The Elliott Wave Principle

In the 1930s, Ralph Nelson Elliott, a corporate accountant by profession, studied price movements in the financial markets and observed that certain patterns repeat themselves. He offered proof of his discovery by making astonishingly accurate stock market forecasts. What appears random and unrelated, Elliott said, will actually trace out a recognizable pattern once you learn what to look for.

Elliott called his discovery "The Elliott Wave Principle," and its implications were huge. He had identified the common link that drives the trends in human affairs, from financial markets to fashion, from politics to popular culture. Robert Prechter, Jr., president of Elliott Wave International, resurrected the Wave Principle from near obscurity in 1976 when he discovered the complete body of R.N. Elliott's work in the New York Library. Robert Prechter, Jr. and A.J. Frost published Elliott Wave Principle in 1978. The book received enthusiastic reviews and became a Wall Street bestseller.

In Elliott Wave Principle, Prechter and Frost's forecast called for a roaring bull market in the 1980s, to be followed by a record bear market. Needless to say, knowledge of the Wave Principle among private and professional investors grew dramatically in the 1980s. When investors and traders first discover the Elliott Wave Principle, there are several reactions: • Disbelief – that markets are patterned and largely predictable by technical analysis alone • Joyous “irrational exuberance” – at having found a “crystal ball” to foretell the future • And finally the correct, and useful response – “Wow, here is a valuable new tool I should learn to use.” Just like any system or structure found in nature, the closer you look at wave patterns, the more structured complexity you see. It is structured, because nature’s patterns build on themselves, creating similar forms at progressively larger sizes.

You can see these fractal patterns in botany, geography, physiology, and the things humans create, like roads, residential subdivisions… and – as recent discoveries have confirmed – in market prices. Natural systems, including Elliott wave patterns in market charts, “grow” through time, and their forms are defined by interruptions to that growth. Here's what is meant by that. When your hands formed in the womb, they first looked like round paddles growing equally in all directions. Then, in the places between your fingers, cells ceased growing or died, and growth was directed to the five digits.

This structured progress and regress is essential to all forms of growth. That this “punctuated growth” appears in market data is only natural – as Robert Prechter, Jr., the world's foremost Elliott wave expert and president of Elliott Wave International, says, “Everything that thrives must have setbacks.” The first step in Elliott wave analysis is identifying patterns in market prices. At their core, wave patterns are simple; there are only two of them: “impulse waves,” and “corrective waves.” Impulse waves are composed of five sub-waves and move in the same direction as the trend of the next larger size (labeled as 1, 2, 3, 4, 5). Impulse waves are called so because they powerfully impel the market. A corrective wave follows, composed of three sub-waves, and it moves against the trend of the next larger size (labeled as a, b, c). Corrective waves accomplish only a partial retracement, or "correction," of the progress achieved by any preceding impulse wave.

As the figure to the right shows, one complete Elliott wave consists of eight waves and two phases: five-wave impulse phase, whose sub-waves are denoted by numbers, and the three-wave corrective phase, whose sub-waves are denoted by letters. What R.N. Elliott set out to describe using the Elliott Wave Principle was how the market actually behaves. There are a number of specific variations on the underlying theme, which Elliott meticulously described and illustrated. He also noted the important fact that each pattern has identifiable requirements as well as tendencies. From these observations, he was able to formulate numerous rules and guidelines for proper wave identification. A thorough knowledge of such details is necessary to understand what the markets can do, and at least as important, what it does not do. You have only just begun to learn the power and complexity of the Elliott Wave Principle. So, don't let your Elliott wave education end here. Join Elliott Wave International's free Club EWI .

The Parabolic Trigger for V Tops and Bottoms

Our previous article about using the ADX for V shaped tops and bottoms was surprisingly well received. We had a great deal of very favorable feedback from our members who experimented with it. This very valuable pattern seems to do an excellent job of spotting major turning points in almost any market from Palladium to Natural Gas to Soybeans or even Lumber.

This pattern seems to work extremely well in almost all futures, stocks and even the hard to trade stock indexes. Much like a kid with a new toy, we've been having fun scanning through our charts and finding all the important signals that have been generated.

For example, when looking at the stock index charts we had some very timely and important signals that the strong bear market in stocks was finally reversing. Let's review very briefly the conditions that create the pattern we are looking for. REVIEW OF SETUPS and TRIGGERS: For those of you who are new to our work, we strongly recommend a two step process for entries. The first step is to identify some "setup" conditions that tell us that an entry is near.

The second step is the "trigger" that tells us we must enter the trade NOW. Just to refresh your memory from the previous Bulletin, let me review the "setup" conditions that we are looking for. Remember that we are trying to anticipate important "V" shaped reversal patterns. We want to be able to trade as near as possible to major tops and bottoms.

As most of you are aware, a major directional price move will cause the ADX to rise to a high level. Depending on the direction of the price movement, either the Plus DI or the Minus DI will also move to an unusually high level. As the market peaks the DI will begin to decline while the ADX is flat or still rising. Near the top (or bottom) the ADX will become the highest line and will be above both the Plus DI and the Minus DI lines.

This is our "setup" and alerts us that an important change in direction is likely in the very near future. The relationship of the three lines with the ADX being the highest tells us that there has already been a very extended price move that is running out of gas. FINDING A TIMELY TRIGGER: While studying the charts using our new ADX pattern we found that our setup conditions often occurred early and that our DMI triggers were sometimes a little bit late. We don't mind having the setup conditions occur early.

After all, lead indicators are rare and very hard to find. However to make this entry pattern even more exciting we thought we would see if we could make the triggers occur sooner. Now that we have our lead indicator in place we want to find a timely entry trigger that gets us started in the direction of the new trend that should just be getting started.

In Bulletin 45 we suggested that the crossing of the Plus DI and Minus DI lines could be the entry trigger. Although this method is acceptable and produces excellent results we observed that there might be room for further improvement. In many cases, by the time the Plus and Minus DI have crossed some profits in the new direction have already been left behind.

After some trial and error we found that the Parabolic indicator did just what we wanted. We believe we can use the Parabolic indicator instead of the DMI crossovers to provide much more timely entry triggers. We have never liked the Parabolic stop and reverse (SAR) method as an independent trading system which was the intent of J. Welles Wilder, its originator.

However we do like to use the Parabolic indicator for exits. As a system we find that the Parabolic reversal points occur much too frequently and this reversal system would drive us crazy with far too many false changes in direction. However the features of the Parabolic indicator that make it useful as an exit strategy are exactly what makes it the timely trigger we need for our ADX reversal pattern.

The Parabolic indicator accelerates steadily as the prices trend until the reversal points are very, very close to the peak of the move. The stronger the trend the closer the Parabolic gets to the prices. That is exactly what we want. When the Parabolic indicator is close to the prices and we have fulfilled our ADX setup conditions we are all set for an outstanding trade. Even a very small countertrend move will now quickly cross the Parabolic and signal our timely entry. AN IDEAL ENTRY PLUS AN ADD POINT: We view the marriage of the ADX setup with the Parabolic entry trigger as an ideal combination.

The entries now occur in a much more timely fashion than when we relied on the DI crossovers for our trigger. In fact, once the Parabolic has been crossed we can use the DI crossover as a confirmation and add to our position. I don't normally believe in pyramiding positions but in this case we are trading a very reliable pattern that is designed to identify a major reversal in direction, so I think that adding to positions early is a very good strategy. As you can probably tell, I really like this ADX and Parabolic entry technique and I think that we have a lot of good concepts working for us here. We have an early setup, a timely trigger and now we can use the delayed confirmation of the DI crossovers as a point to pyramid the position. You can't ask for much more than that for an entry strategy that does a great job of catching big moves early. Take a look at this pattern on your favorite market and give me your comments. Good luck and good trading. by Chuck LeBeau

Average Directional Index for Vtops and V Bottoms

May be have often described how the ADX (J. Welles Wilder's Average Directional Index) can be a useful tool for measuring the strength of trends. To briefly summarize our previous advice, we have found that when the ADX begins to rise it is telling us that a strong trend is developing. A rising ADX has proven to be a particularly reliable indicator after a market has been going sideways for a while and then begins to trend. For best results, the ADX should begin its rise from a low level (less than 15 or 20) because the low level of the ADX indicates that a sideways basing pattern has been formed. Most of our applications of the ADX strategy have been predicated on finding these highly profitable patterns where a trend suddenly emerges after an extended sideways period. Unfortunately not all trends begin with a sideways pattern. There are many V tops and V bottoms that our rising ADX strategy fails to capture. In a V pattern the ADX rises and then peaks out and declines. The ADX does not begin rising again in time to catch the change in direction in a timely fashion. By the time the ADX falls and then begins to rise again a major portion of the new trend will have already been completed. As we have pointed out in our previous Bulletins, any entry on a rising ADX that was not preceded by an extensive sideways period is not a very reliable pattern. Recently in our research on using the ADX for trading stocks we have observed another ADX pattern that we believe shows great promise. This new ADX pattern signals very timely entries that allow us to profit from possible tops and bottoms that are V shaped. Here is how these V shaped top and bottom patterns can easily be recognized:

1. Make sure that your plot of the ADX also includes the plot of the Plus DI and the Minus DI. The pattern begins when the ADX is above both the Plus DI and the Minus DI. Most often when the ADX is above both the Plus and Minus DI the ADX will be at a high level, perhaps greater than 30 or 35. The high level of the ADX indicates that the previous trend was a very strong one. Now we are going to try and catch the reversal of that strong trend.
2. With the ADX at a high level and declining, look for a crossing of the Plus DI and Minus DI. If the Minus DI crosses above the Plus DI it indicates that a strong up market has ended and weakness has set in. If the Plus DI crosses above the Minus DI it indicates that a strong downtrend has ended and a new uptrend can be expected.
3. These reversal patterns should be entered only as the market moves in the new direction. (We suggest that you use stops for entry triggers.) Once you have entered the trade you should expect a substantial move in the new direction.
4. Be sure to use a stop loss at the recent low or high of the previous trend. Be willing to make more than one attempt to catch the new trend. (Sometimes the Plus and Minus DI will cross back and forth more than once before the new trend emerges.)

We have found that this simple pattern identifies major changes in direction in almost any market. However you should be aware that the change of direction pattern we have described is not as reliable as the typical rising ADX pattern that starts with a basing action. However the trades that do work are exceptionally profitable and we know of no other method that is as timely at catching major changes in direction. Most traders take a great deal of personal satisfaction in quickly recognizing major changes in direction. This simple entry method can produce some truly outstanding trades and provides a welcome change from typical trend following strategies. Our Phoenix Bond system uses this technique to identify major bottoms in the bond market. The same system also spots bottoms in individual stocks. To catch major tops we simply reverse the logic. Just put up some charts with the ADX and look for the pattern we have described in this Bulletin. We think you will be very surprised at its accuracy. Give us your comments and observations on the Forum. Good luck and good trading. by Chuck LeBeau