Wave Counting in Financial Markets

R. N. Elliott was the first to discover the wave structure of markets and put together a framework of rules to count waveforms and attempt to predict the outcome. This method has been used with success, most notably by R. Prechter, but in its original form it is ambiguous and has been extended by many in an attempt to improve it. After observing the ambiguity and complexity of patterns in Elliott's method, I developed a fresh set of simpler non-ambiguous rules to assist in the use of Wave Counting.

Defining a Wave

The first step is always definition and we need an unambiguous way of defining a wave. Since a wave is a trend of some length, we can use the familiar trendline and/or parallel channel to define trends in the Transport index chart below. We can see an uptrend wave broken in 1998, a downtrend wave broken in 2003, and as of mid 2007 we have not broken the uptrend yet. We can see that this method works quite well, and is further confirmed by adding time cycles to reveal that the changes of trend do match and are not occuring randomly. We can see why trendlines are the most popular form of technical analysis, since when placed properly they can detect a change of trend.

Wave Myth #1 exposed

The first wave counting myth we must dispel is that impulsive waves are always made up of 5 sub-waves where corrective waves are always made up of 3 sub-waves. Waves can only be made up of an odd number of sub-waves and as the Pascal Law of Probability predicts they get progresssively less common as we go from 1, 3, 5, 7, 9, etc... We can see an example of 3 and 7 sub-waves in both impulsive and corrective waves in the Transport index chart below. I am sure many ways of labeling the obvious 7 sub-waves into a 5 sub-wave structure exists on the web, but we are trying to remove this wave ambiguity, and a child would count it as 7 waves. While the number of sub-waves reveals clues about the trend, it is really irrelevant in the task of identifying waves. The use of a trendline helps us to recognize a developing wave, and most importantly knowing when it ends. The price/time travelled and cycles make sure we are measuring waves of similar degrees.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

Parallel Channels

A wave with 5 or more sub-waves will often evolve between two trendlines forming a parallel channel or an expanding or constricting triangle. These structures can have good predictive abilities when positioned properly. The parallel channel is the most common and can be seen in both impulsive and corrective waves in the Transport index chart below.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

Symmetrical Triangles

Symmetrical Triangles are usually found near the end of trends as they represent indecision and testing of the boundaries of previous price trends. An equally constricting triangle results in an accumulation of trades near the apex price, which results in a good trend developing in the direction of the break. The indecision often means the break is the last move in the trend and it will be fully retraced before another attempt.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

Ascending or Descending Triangles

If the triangle is a constricting triangle slanted towards the previous trend, then it often but not always predicts a reversal of trend and is usually fully retraced. The large descending triangle built over the 80's led to the major low in Silver in the early 90's and should lead to a full retrace of that 1980's decline. The same could be seen in the chart of Palladium as far back as 2005.

Charts courtesy of StockCharts.com


Charts courtesy of StockCharts.com

The Rule of Alternation

Alternations are probably caused by too many traders expecting the previous recent behavior to repeat causing the inverse to happen as their anticipatory trades affect the natural path until it reverts to normal. Alternation occurs more often than not and I consider it a Rule rather than a Guideline as Elliott does, but like cycles it does not always shows up quite as expected. We can see the alternation between the shallow 1900's bear, the sharp 1930's bear, the shallow 1970's bear, and the sharp 2000's bear that followed is quite obvious. Since the 19th Century was a shallow consolidation leading to the sharp bull market of the 20th Century, the Rule of alternation suggests that the next correction in the 21st Century will be sharp and deep.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com

Harmonic Inversions

Harmonic Inversions are a well known Resonance phenomena in physics, were waves resonate at lower and higher multiples of the main cycle. The 1/2 resonance is one of the strongest, and when the underlying cycles are weakest because of a changing larger cycle, the 1/2 resonance can and does alter the top or bottom cycle into a local inversion usually with quite equal moves in Price and Time on each side. This behavior can be seen in the chart of the Russelll 2000 below, where the well known 4 year cycle high interracted with the 1/2 harmonic resonance of the 2 year cycle low and caused a perfect local inversion to demonstrate the dynamic.

Charts courtesy of StockCharts.com

Charts courtesy of StockCharts.com