To me, EW is simply a spontaneous counting of "Fives and threes" and its combination to put the market moves in a predictable order.
Ralph Nelson Elliot observed after years of analysis that the market movement was quite orderly and followed a pattern of waves. It is a theory that reflects the law governing the form of the natural path of all human activities. This Nature's law, though predictable to the dedicated, still leaves much mystery to many.
The comparison with tide, wave and ripple has been used since the earliest days of Dow Theory.
What is a wave..?? There are no parameters to define what is a wave and hence it is left to the imagination of the follower. The example of the waves of the ocean illustrates this quite well..
1. A small wave starts initially.
2. And then it recedes for a while and gathers more strength.
3.On its next advance, the wave becomes stronger than the earlier one.
4.With a further consolidation, the final wave explodes with full strength.
What is a wave..?? There are no parameters to define what is a wave and hence it is left to the imagination of the follower. Years of my observations have helped me to arrive at a basic tool to identify a wave which is "Trendline". When a trendline is combined with the study of Technical indicator such as macd (How to combine EW with macd, you are well guided to put these price movements in an orderly fashion as defined by Elliot wave theory that prices move in 5 waves followed by a 3 wave correction. And this process continues..on and on.
The Elliot theory: Market moves in waves, each of which is interrelated to one another in time and price. A movement in a particular direction can be represented by "5" distinct waves of which three in the direction(called impulse wave-1,3,5) and two against the direction(called Corrective wave-2,4).
One such five-wave would become the first wave of the higher degree. Eg: 5 waves in hour would become one single wave in the Day.
Each corrective wave will subdivide into 3 waves of a lesser degree. And this process continues with variations in actual market place as per the Traders/Investors psychology & their resultant behaviour which moves the markets.
How to apply..? You simply start labeling them in fives and threes as you deem fit using, if necessary, other "Overbought & Oversold" indicators and other methods. There are some basic rules to be followed to help you in counting them correctly which will be discussed next week.
Here is a small illustration to count them and their immense utility in assessing the likely direction of the market which helps in proper entry and exit and above all to "sit tight" with the trades.
1. At the reversal point, the first wave is formed with a swift retracement of the last fall. The illustration here is of the onset of the bull run started in March 2009.(In the 5-minute or 30 minute chart, the faster retracement could have been spotted at 2630 after a positive divergences and highly oversold nature).
As the first set of "5"s is complete, it becomes the 1st or "A" wave (As the upmove from mar.09 low is construed as corrective)of a larger degree/ time cycle.
i.e- from hourly 5 waves, they become the 1st wave of the daily as shown below:
Also note that the last fall from 2798 to 2556 got retraced in shorter time to 2836, confirming a trend reversal.
Always book out at the count of 5, at least partially and re-enter at the count of "abc"-the corrective part. In most bullish cases, the correction ends at the 4th wave of the previous lower cycle. Never miss the "Third wave entry"-one of the most rewarding phase.There are many traders who simply wait for the 3rd wave set ups in various time cycles to make their safer & rich trades. Note in the hourly chart below the irregular correction in the second wave(marked in red) wherein the "b" moved above the "1st" wave suggesting of "Bullish undercurrent" that market is quite impatient to forge ahead.
Here below, you will note the completion of three sets of "fives" connected by two sets of "threes" to form one big "First or A"(Pink) wave to be followed by a correction which ended near the 4th wave of the previous cycle. Now Imagine, what the 3rd wave of this larger time scale can have in store for it after experiencing a small 3rd wave upmove earlier within the "three sets of Fives". We'll see soon.
The more noisy or countless sub-waves are enclosed within the daily waves in a neat fashion.Note also how the "first break of the trendline often gives away the end of a 4th wave and the onset of a powerful 5th wave" This is not a rule but a guideline worth remembering.
Yes..in the daily 3rd wave, the markets gave a Black Swan..a total upward freeze. This happens often to individual scrips.Note also, subsequent to the completion of the 5-waves in daily which make up the 1st or "A" wave of the weekly, a larger correction sets in. A break of the redrawn trendline confirms the "a" wave(first of the three waves of a correction) of that correction.
Once a larger correction in the form of an "abc" (We label the corrections as "abc" to avoid a confusion of labeling both upmoves and downmoves using numbers) is complete, the next big 3rd wave or "C" wave(as it is still considered to be corrective)start to unfold.
The most important factor in labeling the moves is to help identify the direction, its magnitude depending on its time cycle to stay in the direction for the correct amount of time. One should not, for eg.,enter into an hourly 3rd wave and sit tight for days.The hourly direction lasts for "Hours" only.
Remember there are waves within waves and various "Counts" are in force at any given time for different time cycles. EW works well for the larger time scale and requires high agility & proper stop loss & money management to play the shorter version.
My EW learning has come mostly from the shorter version as you will see most of the wave forms in a shorter version since one life time is not enough to see them in larger time scale which can run into centuries.
In the next week, we will learn some basic rules that govern this wave movements.
Have patience..Elliot took 10 years to arrive at his theory.
Get rich slowly.