Riding the Elliot Wave

By David Waggoner

(Observer's note: This is again by David Waggoner on Elliot Wave. Later I'll post more about "golden spiral" when I see some good articles on it.)

Eliminate all other factors, and the one which remains must be the truth.
– Sherlock Holmes, The Sign of the Four

I am an Elliottician. I believe there's a deterministic natural rhythm to the markets that's called the Elliott wave principle (Ewp). I believe it to be truth. Unlike many other technical indicators, it works all the time and it's only the analyst's interpretation of it that fails. The pattern is always there and it's always correct. Everything else is periphery; fundamentals, all other forms of technical analysis, even social evolution itself. Everything that's rooted in behavior follows the natural rhythm of the Elliott wave principle. It's a law like gravity and electricity. And like gravity and electricity, we don't have to fully understand it in order to use it.

I call myself TheMarketDetective. I spend each day, every day, tracking and interpreting the truth. I report my sleuthing in my analysis. I will attempt to explain my analysis for those who want to learn my methodologies, but I will also present actionable opportunities based on clues I uncover in the market that anyone can use.

Forecasting the future with the Elliott wave principle is scientific in its approach; there are 13 simple patterns to the Elliott wave principle that connect and combine in a limited number of possibilities. By identifying Ewp patterns in charts, we can use logic and Fibonacci mathematics to deduce which other Ewp patterns most likely will follow suit. Often, there are several alternatives, but sometimes we can fine tune it to only one possible outcome.

There are two types of wave combinations that occur, impulsive and corrective. Impulsive combinations are found in the direction of the larger trend in force, and corrective patterns are primarily in the direction opposite that trend. Therefore, the manner in which the patterns come together can provide important clues regarding the primary direction of trend.

In order to get to the scientific part you must first correctly interpret the wave patterns - not always an easy thing to do. In fact, this part may be more art than science. For me, being right more often than being wrong came only after thousands of hours of practice. Perhaps I can shorten the learning curve for you. If you want to learn more about the Elliott wave principle, the best place to start is the biblical text; Frost and Prechter's: Elliott Wave Principle.

The wave principle spans the whole of social evolution. I'm only going to focus on the part we can trade. In the three charts that follow, I will provide my perspective of current cycle, primary, and intra-day Ewp patterns.

I'll start with the cycle trend. I call this chart, Prechter's revenge. Robert Prechter Jr. believes that 2000 was the top of the Super Cycle: a 5 count impulse wave up that started in 1932. When the market rallied back from the 2002 low and made a new high, most market watchers quickly dismissed his thesis (and with it the Elliott wave principle). More recently he suggested that 2000 was in fact the top and we are in the midst of a corrective flat. In a classic case of crying wolf syndrome, no one believes him. I do.

I have never seen anyone else attempt to provide a detailed wave count to substantiate his flat theory, but I have done so here. I have also added a probable path of decline based on common Fibonacci wave relationships (in price only: not time).

Prechter's Revenge

It's tempting to go all in short and wait it out isn't it? There are other possibilities however, so it's probably best to focus the lens on multiple timeframes in order to maintain a total perspective, and trade the cycle trend one wave at a time.

Change always starts at the smallest degree and ripples out to the larger degrees. Let’s look at the chart below labeled primary trend for more clues.

At the level of primary trend, based on the evidence of Elliott wave rules, guidelines, and Fibonacci ratio analysis, we have probably completed five waves down and three waves up. The question now is have we resumed the down trend, or are we in a downward correction of the counter-trend correction (which is up), which I will call a correction of the correction.

Primary Trend

The wave patterns are often difficult to interpret short-term at this degree, so I will focus the lens one degree lower to see if the evidence is clearer. Elliott wave patterns are believed to be fractals. Different time frames fit together like Russian nesting dolls. By examining the smaller time frames we can gain detailed insight into the probable direction of the larger ones. Conversely, we sometimes rely on the larger ones to see the forest through the trees when the shorter time frames become too complex. It is a constant balance of interpretation.

In the chart labeled 60 minutes, we can see that on April 7th of this year, we completed the counter-trend corrective combination up called a double zigzag. The end of this pattern clearly indicated a turn, but is it the turn?

Again, based on the evidence of Ewp rules, guidelines, and Fibonacci ratio analysis, I interpret the recent downturn to also be more corrective in nature than impulsive. The wave count shown on 60 minutes is another double zigzag with a close to perfect 11 Fibonacci ratio (outside numbers). It is the cleanest interpretation I can identify on intra-day charts.

However, we're at a crucial test point. We can only sustain a very limited continued downside without a significant 3-wave bounce for this to remain the highest probability. A small extension of the last wave down into Monday’s close, say 1320-1322 would be the preference. This happens to coincide nicely with a .500 Fibonacci retracement of the entire counter-trend double zigzag up from the bottom (inside numbers), a common retracement.

60 Minutes

If this thesis is correct, and we bounce, one of two things will happen. We either resume the counter-trend rally up toward our next Fibonacci target (Read about Fibonacci ratio targets here), or get a significant 3-wave bounce, similar in degree to the bounce on April 10th, and then turn back down. If we bounce and turn back down, it will be the last wave of a correction of the correction. The Ewp rule states that corrective waves can only extend to 3 corrective combinations. We've either completed or are a fraction away from completing two of the three allowed in this wave set. Another turn down after a bounce would also most likely end at 1322 or 1307.

It's important to always look for alternatives with Elliott wave analysis. When I have options to choose from, then I'm confident that good detective work will guide me to the correct one. If and when my preferred option fails, however, I usually have an alternate count/thesis to fall back on. Unfortunately, this happens more often than I would like.

There is a technically feasible impulse wave count combination down from the April 7th high on an intra-day basis (see the chart below: Ugly Duckling). It's undesirable in its symmetry and it contains minor rule breaches. It's clearest on a chart of the E-minis. On the other hand, the Fibonacci ratios are acceptable, and the daily time frame is starting to look like it could turn into an impulse swan.

This is our alternate wave count. It increases in probability if we're unable to get the expected bounce before turning down again. If the slide continues without a significant bounce, and we don't bounce until 1307 -- and we will bounce at 1307 if we go there on this trip down -- then I give the ugly duckling a higher probability. The reason is simply that a 1:1.618 Fibonacci ratio is more common for an impulse wave3 than a corrective wave. It can still be a corrective wave, but the odds will have shifted in favor of our possible swan.

If it comes to this, then the bounce from 1307 will be the next critical test. If we can bounce above 1352, then a correction of the correction thesis returns to front and center. If we can’t, then the ugly duckling will remain our primary thesis and we prepare to head lower. The reason is another rule: wave 4 never moves beyond the end of wave 1.

An impulse wave count down from here would also slightly diminish the cycle trend 2nd wave count thesis. If we are in the 2nd wave at cycle degree, a .382 retracement of wave1 is the least common Fibonacci ratio target.

Ugly Duckling

I've covered a lot of material. If you do not have prior exposure to Ewp, and you are still reading this, you might think that there is Kool-aid in my water supply. No doubt about it, this is extreme technical analysis. Predominant thinking cannot even clear the first hurdle of considering that the markets are deterministic, let alone that the pattern can be interpreted by a lone trader with a data feed and a PC rather than the world’s fastest super computers and a room full of quantitative analysts.

All I ask is that you keep an open mind. I'm confident that I will present you with some accurate market calls that cannot be derived from any another type of analysis.

I've already condensed the unlimited possibilities of a random walk down to just a few probabilities.

Stocks Love Symmetry

By Divid Waggoner

“Beauty is Truth, truth beauty, - that is all Ye know on earth, and all you need to know.”

-Ode on Grecian Urn, John Keats

“God does not play dice with the universe.” -Albert Einstein

The mathematical basis for the Elliott wave principle is Fibonacci mathematics. Leonardo Fibonacci was a 13th century Italian mathematician who is credited with the sequence of numbers bearing his name: 1,1, 2, 3, 5, 8,13, 21, 34, 55, 89 and so forth. Beginning with the number 1, each new term is the sum of the previous two.

It is believed that Fibonacci learned of the additive sequence while studying with Arabs in North Africa. He introduced it to the Western world in his famous book Liber Abaci (Book of the Abacus). The more relevant contribution of the book at that time was the introduction of the Arabic numeral system, which is now used throughout the world as the decimal system. It replaced the Roman numeral system that was in use at the time in Europe.

The additional mathematical fact of the Fibonacci sequence is that the ratio of any two numbers in the sequence approximates 1.618, or its inverse, .618 after the first several numbers. The higher the number, the closer to .618 and 1.618 are the ratios between the numbers. The Fibonacci sequence can be visualized geometrically as a mathematical grid growing larger (or smaller) in which each new unit always bears a relationship of .618 or 1.618 to its predecessors.

The number .618, or to be more exact, .618034... is an irrational number that is known as the golden ratio or "Phi." The Greeks held this ratio to be divine. Plato establishes it in his Socratic dialog of creation, Timaeus, as the mathematical basis of all creation.

The Golden Ratio In The World

The divine ratio was central to Greek thought and the works of Pythagoras, Euclid and Eudoxus. It governs geometry’s golden section, golden rectangle and golden spiral. In Greek architecture, its proportions are responsible for the incredible symmetry of proportion found in the Acropolis and the Parthenon. 2,000 years before Greek civilization, the Golden ratio is found to consciously be incorporated in the construction of the Great Pyramid of Cheops(2,560 BC) and other structures of ancient Egypt. (This is also explained in Timaeus.)

In nature, the Fibonacci sequence and ratios are found in vertebrate, tree branches, honeybee populations, the flight path of birds, the swimming path of fish, pinecones, sunflowers, shells, pineapples, hurricanes, whirlpools, ferns, clouds, flower petals, ocean waves, spiraling galaxies, lightning, snails, animal horns, DNA (the double helix), and, as depicted in Leonardo da Vinci’s Vitruvian Man and On the Divine Proportion, the human body.

Many great thinkers throughout the ages have been obsessed with the golden ratio. Famous scientists were in awe of how it repeated persistently throughout their work. Famous artists, recognizing its aesthetic quality in nature, reproduced it in their work.

Johannes Kepler, the famous astronomer, believed that the golden ratio described virtually all of creation. Isaac Newton, physicist, had the golden spiral engraved on the headboard of his bed. Pythagoras, mathematician, chose the 5-pointed star, in which every segment is the golden ratio to the next smaller segment, as the symbol of his order. Jacob Bernoulli, mathematician and astronomer, directed the golden spiral be etched on his headstone when he died. Leonardo Da Vinci used the golden ratio in much of his art to enhance its aesthetic appeal; the Mona Lisa employs the golden ratio. Mozart consciously used the golden ratio in his sonatas.

The golden ratio is central to arithmetic, algebra, geometry, trigonometry, proportion, architecture, electronics, and music. (According to H.E. Huntly, author of Divine Proportion, the golden ratio naturally appears in the relationship of the intervals or distance between notes in music.)

Fibonacci numbers and the golden ratio are evidenced and accepted as fact to exist in the progress of the cosmos, botany, physics, geophysics, astronomy and biology.

Therefore, is it too much of a leap to accept that human progress might also have form? And if human progress has form, then isn't it a logical conclusion that the stock market, which is a representation of man's progress on this Earth, would embody that form? And wouldn't that form show up in a chart?

The Golden Ratio in the Markets

R.N. Elliott discovered the golden ratio and Fibonacci sequence of numbers, the same persistent, repeating structure and unity evidenced throughout the universe, in the charts of the stock market.

The golden ratio in the stock market is the proportionate relationship of one wave amplitude to another. There is also evidence to support that these relationships exist in time. In my experience, the proportionate amplitude of waves can be detected more easily and consistently for forecasting than time. (But, it doesn’t stop me from trying to figure out time also.)

The following Fibonacci ratios are the most commonly found ratios in the stock market: .382, .500, .618, 1.00, 1.618, and 2.618. These ratios can be applied as either extensions or retracements of wave patterns to forecast price action.

For example, the structure of a motive or impulse wave is 5-3-5-3-5. The most common expression of the golden ratio in a motive or impulse wave is that wave 3 extends to a 1.618 ratio of wave 1, and, in such cases, wave 5 tends toward a .382 ratio of the entire length of waves 1 through 3. Let's take a look at the primary trend wave count thesis to see if these desired proportions are present.

Using a Fibonacci extension tool available with most charting software, one can determine that the actual proportions of the waves are consistent with my thesis: wave 3 is very close to a 1.618 ratio of wave 1, and wave 5 is close to a .382 ratio of waves one through three. That is a powerful confirmation that we have completed five impulse waves down and an example of how the golden ratio presents in the stock market.

Golden Ratio Present in Stock Market

Continuing with my primary trend thesis, I suggested that we were probably in the process of a counter-trend rally second wave. We will now use Fibonacci ratio analysis to target probable turning points. First I will apply a retracement of the entire move from the top.

The inside band of Fibonacci numbers are the resultant retracement levels. Last week I identified a completed counter-trend double zigzag at the 60min level, and I suggested that the downward move from that point was probably a correction of a correction. I then deduced that since we were almost finished with another double zigzag, and near the .500 Fibonacci retracement level, we had a strong set up for a turn. That was in fact correct. With a confirmed turn, I can now project a Fibonacci extension of the double zigzag from the bottom (W-X-Y).

The double zigzag is now part of a larger combination at one higher level of degree, and I have new information to include in our calculations for probable targets. In doing this I have an overlap of two Fibonacci relationships. Both the .618 retracement level and the 1.00 extension are at the same level. This is now my most compelling target for two reasons: 1) A 1:1 ratio is the most common extension of a corrective combination. 2) A .618 to .81 retracement is the most common retracement for a second wave.

New Probability Target for Retracement

Here is one more example of Fibonacci ratios in the stock market on the same chart. I mentioned earlier that second waves most commonly retrace .618 - .81. Take a look at the ratios of all the second waves down from the top.

Repeating Fibonacci Ratios in Stock Market

The relationship between accurate wave counts and the golden ratio is key. It is the best method for proofing wave counts. If the symmetry isn’t there on some level, the wave counts are probably wrong. Nature loves symmetry and proportion, and so does the stock market. Coincidence? What would Isaac Newton think?

References:

Elliott Wave Principle: A.J. Frost and Robert R. Prechter

Secrets of the Great Pyramid, Peter Tompkins and Livio Catullo Stecchini