Elliott Wave Principle

Steven W. Poser
Managing Director, Research
New York Stock Exchange
212-656-4512
sposer@nyse.com
 Today’s Objectives
 Review fundamentals of the Elliott
Wave Principle (EWP)

 Preparation for CMT II&III

 Text: Elliott Wave Principle: Key to

Market Behavior (A.J. Frost, Robert
Prechter Jr.)
2
 Overview
 EWP’s primary value is as a description of
how markets behave.

 Provides context for market analysis.

 Prechter and Frost state EWP “is not

primarily a forecasting tool”

 EWP patterns also visible in economic data

and in general human behavior
3
 Basic Tenets
 EWP is governed by man’s social nature,
which is expressed in repetitive form.

 In markets, this is shown as progressions

of five waves, followed by three waves.

 Three rules
• Wave-2 never moves beyond start of wave-1
• Wave-3 never the shortest
• Wave-4 never overlaps wave-1, except in a
diagonal triangle

4
 Elliott Wave Theory Basics
• Developed by Ralph Nelson Elliott, mostly
in the 1930s

• Related specific price patterns in the stock

market as being nature’s law – in essence,
price patterns were deterministic

• Although most reasonable Elliotticians

would not call EW deterministic, it does
give us deep insight into market behavior
5
 Elliott Wave Theory Basics
• Classic patterns are based deeply in
market psychology

• Each wave and sub-wave has a

characteristic market psyche
attached to it

• This improves forecasting capability

6
The Basic Wave Pattern
5
3
B

1
4 A

C
2

7
 Elliott Wave Basics
• Wave modes
• Motive waves – subdivide into five waves
• Corrective waves – subdivide into a three wave
structure or a triangle

• A complete cycle is eight waves:

• Five wave motive (1-2-3-4-5)
• Three wave corrective (a-b-c)

• Even numbered waves are also corrective

within a motive move
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 Elliott Wave Basics
• Waves are fractal
• Wave-1 breaks into five smaller waves
• Wave-2 subdivides into a three wave move, etc.
• Wave-a is motive against the trend of one larger degree

• Any cycle of five waves forms a larger cycle of one degree

higher than the individual waves. Degree is based on form,
not price and time (despite nomenclature discussed later).

• Even numbered waves are also corrective within a motive

move

• Five wave moves have nothing to do with bull or bear

markets: they can be in either direction. Action in the same
direction as the larger trend is five waves, and countertrend
action develops in three waves.
9
 Elliott Wave Basics
• Actionary moves are motive cycles that
are not diagonal triangles (no overlapping
between wave-1 and wave-4). Also known
as impulse moves.

• A diagonal triangle is also known as a

wedge in classic TA and usually shows up
in wave-5 or wave-C, rarely wave-1.

10
 Elliott Wave Notation
• Elliott created names for cycles of varying sizes and time. Frost
and Prechter revised the names and notations
1. Supermillenium 1 A
2. Millenium (1) (A)
3. Submillenium 1 A
4. Grand Supercycle I a
5. Supercycle (I) (a)
6. Cycle I a
7. Primary 1 A
8. Intermediate (1) (A)
9. Minor 1 A
10. Minute i a
11. Minuette (i) (a)
12. Subminuette i a
13. Micro 1 A
14. Submicro (1) (A)
15. Miniscule 1 A

11
 Extensions
• Usually, one wave in an impulse move extends –
breaks into a larger five wave move. This is
typically the third wave in the stock market and
is often the fifth wave in the commodity
markets.
• A full five wave impulse therefore breaks into a
nine leg cycle. For example: (1)-(2)-1-2-3-4-
5(3)-4-5 where wave-(3) extended into 1-2-3-
4-5.
• Extensions can extend as well: 1-2-3-4-(1)-(2)-
(3)-(4)-1-2-3-4-5(5)5
• The circled waves are primary, the ones in parentheses
are intermediate and the last are minor degree.
12
 Truncations
• More commonly known as failures,
but Frost/Prechter changed the name
to truncation.

• When the fifth wave does not move

beyond the end of the third wave.

13
 Diagonals
• Motive, but not actionary (impulsive)

• Each leg is three waves. One exception is that a diagonal

can appear in wave-a of a zigzag or wave-1 of an impulse.
In those cases, the subdivisions can – but do not have to –
develop as 5-3-5-3-5.

• Third wave still never the shortest

• Usually in fifth and sometimes in c-wave. If in a double

three, can only be in wave-c of the second of the doubles.

• Looks like wedge, with 5th sometimes over shooting,

sometimes undershooting. Frost/Prechter mentions one
case of expanding diagonal.

• Fifth wave extensions, truncated fifths and ending

diagonals often result in dramatic reversals.
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 Corrections - Categories
• Three basic types:
• Zig-zags – 5-3-5 pattern. Also double zig-zag and triple
zig-zag, which represent multiple zig-zag patterns joined
together. These are usually the sharpest corrections.
• Flats – 3-3-5 pattern. Includes regular, expanded
(Frost/Prechter term for irregular) and running. These
corrections are usually horizontal.
• Triangle – Actually have five legs (3-3-3-3-3). Divided
into symmetrical, ascending, descending and expanding
(reverse symmetrical). Always in last correction of an
actionary wave of one larger degree (but can also be
part of a combination). Frost/Prechter then says in very
rare cases it can be a second wave, but usually as part
of combination.
• Combination – Double or triple, combining flats, zig-zags
and triangles
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 Corrections – Labeling
• If you see a five wave move after a motive cycle, then
there will be another five wave move to come, forming a
correction (ie, a zig-zag). Five wave moves never stand
alone.

• Labels for a zig-zag or flat are of the A-B-C variety.

• For combinations (double three and triple three), each

individual “three” is labeled as W, then Y and then Z. The
overall labeling then would be: a-b-c(W), a-b-c(X), a-b-
c(Y), a-b-c(X), a-b-c(Z). The waves between the W,Y and Z
are called X-waves and can be any kind of corrective
pattern, but it is usually a zig-zag.

• If part of a combination is a triangle, that is labeled a-b-c-

d-e instead of a-b-c.

16
 Corrections – Zig-Zags
• Both waves are 5-wave motive moves.

• Wave-A is rarely a diagonal triangle.

• Wave-B can be a triangle, or any other type of correction.

• Wave-C is often like wave-3, very powerful, but can occasionally

be a diagonal triangle.

• Zig-zags are usually faster and correct more price territory than
flats.

• You should look for a double zig-zag if a zig-zag completes that

has ended too quickly and more importantly has not retraced
enough price territory.

• A zig-zag can appear, usually as a Y or Z as part of a combination.

17
 Corrections – Flats
• Usually retraces less ground than a zig-
zag.

• If a flat ends too quickly, although much

of the price retracement may have taken
place, look for a double-three or triple-
three to allow for more time (range
trading).

• Wave-B can retrace more than 100% of

wave-A. This is known as an expanded flat
(Elliott called it an “irregular”, and that
term is used by many Elliotticians).
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 Corrections – Flats (con’t)
• Wave-C typically ends near the end of
wave-A.

• In expanded flats, wave-C may end well

beyond the end of wave-A.

• In a running flat, wave-B ends far beyond

the start of wave-A. This implies strength
in the trend of one larger degree. Wave-C
usually ends well before the end of wave-A
in these cases. These types of
corrections are very rare!

19
 Corrections – Triangles
• Possibly the single most important thing you can
learn from triangles is that the classic technical
analysis books have triangles all wrong:
• You can always predict which direction a triangle will
break.
• Although an ascending triangle is more likely to appear
as a correction in an up trend, the direction it breaks is
based on the prior wave pattern. They are not inherently
bullish. The same is true of descending triangles.

• Triangles, in this terminology are always

corrective. If a triangle appears elsewhere in a
trend, in Elliott terms, it is something different,
even if classic technicians call it a triangle. In all
likelihood, these triangles are less perfect
triangles in standard TA terms.
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 Corrections – Triangles (con’t)
• Triangles are virtually never in wave-2.

• Running triangle – When wave-b of the

triangle moves past the starting point of
wave-a.

• Fifth waves after triangles are usually fast

and the reversals are sharp. The size of
wave-5 is then often about the same as
the width of the triangle (similar to the
classic TA projection measure).

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 Terminology
• Frost/Prechter state that stocks are
directionally progressive. That is, that the
general direction of stock prices is higher.

• In other words, stocks are upwardly

directional, due to man’s general progress.

• Waves denoted by numbers are called

cardinal waves. Waves denoted by letters
are called consonant or sub-cardinal. We
can always says we are in a cardinal wave
of whatever is the current largest degree.

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 Irregular Tops
• Frost/Prechter disagree with Elliott’s irregular top idea.

• Elliott stated that major cycle highs were often irregular.

This would result in a tiny wave-a and an enormous wave-
c.

• The authors state this is because Elliott favored extended

fifth waves, leaving an extra leg at the end of the cycle.
Frost and Prechter prefer using an extended third wave,
which often removes this requirement.

• They note that the Elliott counting often had a strange

second wave which combined an expanded flat with a short
c-wave. (See figure 1-50 in Frost/Prechter).

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 Alternation
• This is not a rule, but it is a strong tendency.

• It states that wave-2 and wave-4 do not usually develop in

a similar fashion. The definition is vague, but examples
may include:
• Flat versus zig-zag
• Expanded versus regular flat
• Combination versus triangle
• Fast versus slow
• Deep versus shallow retracement

• In other words, alternation may be in any dimension: size,

time or form.

• Alternation also exists in corrections

• If wave-a is a flat, expect a zig-zag for wave-b
• If wave-a is simple, wave-b may be complex and wave-c even
more complex. 24
 Depth of Correction
• Fourth waves usually end near the terminus of
the fourth wave of the prior wave of one lesser
degree, especially if the current corrective wave
is a fourth wave itself.

• For example, wave-4 will typically terminate near

the end of the fourth wave of the just completed
wave-3.

• When wave-5 extends, the next correction will

often end near the end of the second wave of
wave-5, though it could end as far as the end of
the prior fourth wave.

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 Symmetry
• In an impulse move, the two non-extended waves tend to
be about equal in size.

• The best measurement tool for equality, for all but very
minor cycles (ie, above minor) is percentage, not price
points.

• If equality does not happen, a Fibonacci ration between the

two (say wave-5 = 61.8% of wave-1) often occurs.

• The extended wave will tend to be at least 1.618 times the

size of the non-extended waves.

• Note: The book talks about how you cannot use intraday
highs and lows in the Dow. This is no longer true, although
it was correct at the time the book was first published.

26
 Channels
• A whole impulse cycle often develops in a channel.

• Alternately, you may be able to draw a channel by

connecting the lows of waves 2&4 and projecting from the
extreme of wave-3 to provide you with a fifth wave target
area.

• If a fifth wave approaches its resistance line on lower

volume, it may fail to reach that resistance line.

• A move above the resistance line in wave-5, known as a

throw over, is often preceded by a throw under for wave-4.
A throw under is when wave-4 briefly falls below channel
support.

• If volume in a fifth of less than Primary degree is seen, you

are probably in a fifth wave extension.

• Volume tends to be higher if fifths of Primary degree and

higher (capitulation or blow-off in classic TA terms of major27
cycles).
 Wave Characteristics
 Wave-1 (I am writing this from the perspective of
a bullish first wave. It can also be bearish, just
reverse bull for bear and bear for bull in all
sentences)
• Start of bull move
• Almost everybody still bearish
• Rally seen as selling opportunity
• Volume may not be very high, but usually there is a
small increase in volume and improved market breadth.
• About half of first waves have very deep retracements.
• Fundamental news probably still bad
• In futures, open interest might fall
• In stocks, A/D line may have already been improving
before bottom.

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 Wave Characteristics
 Wave-2
 Correction of first leg of bull move
 Fundamentals still mostly negative

 Drop seen as resumption of bear trend

 Bears tell bulls, “I told you so!”

 But, volume weaker on drop

 In futures, open interest falls

 Most sentiment surveys still bearish

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A Diversion: Behavioral Finance
 Studies how human emotion and
crowd psychology can cause
inefficiencies in the markets

 Can be used to support both

fundamental and technical analysis
as being able to offer positive alpha

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 Behavioral Finance
 Some academics in behavioral
finance have embraced technical
analysis as a tool in their cadre.

 Two examples are be Blake LeBaron

(Brandeis) and Andrew Lo (MIT)

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 Back to Elliott – Wave-3
Characteristics
 Elliotticians dream of third waves (they don’t
have much of a life, do they?)
 Usually most powerful and largest price move
 The public jumps on board during this move
 High volume, momentum confirms
 Typically at least 1.618 times as large as wave-1
 Fundamentals (finally) confirm the positive price
action
 Breakouts, continuation gaps are common.
 Excellent market breadth with Dow Theory
confirmation for higher degree stock market bull
cycles.

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Wave-3 and Behavioral Finance
 Sentiment should be at highest level
during this move
 Forecasts should show revisions to extend
earlier expectations
 Recognition that this is a bull market is
likely
 While should be easy to get in, some will
want to wait for a pull back to get a
bargain, and they will miss the boat

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 Wave-4 Characteristics
 Often the most difficult wave to trade

 Trend is still up

 Extended range trading possible, and irregulars very

common

 Seen as buying opportunity.

 Forms first support in head and shoulders neckline

 Preferably, trend line drawn from start of wave-1 through

bottom of wave-2 is not breached

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 Wave-5 Characteristics
 Everybody is bullish; it is a true bull
love fest
 Bears are regularly ridiculed in the
financial media
 The news is all good
 Prices make new highs

BUT....
35
 Wave-5 Characteristics
 Volume probably lower than at end of third wave, except in
Primary degree and higher where there can be a blow-off
type situation. Also, volume is high in a fifth wave
extension.

 Open interest (in futures) might not confirm gains

 Usually see momentum divergences

 COT reports may show growing short positions held by

hedgers

 Optimism is extreme. The bull market will never end!

36
 Wave-5 Behavioral Clues
 Forecast targets extended to allow for new
paradigms

 Your friendly neighborhood plumber is talking

about the investment

 Cover stories in mass media magazines such as

Time and Newsweek

 Nobody will talk to all of the famous bearish

gurus, except to ridicule them. Remember how
technical analysts were treated in early 2000 by
the mainstream financial media?
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 Wave-A Characteristics
 At the start of the bear market,
people still think they should be
buying dips.
 Sentiment is still bullish.
 If Wave-A is five waves, it means
that the bear market will be a zig-
zag

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 Wave-B Characteristics
 A wolf in sheep’s clothing.
 Market participants still following the bullish
mantra and see the just completed wave-A as
corrective.
 Everything is going to be okay.
 But, volume probably not very strong (except in
Primary Degree and higher) and market breadth
is poor even if sentiment is still strong and
fundamentals, which tend to be trailing, still look
constructive.
 Wave-B is the right shoulder of the classic head
and shoulders reversal pattern.
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 Wave-C Characteristics
 Cousins of third waves.
 Usually impulsive, but can be diagonal
triangles.
 High volume as end of wave is reached (at
the end of a bear, this would be termed a
capitulation)
 Everybody finally buys into the bear
market.
 However, as the end approaches, there
might even be some technical lights at the
end of the tunnel (which are not an
oncoming train).
40
 Waves D&E (Triangles)
 Wave-D might see higher volume in non-
expanding triangles.
 This may be due to the fact that they
follow c-waves and can be initially
believed to be the start of the next cycle
and the end of the correction.
 E-waves look like the resumption of the
bear market and news can be very
negative. They often break below triangle
support. But, they are a fake-out as the
market is then ripe for a return to the
prior up trend.
41
 Da Rules!
 It is not worth going through all of the guidelines
and rules noted in the 2005 edition on pages 86-
91, but you should be familiar with most of them.
 Note that most of these guidelines have been
discussed in prior slides.
 Here are a few of the less obvious but more
important rules and guidelines:
• Usually, only one motive wave extends, but two might in
Cycle or Supercycle degree.
• When wave-5 extends, it is typically in a Fibonacci
proportion to the distance traveled by waves 1-3
• Wave-4 usually ends in the area of the fourth of wave-3
• Wave-4 often subdivides the entire impulse in a
Fibonacci price or time proportion

42
 Da Rules! (con’t)
 An ending diagonal always appears as wave-5 of
an impulse or wave-c of a zig-zag or flat.
 A leading diagonal always appears as wave-1 of
an impulse or wave-A of a zig-zag or flat.
 All waves of an ending diagonal and waves 2&4
of a leading diagonal always divide into a zig-zag.
 Wave-4 of a diagonal always overlaps wave-1.
 Diagonals look like classic TA wedges.
 Wave-3 is still never the shortest wave and in an
expanding diagonal wave-5 always ends beyond
the terminus of wave-3.
 Waves 2&4 usually retrace 66% to 81% of the
prior wave.
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 Da Rules! (con’t)
 In an impulse, a diagonal is unlikely unless wave-3 is
extended.
 In a zig-zag, wave-B never retraces more than 100% of
wave-A
 If wave-B is a running triangle, it will typically retrace 10-
40% of wave-A
 Wave-B usually retraces 38-79% of wave-A if it isn’t a
running triangle.
 If wave-B is a zig-zag, it typically retraces 50-70% of wave-
A.
 Wave-A is never a triangle in a flat (or a zig-zag).
 Wave-B always retraces at least 90% of wave-A and usually
retraces 100-138% of wave-A in a flat.
 In a flat, wave-C is typically 100-162% of wave-A.
 Wave-C usually ends beyond the end of wave-A in a flat.

44
 Da Rules! (con’t)
 An expanded flat is when wave-B is more than 105% of
wave-A and wave-C ends beyond the end of wave-A.
 If wave-B is more than 100% of wave-A, but wave-C does
not move past the end of wave-A, then the flat is called a
running flat.
 In a contracting triangle, at least four of the waves must
divide into a zig-zag or a zig-zag combination.
 Except for wave-E, a wave in a contracting triangle never
retraces more than 100% of the prior wave.
 A triangle never has more than one complex wave and if it
does, it is either a zig-zag combination or a triangle itself.
 About 60% of the time, wave-B does not end beyond the
end of wave-A. This is a running triangle.
 Wave-5 following a triangle is typically either brief or an
exceptionally long extension.

45
 Da Rules! (con’t)
 In an expanding triangle, waves c,d and e retrace at least
100%, but not more than 150% of the prior subwave. They
usually retrace 105-125% of the previous subwave.
 Combinations are formed by two or three corrective
patterns separated by corrective pattern(s) in the opposite
direction.
 A double three flat is either a zig-zag&flat, a flat&zig-zag,
two flats, a zig-zag and triangle or a flat&triangle.
 A triple three flat comprises three flats.
 Double and triple zig-zags take the place of zig-zags while
double and triple threes stand in for flats or triangles.
 An expanding triangle has never been seen as part of a
combination.

46
 Determining Your Count
 You should consider all factors discussed to this point in
developing a wave count.
 More than one count may be possible. Frost&Prechter
recommend always having an alternate count. Alternates
must also abide by these rules and guidelines.
 Never forget that wave form is more important than
volume, exact timing, price target calculations of non-Elliott
indicators, be they technical or fundamental in developing
your count.
 In the next section, we will cover in greater detail Fibonacci
ratios to help you more closely compute potential time and
price targets. However, these calculations remain less
important than wave form.
 Despite these admonitions, if several methods provide you
with a good price target (such as equality between wave-1
and wave-5, a trend line, a day count, plus volume and
indicators), the probability of your being correct is better.
47
 Fibonacci - Introduction
 Based on the work of the mathematician
Leonardo da Pisa (later known as Fibonacci).
 Many waves relate to prior subwaves and degrees
based on comparisons using Fibonacci-based
ratios.
 Ratios based on the series of numbers where Sn
= Sn-1 + Sn-2
• Example: 1,1,2,3,5,8,13,21,34
• Example: 6,11,17,28,45,73,118
 The ratio of number n in the series, to number n-
1, quickly approaches 1.618.
 The inverse of this is 0.618 and is known by the
Greek letter phi (Φ).

48
 Fibonacci - Introduction
 There is a whole lot of numerology involved with Φ, which
is not all that relevant to Elliott.
 What is relevant are the main ratios and retracements that
Elliotticians use:
• 0.382 (Sn/Sn-2) 1.618
• 0.618 2.618 = 1.618*1.618
• 0.236 (Sn/Sn-3) 4.236 = 1.6183
• 0.764 (1-0.236) or 0.786 (Φ0.5)
 The Golden Mean (or Golden Ratio) is 0.618 or 1.618
according to Frost/Prechter.
 The Golden Section: The point on a line where the ratio
between the smaller part of the line and the larger part of
the line equals the ratio between the larger part of the line
and the whole line. This is at the 0.618 point.
 The book covers the Golden Rectangle and Golden Spiral.

49
 Using Fibonacci
 Some basic tendencies were discussed in “Da
Rules” earlier.
 You can use Fibonacci ratios for determining
possible targets for retracements and for current
and later wave termini.
 You can also use Fibonacci numbers and ratios to
help you time when waves might end.
 On their own, a dependence on Fib numbers can
be dangerous, but when combined with the
principals of channeling as well as by using
volume and momentum, plus an understanding
of Crowd Behavior, you can learn to apply Elliott
Wave in a profitable and easy-to-understand
manner.
50
 Using Fibonacci (con’t)
 When wave-3 extends, wave-1 and wave-5 end
to be equal in size.
 When wave-5 extends, it tends to travel about
1.618 times the distance traveled by waves 1-3
 When wave-1 extends, it will often travel 1.618
times the distance of waves 3-5.
 Wave-4 often divides a whole move into the
Golden mean (ie, wave-5 is 38.2% or 61.8% of
the distance from the start of wave-1 to the
bottom of wave-4).
 In a contracting triangle each alternate wave
tends to be 0.618 times the preceding alternate
wave (ie, wave-e = 0.618 times wave-a)

51
 Using Fibonacci (con’t)
 You can also use Fibonacci numbers to look for
timing targets.
 Waves will often take Fib ratios in terms of time
as well. For example, if wave-1 takes eight days,
wave-2 might take five, and wave-3 13.
 I have often found that daily cycles tend take
Fibonacci numbers of days.
 My work has also shown that trading days works
better than calendar days. However, neither this
or the previous point is noted in Prechter/Frost.
 Frost/Prechter notes the Benner-Fibonacci cycle.
Although I doubt it will be on the exam, this 20-
18-16 year cycle has done a very good job of
forecasting panics and blow-offs.
52
 Using Fibonacci
 When wave-3 extends, wave-1 and wave-5 end
to be equal in size.
 When wave-5 extends, it tends to travel about
1.618 times the distance traveled by waves 1-3
 When wave-1 extends, it will often travel 1.618
times the distance of waves 3-5.
 Wave-4 often divides a whole move into the
Golden mean (ie, wave-5 is 38.2% or 61.8% of
the distance from the start of wave-1 to the
bottom of wave-4).
 In a contracting triangle each alternate wave
tends to be 0.618 times the preceding alternate
wave (ie, wave-e = 0.618 times wave-a)

53
 Some Final Thoughts
 Frost and Prechter note that wave theory is applicable to
business activity. Prechter has extended this to the new
science of Socioconomics. Socioconomics is not mentioned
in the book, and is not likely to be tested on, but the Elliott
Wave Principle is its basis.
 Note that this ties us back into the idea of Behavior
Finance. It is not the news that counts, but how the market
(or stock, or commodity) reacts to the news. In terms of
Elliott, it is how that reaction is represented in wave forms.
 Dow Theory has some minor overlaps with Elliott. They
both recognize the behavioral and psychological differences
between bull and bear cycles.
 Dow Theory divergences (Industrials at new high,
Transports not) couples well with momentum divergences
often noted at the top of fifth waves.
 Dow bull and bear markets are not directly tied to any
specific degree and Elliott does not have a true bull or bear.
54
Charts to Discuss

55
Charts to Discuss

56
Charts to Discuss

57
 Further Readings and Sources
 Robert Prechter Jr.’s site:
http://www.elliottwave.com
 R.N. Elliott’s Masterworks (edited by Robert
Prechter Jr.)
 Applying Elliott Wave Theory Profitably (by
Steven W. Poser) – Note that my book does not
exactly follow Frost/Prechter. It should be useful
when you get beyond the exam and wish to start
applying Elliott Wave in the real world.
 Pioneering Studies in Socioconomics&The Wave
Principle of Human Social Behavior (by Robert
Prechter Jr.)

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