RETRACEMENTS

It was already stated that wave theory is comprised of three aspects—wave form, ratio, and time. We’ve already discussed wave form, which is the most important of the three. Let’s talk now about the application of the Fibonacci ratios and retracements. These relationships can apply to both price and time, although the former is considered to be the more reliable. We’ll come back later to the aspect of time.

First of all, a glance back at Figures 13.1 and 13.3 shows that the basic wave form always breaks down into Fibonacci numbers. One complete cycle comprises eight waves, five up and three down—all Fibonacci numbers. Two further subdivisions will produce 34 and 144 waves—also Fibonacci numbers. The mathematical basis of the wave theory on the Fibonacci sequence, however, goes beyond just wave counting. There’s also the question of proportional relationships between the different waves. The following are among the most commonly used Fibonacci ratios:

1. One of the three impulse waves sometimes extends. The other two are equal in time and magnitude. If wave 5 extends, waves 1 and 3 should be about equal. If wave 3 extends, waves 1 and 5 tend toward equality.
1. A minimum target for the top of wave 3 can be obtained by multiplying

the length of wave 1 by 1.618 and adding that total to the bottom of 2.

1. The top of wave 5 can be approximated by multiplying wave 1 by 3.236 (2×1.618) and adding that value to the top or bottom of wave 1 for maximum and minimum targets.
1. Where waves 1 and 3 are about equal, and wave 5 is expected to extend, a price objective can be obtained by measuring the distance from the bottom of wave 1 to the top of wave 3, multiplying by 1.618, and adding the result to the bottom of 4.
1. For corrective waves, in a normal 5-3-5 zig-zag correction, wave c is often about equal to the length of wave a.
1. Another way to measure the possible length of wave c is to multiply .618 by the length of wave a and subtract that result from the bottom of wave a.
1. In the case of a flat 3-3-5 correction, where the b wave reaches or exceeds the top of wave a, wave c will be about 1.618 the length of a.
1. In a symmetrical triangle, each successive wave is related to its previous wave by about .618.

Fibonacci Percentage Retracements

The preceding ratios help to determine price objectives in both impulse and corrective waves. Another way to determine price objectives is by the use of percentage retracements. The most commonly used numbers in retracement analysis are 61.8% (usually rounded off to 62%), 38%, and 50%. Remember from Chapter 4 that markets usually retrace previous moves by certain predictable percentages—the best known ones being 33%, 50%, and 67%. The Fibonacci sequence refines those numbers a bit further. In a strong trend, a minimum retracement is usually around 38%. In a weaker trend, the maximum percentage retracement is usually 62%. (See Figures 13.25 and 13.26.)

Figure 13.25 The three horizontal lines show Fibonnaci retracement levels of 38%, 50%, and 62% measured from the 1981 bottom to the 1993 peak in Treasury Bonds. The 1994 correction in bond prices stopped right at the 38% retracement line.

Figure 13.26 The three Fibonacci percentage lines are measured from the 1994 bottom in bond prices to the early 1996 top. Bond prices corrected to the 62% line.

It was pointed out earlier, that the Fibonacci ratios approach .618 only after the first four numbers. The first three ratios are 1/1 (100%), 1/2 (50%), and 2/3 (66%). Many students of Elliott may be unaware that the famous 50% retracement is actually a Fibonacci ratio, as is the two-thirds retracement. A complete retracement (100%) of a previous bull or bear market also should mark an important support or resistance area.

FIBONACCI TIME TARGETS

We haven’t said too much about the aspect of time in wave analysis. Fibonacci time relationships exist. It’s just that they’re harder to predict and are considered by some Elliotticians to be the least important of the three aspects of the theory. Fibonacci time targets are found by counting forward from significant tops and bottoms. On a daily chart, the analyst counts forward the number of trading days from an important turning point with the expectation that future tops or bottoms will occur on Fibonacci days—that is, on the 13th, 21st, 34th, 55th, or 89th trading day in the future. The same technique can be used on weekly, monthly, or even yearly charts. On the weekly chart, the analyst picks a significant top or bottom and looks for weekly time targets that fall on Fibonacci numbers. (See Figures 13.27 and 13.28.)

COMBINING ALL THREE ASPECTS OF WAVE THEORY

The ideal situation occurs when wave form, ratio analysis, and time targets come together. Suppose that a study of waves reveals that a fifth wave has been completed, that wave 5 has gone 1.618 times the distance from the bottom of wave 1 to the top of wave 3, and that the time from the beginning of the trend has been 13 weeks from a previous low and 34 weeks from a previous top. Suppose further that the fifth wave has lasted 21 days. Odds would be pretty good that an important top was near.

Figure 13.27 Fibonacci time targets measured in months from the 1981 bottom in Treasury Bonds. It may be coincidence, but the last four Fibonacci time targets (vertical bars) coincided with important turns in bond prices.

Figure 13.28 Fibonacci time targets in months from the 1982 bottom in the Dow. The last three vertical bars coincide with bear market years in stocks— 1987, 1990, and 1994. The 1987 peak was 13 years from the 1982 bottom—a Fibonacci number.

A study of price charts in both stocks and futures markets reveals a number of Fibonacci time relationships. Part of the problem, however, is the variety of possible relationships. Fibonacci time targets can be taken from top to top, top to bottom, bottom to bottom, and bottom to top. These relationships can always be found after the fact. It’s not always clear which of the possible relationships are relevant to the current trend.

ELLIOTT WAVE APPLIED TO STOCKS VERSUS COMMODITIES

There are some differences in applying wave theory to stocks and commodities. For example, wave 3 tends to extend in stocks and wave 5 in commodities. The unbreakable rule that wave 4 can never overlap wave 1 in stocks is not as rigid in commodities. (Intraday penetrations can occur on futures charts.) Sometimes charts of the cash market in commodities give a clearer Elliott pattern than the futures market. The use of continuation charts in commodity futures markets also produces distortions that may affect long term Elliott patterns.

Possibly the most significant difference between the two areas is that major bull markets in commodities can be “contained,” meaning that bull market highs do not always exceed previous bull market highs. It is possible in commodity markets for a completed five wave bull trend to fall short of a previous bull market high. The major tops formed in many commodity markets in the 1980 to 1981 period failed to exceed major tops formed seven and eight years earlier. As a final comparison between the two areas, it appears that the best Elliott patterns in commodity markets arise from breakouts from long term extended bases.

It is important to keep in mind that wave theory was originally meant to be applied to the stock market averages. It doesn’t work as well in individual common stocks. It’s quite possible that it doesn’t work that well in some of the more thinly traded futures markets as well because mass psychology is one of the important foundations on which the theory rests. Gold, as an illustration, is an excellent vehicle for wave analysis because of its wide following.

SUMMARY AND CONCLUSIONS

Let’s briefly summarize the more important elements of wave theory and then try to put it into proper perspective.

1. A complete bull market cycle is made up of eight waves, five up waves followed by three down waves.
1. A trend divides into five waves in the direction of the next longer trend.
1. Corrections always take place in three waves.
1. The two types of simple corrections are zig-zags (5-3-5) and flats (3-3- 5).
1. Triangles are usually fourth waves, and always precede the final wave. Triangles can also be B corrective waves.
1. Waves can be expanded into longer waves and subdivided into shorter waves.
1. Sometimes one of the impulse waves extends. The other two should then be equal in time and magnitude.
1. The Fibonacci sequence is the mathematical basis of the Elliott Wave Theory.
1. The number of waves follows the Fibonacci sequence.
1. Fibonacci ratios and retracements are used to determine price objectives. The most common retracements are 62%, 50%, and 38%.
1. The rule of alternation warns not to expect the same thing twice in succession.
1. Bear markets should not fall below the bottom of the previous fourth wave.
1. Wave 4 should not overlap wave 1 (not as rigid in futures).
1. The Elliott Wave Theory is comprised of wave forms, ratios, and time, in that order of importance.
1. The theory was originally applied to stock market averages and does not work as well on individual stocks.
1. The theory works best in those commodity markets with the largest public following, such as gold.
1. The principal difference in commodities is the existence of contained bull markets.

The Elliott Wave Principle builds on the more classical approaches, such as Dow Theory and traditional chart patterns. Most of those price patterns can be explained as part of the Elliott Wave structure. It builds on the concept of “swing objectives” by using Fibonacci ratio projections and percentage retracements. The Elliott Wave Principle takes all of these factors into consideration, but goes beyond them by giving them more order and increased predictability.

Wave Theory Should Be Used in Conjunction with Other Technical Tools

There are times when Elliott pictures are clear and other times when they are not. Trying to force unclear market action into an Elliott format, and ignoring other technical tools in the process, is a misuse of the theory. The key is to view Elliott Wave Theory as a partial answer to the puzzle of market

forecasting. Using it in conjunction with all of the other technical theories in this book will increase its value and improve your chances for success.

REFERENCE MATERIAL

Two of the best sources of information on Elliott Wave Theory and the Fibonacci numbers are The Major Works of R.N. Elliott, (Prechter, Jr.) and the Elliott Wave Principle (Frost and Prechter). All of the diagrams used in Figures 13.1-13.24 are from the Elliott Wave Principle and are reproduced in this chapter through the courtesy of New Classics Library.

A primer booklet on the Fibonacci numbers, Understanding Fibonacci Numbers by Edward D. Dobson, is available from Traders Press (P.O. Box 6206, Greenville, S.C. 29606 (800-927-8222).

INTRODUCTION

Our main focus up to this point has been on price movement, and not too much has been said about the importance of time in solving the forecasting puzzle. The question of time has been present by implication throughout our entire coverage of technical analysis, but has generally been relegated to secondary consideration. In this chapter, we’re going to view the problem of forecasting through the eyes of cyclic analysts who believe that time cycles hold the ultimate key to understanding why markets move up or down. In the process, we’re going to add the important dimension of time to our growing list of analytical tools. Instead of just asking ourselves which way and how far a market will go, we’ll start asking when it will arrive there or even when the move will begin.

Consider the standard daily bar chart. The vertical axis gives the price scale. But that’s only half of the relevant data. The horizontal scale gives the time horizon. Therefore, the bar chart is really a time and price chart. Yet, many traders concentrate solely on price data to the exclusion of time considerations. When we study chart patterns, we’re aware that there is a relationship between the amount of time it takes for those patterns to form and the potential for subsequent market moves. The longer a trendline or a support or resistance level remains in effect, the more valid it becomes. Moving averages require input as to the proper time period to use. Even oscillators require some decision as to how many days to measure. In the previous chapter, we considered the usefulness of Fibonacci time targets.

It seems clear then that all phases of technical analysis depend to some extent on time considerations. Yet those considerations are not really applied in a consistent and dependable manner. That’s where time cycles come into play. Instead of playing a secondary or supporting role in market movement,

cyclic analysts hold that time cycles are the determining factor in bull and bear markets. Not only is time the dominant factor, but all other technical tools can be improved by incorporating cycles. Moving averages and oscillators, for example, can be optimized by tying them to dominant cycles. Trendline analysis can be made more precise with cyclic analysis by determining which are valid trendlines and which are not. Price pattern analysis can be enhanced if combined with cyclic peaks and troughs. By the use of “time windows,” price movement can be filtered in such a way that extraneous action can be ignored and primary emphasis placed only on such times when important cycle tops and bottoms are due to occur.