Guidelines Of Wave Formation

GUIDELINES OF WAVE FORMATION

ALTERNATION

The guideline of alternation states that if wave two of an impulse is a sharp retracement, expect wave four to be a sideways correction, and vice versa. Figure 20 shows the most characteristic breakdowns of impulse waves, both up and down. Sharp corrections never include a new price ex­treme, i.e., one that lies beyond the orthodox end of the preceding impulse wave. They are almost always zigzags (single, double or triple); occasionally they are double threes that begin with a zigzag. Sideways corrections include flats, triangles, and double and triple corrections. They usually include a new price extreme, i.e., one that lies beyond the orthodox end of the preceding impulse wave.

DEPTH OF CORRECTIVE WAVES

No market approach other than the Wave Principle gives as satisfactory an answer to the question, “How far down can a bear market be expected to go?” The primary guideline is that corrections, especially when they them selves are fourth waves, tend to register their maximum retracement within the span of travel of the previous fourth wave of one lesser degree, most commonly near the level of its terminus. Note in Figure 21, for instance, how wave 2 ends at the level of wave four of 1, and how wave 4 ends at the level of wave four of 3.

CHANNELING TECHNIQUE

Elliott noted that parallel trend channels typically mark the upper and lower boundaries of impulse waves, often with dramatic precision. Analysts should draw them in advance to assist in determining wave targets and to provide clues to the future development of trends.

To draw a proper channel, first connect the ends of waves two and four. If waves one and three are normal, the upper parallel most accurately forecasts the end of wave 5 when drawn touching the peak of wave three, as in Fig­ure 21. If wave three is abnormally strong, almost vertical, then a parallel drawn from its top may be too high. Expe­rience has shown that a parallel to the baseline that touches the top of wave one is then more useful.

The question of whether to expect a parallel channel on arithmetic or semilog (percentage) scale is still unre­solved as far as developing a definite tenet on the subject. If the price development at any point does not fall neatly within two parallel lines on the scale (either arithmetic or semilog) you are using, switch to the other scale in order to observe the channel in correct perspective. To stay on top of all developments, the analyst should always use both.

Within parallel channels and the converging lines of diagonal triangles, if a fifth wave approaches its upper trendline on declining volume, it is an indication that the end of the wave will meet or fall short of it. If volume is heavy as the fifth wave approaches its upper trendline, it indicates a possible penetration of the upper line, which Elliott called “throw-over.” Throw-overs also occur, with the same characteristics, in declining markets.

VOLUME

In normal fifth waves below Primary degree, volume tends to be less than in third waves. If volume in an ad­vancing fifth wave of less than Primary degree is equal to or greater than that in the third wave, an extension of the fifth is in force. While this outcome is often to be expected anyway if the first and third waves are about equal in length, it is an excellent warning of those rare times when both a third and a fifth wave are extended.

At Primary degree and greater, volume tends to be higher in an advancing fifth wave merely because of the natural long-term growth in the number of participants in bull markets.

LEARNING THE BASICS

The Wave Principle is unparalleled in providing an overall perspective on the position of the market most of the time. While this perspective is extremely comforting and useful, the more practical goal of any analytical method is to identify market lows suitable for entering positions on the long side and market highs offering the opportu­nity to take profits or enter the short side. The Elliott Wave Principle is especially well suited to these functions. Nev­ertheless, the Wave Principle does not provide certainty about any one market outcome. One must understand and accept that any approach that can identify high odds for a fairly specific outcome will produce a losing bet some of the time.

What the Wave Principle provides is an objective means of assessing the relative probabilities of possible future paths for the market. What’s more, competent ana­lysts applying the rules and guidelines of the Wave Principle objectively should usually agree on the order “of those prob­abilities.” At any time, two or more valid wave interpretations are usually acceptable by the rules of the Wave Principle. The rules are highly specific and keep the number of valid alternatives to a minimum. Among the valid alternatives, the analyst will generally regard as pre­ferred the interpretation that satisfies the largest number of guidelines and will accord top alternate status to the interpretation satisfying the next largest number of guide­lines, and so on.

Alternate interpretations are extremely important. Your second-best “count” is an essential aspect of trading with the Wave Principle, because in the event that the market fails to follow the preferred scenario, your top al­ternate count becomes your backup plan.

The best approach is deductive reasoning. Knowing what Elliott rules will not allow, one can deduce that what­ever remains must be the most likely course for the market. By applying all the rules of extensions, alternation, over­lapping, channeling, volume and the rest, the analyst has a much more formidable arsenal than one might imagine at first glance.

Most other approaches to market analysis, whether fundamental, technical or cyclical, disallow other than ar­bitrarily chosen stop points, thus keeping either risk or frequency of stop-outs high. The Wave Principle, in con­trast, provides a built-in objective method for placing a loss-limiting stop. Since Elliott wave analysis is based upon price patterns, a pattern identified as having been com­pleted is either over or it isn’t. If the market changes direction, the analyst has caught the turn. If the market moves beyond what the apparently completed pattern al­lows, the conclusion is wrong, and any funds at risk can be reclaimed immediately.

Of course, there are often times when, despite a rigor­ous analysis, the question may arise as to how a developing move is to be counted or perhaps classified as to degree. When there is no clearly preferred interpretation, the ana­lyst must wait until the count resolves itself, in other words, to “sweep it under the rug until the air clears,” as Hamilton Bolton suggested. Almost always, subsequent moves will clarify the status of previous waves by revealing their po­sition in the pattern of the next higher degree. When subsequent waves clarify the picture, the probability that a turning point is at hand can suddenly and excitingly rise to nearly 100%.

The ability to identify junctures is remarkable enough, but the Wave Principle is the only method of analysis which also provides guidelines for forecasting. Many of these guidelines are specific and can occasionally yield results of stunning precision. If indeed markets are patterned, and if those patterns have a recognizable geometry, then re­gardless of the variations allowed, certain price and time relationships are likely to recur. In fact, real world experi­ence shows that they do. The next section addresses some additional guidelines that are helpful in the forecasting exercise.