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Elliott Wave Theory

Taso Anastasiou
Director: FX/PM Global Technical Strategy Group
UBS Investment Bank
Phone : +44 (0)20 7567 6870
E-Mail : taso.anastasiou@ubs.com

Elliott Wave theory


5
b

3
a
4

1
2

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Market Psychology
SECTION 1

A Quotation
Traders of my generation armed themselves with charts and
computer-generated graphics that predicted future price
direction. We sat day after day in front of these screens,
mesmerised by blinking lights and ever-changing numbers
in a deafening cacophony of information overload.
With the possible exception of Elliott wave theory, an
intellectual framework for understanding the course of social,
political, and economic events was noticeably forgotten in
favour of just making sure that one was part of the ever
quickening process.

Paul Tudor Jones II, The alchemy of finance by George Soros

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Dow Theory - Important Elements


The averages discount everything
The market has three trends
Major trends have three phases
The averages must confirm each other
Volume must confirm the trend
A trend is assumed to be in effect until it gives definite
signals that it has reversed

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Anatomy of Price Action


W eak
r e s u m p t io n

W e a k te st

C o n s o lid a t io n

se

Reversal

p ri

but

Consolidation

sur

Trend

Stro n g
re ve rsa l

Stro n g
r e s u m p t io n
Stro n g
d -tre n d

C o n s o lid a t io n

Stro n g re ve rsa l

t
bu

su

rp

r is

C o n s o lid a t io n

W e a k te st

W e a k r e s u m p t io n

Market will always be in one of these 3 modes


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Psychological Make up of a trend - Phase 1


A trend is very difficult
to detect at this stage

Very few traders and

investors will actually


open positions in
this phase

Economic news and

cycles are generally


still bad but improving

No public participation
1

Most traders will still


be trying to sell into
the rallies
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Phase 2

Market exceeds previous


top trend is now identified

Traders begin to buy as


bearish sentiment fades

Economic news generally


improving

Media starts to report a


new bull phase

Public begins to participate

Traders are now buying


the dips

Is the most powerful phase


of the three and most
profits are generated in
this phase

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Phase 3

33

Market once again


exceeds previous top
as trend is confirmed

Fear of intervention makes


traders wary

Fundamental factors
peaking

Media still reporting


positive news but
now wondering how
far we can go

Increased public
participation

A few scares and profit


taking causes concern
stops are raised

Blow off occurs as stops


triggered

Generally the weakest


of the three phases
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Awareness of market psychology


and how it affects trading activity is
essential for a greater understanding
of the Elliott Wave Theory.

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The BasicsBuilding on Dow theory


SECTION 2

The Building Blocks


Elliott isolated 13 waves, or price patterns of directional
movement that recur in markets and are repetitive in
their form

His descriptions constitute a set of empirically derived


rules and guidelines for interpreting market action

First we must look at the basic structure or the five


wave pattern

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The basic five wave structure


Any major movement will

unfold in a pattern of five waves


and in turn will be corrected by
a pattern of three waves going
in the opposite direction

The five wave movement can be

a
c

split into two distinctive


segments
the numbered phase
the lettered Phase

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The impulse
Impulsive segment

The Trend phase is known

as the impulse

This the numbered phase

An impulsive segment (1-5)


4
1

a
c

is itself constructed as a
series of five waves of
which 135 are impulses
of a minor degree

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The impulsive segment


5

Zoomed in

3
5

Phase
Impulsive segment

c1

b
a

2
c

2
c

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The corrective phase


5

Correction

4
1

peaks and troughs

The lettered phase is

Trends move in a series of

known as the corrective


segment and is always
counted in threes, abc

a
c

Wave 2 corrects Wave 1


Wave 4 corrects Wave 3

abc corrects
Waves 1 to 5

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In Practice
Your start point

should always be
a significant high
or low

Start point is

labelled 0, the
impulse segment in
this phase is labelled
1 and is corrected by
the lettered phase
labelled 2

2
0
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Summary of wave structure


5
3

4
1

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Summary of wave structure (continued)


Waves 135 are impulses moving in the direction of the trend
5

5
b

3
4

3
c

4
1

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Summary of wave structure (continued)


Waves 24 are counter trend movements
5

4
1

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Summary of wave structure (continued)


The complete structure

5
5

5
4
b

1
5

b
2

2
c

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USD/CAD
1
5
3

a
2

c
2

11

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Impulsive waves 135


SECTION 3

Rule 1
There are three basic ground
rules used when defining an
impulsive phase

The first inviolable rule is that


from your start point at 0
(major high or low) Wave 2
must never move below the
start of Wave 1 at 0

0
2

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Rule 2
Incorrect count

3
1

Alternative count

Wave 3 can never


be the shortest
wave in the impulse

This doesnt mean


that it is necessarily
the longest

In the example the


alternative count
provides the clue as
Wave 3 is probably
extending

iii

i
1

ii

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Rule 3
5

Wave 4 should not overlap


Wave 1

There are two exceptions to


this rule:

Wave 1 can be a leading


diagonal triangle and price
action can overlap (wedge)
Wave 5 can be an ending
diagonal triangle where
price action overlaps
(wedge)

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Impulse wavesthe extension


An extension can only occur in one of the impulse waves 135.
Most extensions will actually occur in the 3rd wave. Extensions
may also occur in the extending wave itself
5
3
v

iii
4
iv

ii
2

5
b

3
4

2
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Labelling the cycles


0

0 1 2

4 5

A B C

Super cycle

0 I

II III IV V

A B C

Cycle

Primary

(0)(I) (2) (3) (4) (5)

Grand super cycle

(a) (b) (c)

Intermediate

0 1

Minor

0 i

ii iii iv v

Minute

0 1

Minuette

0. i. ii. iii. iv. v.

a. b. c.

Sub-minuette

0 I

II III IV V

Micro

0 i

ii iii iv v

Sub-micro
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Extensions
5
3
1

5
7

3
1

1
2
2

1
3

1
2

22

1
1

3
5

5
5

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Example of an extension
B
2

ii

iv

1
3
5

iii

v
3
5

C
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In Practice - GBP/USD

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In Practice - GBP/USD
5
3

4
1

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In Practice - GBP/USD
5

3
b

a
c
4

1
b

a
c
2
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In Practice - GBP/USD
5

3
v
b
iii
a
iv
1

c
4

b i
a
c
2

ii

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The ending diagonal triangle


An ending diagonal
triangle is counted
as a five wave up
but sub-divides
into threes

Diagonal triangles are


5
v

iii
i
iv

3
ii
4

formed by two converging


lines, in its usual form. This
pattern occurs in fifth
wave positions

The only exception to the


overlap rule between
Wave 14 can occur in
a diagonal

A diagonal can also be

located in the C wave


positions. As in a rising
wedge this is to be
considered a
termination pattern
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Ending diagonal triangles


5 iv
iii
i
iv

3
ii
4

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Ending diagonal triangles


5
3

3
1

4
1

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Leading diagonal triangles


5

In normal circumstances this


pattern would be referred to as
a rising wedge and is a bearish
pattern as it is assumed that the
pattern will break the support

The target on the break would


suggest a re-test of the base

This pattern is only found in


Wave 1 or A

All other rules apply


e.g. Wave 3 is not the shortest
and 2 doesnt break below the
start point then you must buy
the dip as it will turn out to be
a bullish pattern

1
v

iii
i

2
iv
ii

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The failed fifth wave


3
5

As Wave 5 is the weakest

part of the trend it


sometimes has a tendency
to fail early, creating what
we traditionally call
a double top

The Internal wave

structure must still


count up in five

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Failed fifth waves & leading diagonal


5

1
5

4
2

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Failed fifth waves (continued)


Incorrect counting as Wave (5) would only count up in 3
100
3

90

80

70

60

1991

1992

1993

1994

1995

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Failed fifth waves (continued)


Correct count where (I) is a leading diagonal triangle,
(III) has extended and (V) has failed
100

2
91.22

90
1

80

(II)

a
4

3
3

(I)

70

(IV)
c

60
(III)
1991

1992

1993

1994

(V)
1995
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The Trap...

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Successful Trend Definition Is Essential

Analysis and therefore positioning


must be biased in the direction of the
prevailing trend

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Trend Definition Is Essential

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Ground Rules
You can quantify trends and market positioning by biasing your
position base in the direction of the underlying trend

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Corrective waves abc


SECTION 4

Corrective waves
We have seen that movements against the trend are known as
corrective waves, sometimes referred to as consolidations or
lettered phase

Identifying and fitting corrections into particular patterns in


advance is very difficult

The complexity of corrective waves can increase or decrease


without warning

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The three corrective wave types


Corrective waves fall into four categories

Zig-Zag

535

includes three variations single,


double and triple

Flats

335

includes 3 variations, regular,


expanded, running

Triangles

33333

four types, ascending,


descending, contracting, expanding

Double and

triple threes

(combined structures)

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Zig-Zags 535
Bull market correction

Bear market correction

ii
b
c

i
iv

a
ii

iii

iv

v
a

b
iii

v
c
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Zig-Zag corrections
Zig-Zags have a 535 wave structure
These formations are usually found in Wave 2 position
It would be fair to assume that they would also occur after
Wave 5 as a traditional head and shoulders reversal pattern
is formed

Wave C of the Zig-Zag will typically extend the same distance


as Wave A

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Example of a Zig-Zag correction


2

B2

4
1
3

4
5

A
3
5

C
A=C

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Flat corrections 335


Bull market correction

Bear market correction

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Example of a flat correction


B2

ii

b
1

i
iv

a
iii
c

v
3
5

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Irregular flats 335


Bull market correction

Bear market correction

b
c
a

a
c
b

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Flats 335
Flats are counted as 335
There are standard flats which are typically ranges
There are irregular flats where the B wave exceeds the high,
but can only be counted as a 3-wave affair

Last but not least there are running flats


Flat corrections are typically found in fourth and B wave
positions and tend to have lower retracement values

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Triangles 33333
Bull market correction
b
d

Five waves a / b / c / d / e
e

Each wave subdivides into 3waves

c
a

Each wave tends to be related


to a preceding wave by the
0.618 ratio.

Bear market correction


a

e
d

Wave d will be 0.618 of wave b


Wave e will be 0.618 of wave c

This correction is typically found


in wave-4

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Complex corrective forms (double threes) Zig-Zag


Zig-Zag -x- Zig-Zag
Bull market correction
ii
i

b
c

iv
iii

b
v
a

ii

ii
b
c

iv

iv

ii

iii
iii
v
c

b
v
a

iv

iii
v
c
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Complex corrective forms (double threes) Zig-Zag


Zig-Zag -x- flat
Bull market correction

ii

b
c

i
iv

iii

ii

iv

v
a
iii

v
c

c
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Complex corrective forms (double threes) Zig-Zag


Zig-Zag -x- triangle
Bull market correction

ii

b
c

i
iv

iii

ii
b

i
iv

v
a

e
c

iii
a
v
c

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Complex corrective forms (double threes) Zig-Zag


Zig-Zag -x- irregular flat
Bull market correction
b

ii
b
c

i
iv

ii

iii

b
v
a

iv
iii
v
c

a
c
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Complex corrective forms (double threes) flat


Flat -x- flat

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Complex corrective forms (double threes) flat


Flat -x- Zig-Zag

ii
ii
b
b
cc

ii
iv
iv
iii
iii

bb
v
va
a

ii
ii

aa
ii

iv
iv
iii
iii

v
cv
c
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Complex corrective forms (double threes) flat


Flat -x- triangle

b
d

e
c
a
a

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Complex corrective forms (double threes) flat


Flat -x- irregular

a
c
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Complex corrective forms (double threes)


Irregular -x- irregular
b

a
c
a

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Complex corrective forms (double threes)


Irregular flat -x- flat
b

x
b

a
c

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Complex corrective forms (double threes)


Irregular flat -x- Zig-Zag
b

ii
b
c

i
a

iv
iii

ii
b

iv

v
a
iii
a

v
c

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Complex corrective forms (double threes)


Irregular flat -x- Zig-Zag

b
d

e
c
a

a
c

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Complex corrective waves


To date we have looked at standard corrective waves as well as
double complex waves. There is a third type of complex correction
which is called the complex triple three.

ii
iv

iii

b
v
a

b
c

ii
i

iv
e
iii

c
v
c

c
Zig-Zag

Irregular flat

Triangle

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Examples of complex corrections


i

B
X

a
c

A
A

A
c

C
FLAT

IRREGULAR
FLAT

FLAT

C
ii
ZIG-ZAG
A=C

C
ZIG-ZAG

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The rule of alternation


SECTION 5

The rule of alternation


This rule is relatively simple as it states that no two corrective
phases are similar

If Wave 2 is a Zig-Zag then Wave 4 will probably be a flat or


a triangle typical scenario

The rule also states that only one of the impulse waves will extend
(and can itself extend)

If two corrective phases are similar then one will differ in


magnitude or length

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Alternation
5

4
4

1
2

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The rule of alternation


5

a
FLAT

TRIANGLE
b

c
a

2
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The depth of corrective waves


SECTION 6

The depth of corrective waves


No market approach other than the Elliott Wave Theory gives a satisfactory
answer to this question. The primary guideline is that corrections , especially
when they themselves are fourth waves tend to register their maximum
retracement within the span of travel of the previous fourth wave of one
lesser degree which would also represent support (or resistance for a rising
market).
5
3

4
1

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The Fibonacci sequence and its application


SECTION 7

Ratio analysis
Ratio analysis has revealed a number of precise price

relationships that occur often among waves. There are two


categories of relationships: retracements and multiples

Retracements

Fairly often, a correction retraces a Fibonacci percentage of


the preceding wave

Sharp corrections tend more often to retrace 61.8% or 50%

of the previous wave, particularly when they occur as Wave 2


of an impulse wave, Wave B of a larger Zig-Zag, or Wave X in
a multiple Zig-Zag

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Retracements
Typical retracement levels

100

24.6
38.2
50.0
61.8
76.4

Typical of Wave 2

100

Typical of Wave 4

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Impulse wave multiples


When Wave 3 has extended, waves 15 will tend towards
equality (1.00) or a 0.618% relationship. All three impulse
waves tend to be related by Fibonacci mathematics whether
by equality, 1.618 or 2.618 whose inverses are 0.618 and
0.382

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Impulse wave multiples (continued)


3rd wave extension

5th wave extension


5

5
3

1st wave extension


5

1.00

3
.618

.382

2
3
.618

.382
1
2

1.00
2

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Corrective wave multiples


Double Zig-Zag

b
x
b

1.00/.618/2.618

1.00

1.00/6.18/1.618

1.00

Zig-Zag

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Corrective wave multiples (continued)


Flat

Irregular flat
b
b
1.00

1.00
.618 a

1.618
c
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3?

1
ii

2
Wave 3 = 1.00/1.618/2.618 of Wave 1

2
Wave 5 can be equal to wave 1
0.618 of 3 0r .382 of waves 1 and 3

Calculating targets

5?

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Fibonacci relationships
Wave 2 retraces just
above the 61.8% level
of wave-1

2
ii

Wave 4 retraces just


above the 38.2% level
of wave-3

4
iv

Failed

iii

v 5th

5
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Fibonacci relationships (continued)


1.9000

(V)

Wave (V) is 1.00 multiplied by the length of wave (I)

1.8904

1.8500
1.8000

(III)

Wave III is 2.62 multiplied from the length of wave I

1.7500

1.7207

1.7000

Wave (III)and III retraces Wave (IV) and IV by 24%

1.6500

(I)

1.6000

1.5000
II

1.4500

IV

1.6618

(IV)

1.5489

1.5500

III

Wave II retraces Wave I by 62%

(II) Wave (II) retraces Wave (I) by 50%

1.4000

1.3811

(0)

1.3500
May-95

Nov-95

May-96

Nov-96

May-96

Nov-96

May-97

Nov-97

tmta3 DEM-USD Weekly Bar 06-Mar-9528-Nov-97 [Zoomed] 1.8904 1.3455 1.7635 0.3685 0.0000
V 2.980014 Copyright 1994-1997 Tradermade International Ltd.
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A word on momentum
2

Divergence between price


and momentum warns of
technical weakness in a
trend

Divergence between price


and momentum is typical
during the 5th and final
wave.

One would also expect


such a set-up to develop
during wave-C

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Fibonacci Relationships - S&P Cash

1.00 of wave 1 (1246)


0.618 of wave 1 (1175)

4?
1

2
Potential for bearish divergence in momentum

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Fibonacci Relationships - S&P Cash

iii

3
i

5
v

iv
ii

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Analyse

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Analyse

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Analyse

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Analyse

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