RN Elliott  
 

Mastering Elliott Wave Principle

Elementary Concepts, Wave Patterns, and Practice Exercises

Constance Brown, CMT

elliot wave patterns

Chapter 2 offers you a basic start with the Elliott Wave Principle. The quizzes have been removed and the last section of the chapter on Termination and Leading Diagonal Triangles. If you would like to learn more please visit Amazon or your local book store. Hint: The hardcopy is recommended by other readers.

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Copyright © 2012 by Constance Brown. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Brown, Constance M.
Mastering elliott wave principle : elementary concepts, wave patterns, and practice exercises / Constance Brown.




Chapter 2: The Elliott Patterns That Describe Trending Market Movement

Now we begin to discuss the individual puzzle pieces that create
the 14 Elliott Wave Principle patterns.

 

Every market move can be described using just these puzzle pieces. You will be given a cheat sheet with all the patterns in Chapter 4 to use as flash cards at your computer or to help with the study quizzes in this book. People struggle with stick drawing representations of patterns. They seem to understand until they are given a bar chart. Then it all looks different to them and a blank stare appears on their face. I have seen this occur so often that I plan to try a different approach. Do not get hung up with memorization of the components like 5-3-5. That will come later. What I want you to learn is the feel of a specific pattern. That way you will recognize it more easily in different chart scenarios and when market character changes. If we look at patterns in many different ways, it is my goal to help you gain a better foundation so we can build upon these correct basics in the higher levels.

It is of paramount importance you truly understand that price swings and Elliott Waves are not the same thing. Everyone begins with counting price swings since these are the easiest to understand, but the final result is disastrous. Why? You learn to ignore the internal components of a price swing and overlook the rules.

elliott wave 5 wave pattern

Impulse Waves Create Market Trends Figure 2.1

A Five-Wave Pattern Source: Aerodynamic Investments Inc., TradeStation.

Impulse waves are strong trending price moves. Figure 2.1 is a weekly chart of a stock displaying a strong bullish trend. I have drawn three boxes. The boxes help to focus this discussion in several ways. The first wave up in the larger rally develops throughout the first box. We label waves when they are finished at the end of the wave. Not in the middle. Not somewhere near the side of the wave, but by being as precise as possible we label a wave just above the price high or under the price low that completes the wave. It is not always possible, but close enough will never do at any time with this analytic methodology. There is a lot to learn. Be patient with yourself. It takes time and practice. One of the problems for people is when they have to switch between different chart styles. Patterns easily identified in line charts do not transfer with the same confidence as working with bar charts. Therefore this chapter has lots of examples to get you on the right track.

Figure 2.1 shows the data at the top right corner of box 1 ends wave 1 up. Notice the shape of this box. It is close to square in shape. The internals within box 1 can be subdivided into a smaller unit of five waves. In fact, box 1 must subdivide in such a manner to create an impulse wave that will build the larger trend. As this is your first chart, we'll stay focused for the moment on the larger trend through the chart.

After box 1 is complete there is a correction that interrupts the forward and upward movement of the trend. The counter-trend move is not inside a box.

We then see the start of the next leg up from where the correction ends. The top of the box is marked wave 3. The box is a rectangle that is narrow and tall. Wave 3 wasted little time to travel a distance greater than was gained within box 1. The height and width of the boxes make for an easy comparison between waves 1 and 3.

The internal building blocks within box 3 can also be subdivided into a subset of five smaller waves. Again, it is worth stating it must breakdown into five-waves in order for the box to be a complete unit that can be identified as wave 3.

From the top of wave 3 we see an immediate corrective decline. The bottom of the correction is marked wave 4. A third impulse wave then begins creating the last box containing wave 5. Once again, the internals in box 5 must subdivide into its own complete unit of five waves. The last box containing subdivisions of five waves is the toughest for a beginner. Wait until we have discussed a few more illustrations.

What you need to know from this chart is that the larger picture of a strong bullish trend is created from five waves. Waves 1, 3, and 5, or in this figure boxes 1, 3, and 5, are all examples of impulse waves. They build from each other and contribute to the larger trend. When interruptions occur to the trending market, there are two intervals of corrective waves. They move in the opposite direction of the larger trend. They also have a few rules to follow to allow them to stay within the same family of trending waves. Notice the bottom of the fourth wave. It starts the rally that defines wave 5 up. The end of the fourth wave is not allowed to decline so far down that it enters the range of the first box. When there is an overlap we immediately know something important about the trend that is forming. That will be discussed later in Figures 2.5 and 2.6.

elliott wave previous fourth

Figure 2.2 Targets in the Previous Fourth Wave

Source: Aerodynamic Investments Inc., TradeStation.

It is impossible to discuss impulse waves alone without some mention of the structures that connect them. When one impulse wave ends, where does the correction go to that follows? Is there any consistency to where the counter-trend move will target? Yes, there is a general guideline you can consider because it happens so often.

There are now two gray boxes in Figure 2.2. This is the same chart data I used to highlight impulse waves 1, 3, and 5. Now waves 2 and 4 are in small gray boxes. The labels for waves 2 and 4 are at the bottom of their boxes because we mark their endings only.

The price high marked the end of the completed picture of a five-wave rally. Notice the decline that followed. The very last swing down falls into a box that overlaps the y-axis on the right side. Look to the left and compare the shaded box that became wave 4 down to the clear box on the price axis on the right. The decline from the market high to the low has entered the far right box drawn to simulate the location of wave 4 on the left. When you complete five waves the correction often targets the vicinity of the previous fourth wave (of one lesser degree). It just identifies a target range. Look to the left of wave 4. There is a clear box within the developing move to its left that became wave 3 up. The clear box is the smaller fourth wave within the developing five-wave unit that defined the building blocks within wave 3.

A similar reaction develops for the correction that becomes wave 2. The gray box that contains wave 2 falls into the range boxed in within the first rally. The clear box contains a small fourth wave that helped to develop the unit we called wave 1. Wave 2 found support and bottomed in the general range of a previous fourth wave. Are there more accurate ways to identify the target? Yes. I favor Fibonacci analysis as one method. The steps I follow create target zones where multiple Fibonacci ratios cluster together. But I know the most likely target zone will fall within the range of a previous fourth wave when the larger trend is incomplete. Therefore understanding that markets track to the range of a previous fourth wave is added guidance for any price projection method you favor.

Elliott Wave internal wave patterns

Figure 2.3 Subdividing Internal Wave Structure

Source: Aerodynamic Investments Inc., Trading Seminar

The last discussion put great weight on the internal composition of impulse waves. They must subdivide into their own five-wave patterns. In Figure 2.3 you will begin to see how smaller internal structures form. The chart is weekly data of a real market that will remain unidentified. It does not matter if the chart was a bar chart with semi-annual data or 60-minute data. However, the difference is how many more opportunities you have to examine the internals with greater detail. To drop down in time horizon is like rotating a new eyepiece and lens of higher magnification on a microscope. People who see someone change time horizons may not understand that you are not looking for something different to support your opinion that is subjective. When the waves are magnified and studied in a shorter time interval it offers a way to examine the patterns to ensure they meet a very stringent series of tests. Should an internal pattern fail any one of the tests; the box method I used to show a completed five-wave structure could not be drawn.

Figure 2.3 shows the first box contains the wave 1. Then follows the correction called wave 2. Wave 3 is a complete five-wave pattern that just happened to form exceptionally clear and distinctive subdivisions. Within the box containing wave 3 are three additional gray boxes. Each gray box can itself be subdivided into a complete five-wave pattern that could stand alone as an ideal example. The middle gray box ends a third wave because there is a gray box on either side of it. But I could have taken the middle gray box and subdivided it further for you. The middle gray box has a clear pattern of five waves within it as well. There is no question impulse waves have repeating fractal properties.

How to Label a Specific Price Pivot

The substructure within a larger pattern, like the gray boxes drawn within wave 3 of Figure 2.3, is the internal building blocks of the bigger picture. If the big picture has reserved the numbers 1, 2, 3, 4, and 5 to map the developing five-wave pattern, how do you name the other pivots without repeating the same numbers? As an example, the first box in Figure 2.3 was identified as wave 1 when it was completed. I cannot use 1 again without causing confusion. To keep all these building blocks identified correctly each subset will need a unique name.

We do not repeat the numbers 1, 2, 3, 4, and 5 again. We use lower case roman numerals: i, ii, iii, iv, and v. But if I just referenced wave iii when describing Figure 2.3, you would not know whether I was looking at a wave iii within the first box, or wave iii in the second box that shows the completion of wave 3. So we write these smaller puzzle pieces in a way that you know what building block is forming and the unit it is contributing to within the bigger picture. It is like using a line to identify the street, city, state, and country within a postal address.

QUIZ: (Quizzes removed. Please see the published book.)

You are learning several things by using boxes. The boxes force you to examine the internal structure of the box. You are also learning more about balance and proportion. If you are drawing boxes in one chart, it is unlikely you will suddenly change to drawing massive or tiny boxes. We will look at a complete table traditionally used to label various degrees within a market. You only have three now, but that is sufficient until we arrive at Chapter 3. I think it is more important to continue our discussion about impulse waves.

Using Fewer Bars to Represent Complete Impulse Waves

You are learning several things by using boxes. The boxes force you to examine the internal structure and you have learned that every five-wave move can further subdivide waves 1, 3, and 5 into five smaller waves. When you look at waves in different time horizons they can display more or fewer bars because time expands and contracts. I have discovered most new to the EWP will get his question wrong.

How many bars does it take to illustrate a five-wave move?

Elliott Impulsive Trend

Figure 2.4 Five-Wave Structures

Source: Aerodynamic Investments Inc., Seminars, TradeStation.

 

Figure 2.4 shows a 120-minute bar chart of the S&P 500. Not only are the three impulse waves contained within boxes (clear), but the corrective waves are in boxes as well (gray). You need to study the internals of these three impulse waves in the clear boxes. They all have five-wave internals. The first box is the easiest. The middle box for wave 3 will be difficult if you do not realize the bars above the gray dot create a small five-wave pattern to end wave 3. In other words, the fifth wave subdivided into its own smaller pattern of five-waves. If I went up in time horizon the entire five-wave move might look like the right-hand insert that contains the same gray dot. Some of the bars compress into the new time horizon. It does not change the wave interpretation.

Now we need to be more formal with the Elliott Wave Principle rules.

1. Wave 3 cannot be the shortest. That means if wave 3 and wave 1 are the same length, wave 5 would have to be shorter than both. Wave 3 does not have to be the longest. Somehow people twist this rule. Just don't make wave 3 the shortest in comparison to waves 1 and 5.

2. Wave 4 cannot retrace into the range of wave 1. There is going to be an exception to this rule later, but it is a pattern we have not discussed yet.

3. The Wave Principle has a guideline demonstrated in Figure 2.4. Guidelines are observations that are often repeatable. They do not create hard and fast rules, however. When you look at the corrective waves in box 2 and 4, one is about half the size of the other. This is the guideline of alternation. If the wave in the second position takes a long time to develop, the fourth wave will likely form in less time. If the second wave is complex in appearance, the fourth wave might just be very simple. The opposite applies when the second wave is simple and/or takes little time to develop. These alternating characteristics between corrective waves can be exceedingly helpful. Neither of the insets in the right margin of Figure 2.4 illustrates the guideline of alternation.

Returning to Figure 2.4, look at the more detailed chart with five boxes. All rules remain valid. Now look at the upper insert on the right margin with a gray dot. Using only five bars I can easily represent a fully qualified five-wave swing. The gray dot ends wave 4 and it does not enter the range travelled by wave 1. The fifth wave in this bar chart is just a straight single line that moves up from the gray dot. We know our rules so well that impulse waves must subdivide into five waves that we no longer have to be shown all the subdivisions. We know they are impulse waves with five-wave internals because the fourth wave does not fall into the range travelled by the first wave and the third is not the shortest. So with five bars I know there is a five-wave structure present.

Now look at the bottom insert in the margin of Figure 2.4. If I took the bar chart in the upper insert and changed it from a weekly chart to a two-week chart, the lower insert is how the data would appear. With just three simple bars I can obtain a five-wave swing. The third wave is not the shortest. There are three impulsive waves. There are two corrective waves. Really, you may ask? Yes. The third bar retraces a portion of the first bar. Therefore, I know a second wave is present. The same can be said for the fourth wave being present because the third bar retraced a portion of the middle bar. I also know the fourth wave did not retrace the third to such an extent the range of the first bar was challenged. The middle bar is not the shortest. These three bars exhibit all the rules necessary to identify it as a complete five-wave structure.

Knowing that these three figures in Figure 2.4 all represent complete and legitimate five-wave patterns is critical in developing your skills to interpret wave patterns in any time horizon.

We have only discussed simple and extending five-wave patterns up to this point. Now we need to move forward to see how to determine if an extending five-wave pattern is complete or not. Extending impulse waves are much harder to work with than many think. It can be made much easier when you know where to start your wave interpretation.

Working with Impulse Waves in Strong Trends

Elliott Principle Extending Wave Patterns

Figure 2.5 Extending Five-Wave Patterns

Source: Aerodynamic Investments Inc., Seminars, TradeStation.

Figure 2.5 is a market decline in the S&P 500. Many people have the misunderstanding that extending five-wave patterns are much easier to label than corrective waves. This is rarely the case. These moves that just keep going and going can be very tricky. Experience has shown there are a few unorthodox ways to handle these strong trends.

The first thing to do with them is to start your wave interpretation in the middle of the strongest segment. I can picture many expressions right now as I see the shock often. Our objective is to stay in sync and develop a sense of where we are within a bigger developing picture. Our livelihood depends on being right more often than wrong on the far right hand side of the chart. If we make errors in the top left of the chart it is not as serious. Begin looking at a chart to find the wave that is the strongest within the move. In Figure 2.5 wave iii of 3 is the strongest. I am referencing the entire length of the decline from the end of wave ii up to the end of wave iii down. My first label was to put iii on the pivot low of this move. We know impulse waves must contain five waves. Wave iii completes five-wave into the pivot marked wave ii. Wave ii is a correction. Next, find its counterpart correction. The bounce off of wave iii is very clean and direct with an ending we know is wave iv up.

It is very important to make this next consideration.

How do waves ii and waves iv compare in size? Consider both distance travelled and time.

1. They both retrace to previous fourth waves of one lesser degree.

2. Wave ii takes about half the time that was needed to complete wave iv.

3. Wave ii travels about a third of the way up that wave iv travelled. But the distances travelled by waves ii and iv are proportionally about the same relative to the trending segment they are correcting. Another way to say this is to study the length of point 2 to point i. Then consider the length of point ii to point iii. Now look at points ii and points iv. You study the space under both points to the reversals at point i and point iii.

4. Consider where waves ii and iv divide waves i and wave iii. The top right insert in Figure 2.5 will help you.

5. Then consciously consider the space over the point ii into 2. Also the space above point iv into point ii. You simply consider the vertical height and do not give any consideration to the slope of the decline. Now you should be able to sense they are somewhat similar.

All of the patterns and substructures of the Elliott Wave Principle require these ratio comparisons between internal units. If you didn't know geometry beforehand, you are learning it now. The areas of space above and below the midlines are not far off when considering one to the other. It doesn't have to be exact.

In my experience, engineers by training have the greatest trouble with this. As odd as it may sound, if you are having a hard time with this comparison it is time to take remedial action! Sign up for an art class. Not just any class. Start with still life. As you draw a Venetian or Greek vase you suddenly have to take notice of what is called positive and negative space. The positive space is the silhouette form of the vase itself. The negative space is the void of space behind the object. Our bars of data are the positive space. The blank space inside a box behind the data is the negative space. Learn to use it.

We will not look at the shapes and proportional guidelines between corrective waves until the next chapter. But we could not escape a brief introduction to complete Figure 2.5.

From the price high marked wave iv there is a five-wave decline. So immediately label the price low as wave v. I know we don't have wave i identified. It is going to be harder and does not change the message of the price low marked wave v.

QUIZ: (quiz removed, please see the published book)

Before we move away from Figure 2.5, there is a small insert on the bottom left. The bullets mark the top and bottom of a third wave within the wave (1) from the top of the screen so you can see the subdivision more clearly. The higher boxes drawn for waves (2) and wave 2 enclose the exact same pattern. Remember the N. They are back. These patterns are flats and the lower overlaps the higher one. The lower one is smaller than the first one. When you see a market creating mirror duplicates and getting smaller, the market is coiling for one heck of a big move.

Because we started in the middle with the strongest segment, we know how many waves are missing in the larger picture. But what if we bounce into the range of wave iv and the market has a complete meltdown that is even longer than wave 3? You likely have a new midline for the move. Just go with it. You were not wrong, as the work and wave interpretations you made kept you on the right side of the market. That is the whole point. We are trading market moves and not being paid for gorgeous charts and beautiful labels.

The method of using boxes is valuable because it makes it very clear how a market is developing internal building blocks. I'd like to spend more time on this in Figure 2.6.

Kuwait Stock Exchange

Figure 2.6 Extending Five-Wave Pattern Weekly Kuwait Stock Market

Source: Aerodynamic Investments Inc., � 2011 Bloomberg L.P. All Rights Reserved.

Figure 2.6 is the weekly Kuwait Stock Market. This is the first time you have worked with a line on close chart style. Wave structure is no different using a line than what you have seen in the prior charts. In fact, it sometimes makes it easier to see the pattern developing.

Where do we start? At the middle, and we need to select the strongest leg up within the rally. The strongest wave is located and a horizontal line is drawn in the approximate middle. The mid-line is market with an M to the right. Either side of the line you will find two black boxes. They mark the start and end of that wave. We know the top of the box will be iii. The bottom of the box always ends wave ii. We know the middle and the faint turns within the range clearly define a five-wave structure. The second and fourth waves are nothing more than a slight pause, but that is all that is needed.

Two gray boxes are drawn, one below the black boxes and one above the higher black box. The lower area is extended to the left so you can see it tracks from the low of wave 2 to the end of wave i. Wave iii has an enclosed box. The correction marking wave iv down falls back inside the middle box. The swing that follows defines the higher gray box. Could the two gray boxes and black create a complete five-wave unit? Yes. But do not put wave v of 3 at the top of the higher gray box just yet. Under the first gray box there are two clear boxes showing first wave swings that must be offset with fifth waves into the top to end the move. But when we look at the high there is only one clear box into the high. It means a decline and final rally is ahead. It will end the rally from the bottom marked wave (2) and therefore end wave 3 up. A larger correction would then begin, but it will only define wave 4 down. All the boxes in Figure 2.6 show the building blocks for just wave (3).

If you take a measured move from the midline to the bottom of the lower box, that measured move added to the midline will end at the top of the higher gray box. The market is moving in a mirror image above the midline as below. This market displays a strong trend, but at this time it was neither expanding nor contracting. If it had been expanding, the height of the boxes above the midline would be longer than those below the line. If the market was developing waves over the midline that were contracting, the height of these boxes would not be as high as those under the midline. Contracting box heights warn a market is weakening. Elongating boxes over the midline show the market is becoming parabolic. The use of boxes will force you to be aware of balance, symmetry, and proportion-all good things to keep us on the right side of the market.

extending wave pattern

Figure 2.7 Extending Five-Wave Patterns

Source: Aerodynamic Investments Inc., Seminars, TradeStation.

You have one last chance to understand extending five-wave patterns before I toss you out of the nest to take a test, so study Figure 2.7 very closely.

Figure 2.7 gives you waves (1), (2), (3), and (4). The common error made by many people is to jump down to the bottom of the swing and write (5) under the lowest price pivot. Wrong. How many waves must there be in wave (5)? It must define 5 swings where the fourth wave does not retrace into the first wave and wave three doesn't become the shortest. There is only one swing that meets all these rules. Wave (5) ends at the third pivot low from the bottom of the chart. To the right is the same data. However, I have pulled the bars apart that define the waves. The last pattern into the bottom contains a three-wave swing down to a low marked B. It is a middle leg of a corrective pattern you will study in the next chapter.

In this example wave (5) becomes a pivot many find very confusing. It is referred to as the orthodox low (or high in a bull trend). It is the pivot that completes the five-wave decline. However, the market tries to keep on going. Do not try to stuff those extra swings into your impulse wave. The data that forms below wave A begins to overlap. There is a serious middle leg that overlaps the first swing down from A. The entire move down from A to the low cannot remain true to the rules of a developing five-wave pattern. Something else is going on. It is a leg within a corrective pattern. Oscillators will diverge and the volume will be lower than the volume into the final bar that offered capitulation at the end of wave (5). This chart is the most important chart I can offer you to prove price swings and Elliot Waves are not the same thing.

Let's see if you have it etched in stone before moving on.

QUIZ: (Quiz removed, please see the published book)

Termination Diagonal Triangles: � (text removed, please see the published book. Thank you)

Please refer to Mastering Elliott Wave Principle

Elementary Concepts, Wave Patterns, and Practice Exercises

by Constance Brown