ASX Charting Course

Chapter 38

The Elliot Wave Principle

Associated Rules and Guidelines

Wave Personality

The psychology of the market is largely reflected in the individual wave formations. Irrespective of the time frame the characteristics of the each individual wave remain fairly constant and therefore allow us to identify unique characteristics to each wave.

First Waves

Wave one has to occur following a decline naturally and therefore the first wave of a five wave advance is often part of a basing process. It is generally heavily corrected by the second wave. If they aren’t part of the basing process they are the result of it. They can come as the result of a large base or extreme compression and both circumstances would signal potentially explosive first waves.

Second Waves

Wave two often retraces nearly all of wave one, which can be incredibly psychologically damaging if you’ve identified the end of a bear market and the start of a new bull market. Wave two often feels like it’s the resumption of the bear market trend with one major difference, volume and volatility which indicate selling pressure drying up. Wave two is more than likely going to be a simple correction, a flat or a zigzag correction.

Third Waves

Elliot said “Third waves are wonders to behold.” They tend to be stronger than wave one and more often than not longer by a factor of at least 0.618. They display trending qualities and generate a lot of volume in the process. One will often see five minor waves within the third wave and the third of the third wave will often be the strongest section. If the wave structure is going to throwover the trend channel or gap higher or break out above previous resistance it will most likely do it in the third wave. It is possibly the most tell tale wave of all after the B wave.

Fourth Waves

Thanks to the rule of alternation we can generally predict that wave four will differ in complexity to wave two. Given that wave two is most often simple in its structure. Wave four is probably more often than not, going to be complex. The degree of complexity will provide a clue to the strength and length of wave five. After all wave four is just a base for the next and final fifth wave advance.

Fifth Waves

Surprisingly enough fifth waves can be quite disappointing, pathetically lacking dynamics. Unless there’s an extension of some sort going on making for a blow off spike top, fifth waves are almost always less impressive than the previous third wave. There are some circumstances that the fifth wave even fails to take out the top of the third. Nevertheless it is probably when the market exhibits its highest optimism, whether that be a measure of bulls and bears or through the optimistic economic reporting at the time, that the fifth wave is the most disappointing.

Wave “A”

This is the first leg of a correction, but the investment world is nearly always fooled into thinking that it’s probably just a minor dip, an opportunity to load up prior to the next advancing leg. The A wave sets the tone for the B wave leg which will inevitably follow. A flat A will be followed by a zigzag B and a zigzag A will probably be followed by a flat B.

Wave “B”

When you hear an analyst utter the words “Something’s wrong with this market” you can bet it’s a B wave. B waves are phones, sucker plays. In a bull market they are bull traps. They’re emotionally based, generally technically weak and doomed to the catastrophe of the impending wave C.

Wave “C”

C waves are persistent and broad, they can be devastatingly destructive. They are third waves and exhibit most of the characteristics of a third wave. They go further than anticipated and seem to be relentless, stopping out traders rather than letting them out with corrective ticks. C waves unfold in 5 waves and can be fairly dynamic therefore they often create a dilemma in the count. Is it an A-B-C or a 1-2-3?

Learning the Basics

“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.” Said Sherlock Holmes to Dr Watson and thus deductive reasoning was brought to the masses. This sums up the best approach to Elliot, knowing what Elliot theory won’t allow, reveals the most likely remaining course for the market to take.

There is no perfect predicatory system for any market however Elliot wave theory certainly provides some insight into the machinations of the market. It one of the best indicators for market turns in the technical analysts’ arsenal.