Wave Three
in progress
Gap of Wave Three
1
STOPS
Top of Wave One
2
The next sequence of events are as follows: Traders who were initially long from the bottom finally have something to cheer about. They might even decide to add positions.
The traders who were stopped out (after being upset for a while) decide the trend is up and they decide to buy into the rally. All this sudden interest fuels the Wave 3 rally.
This is the time when the majority of the
traders have decided that the trend is up.
Traders
3
buying
Finally, all the buying frenzy dies down,
Wave 3 comes to a halt.
In general,
Stops
a majority
taken
Profit taking now begins to set in. Trad-
of traders
1
out
ers who were long from the lows de-
decide and
agree that
cide to take profits. They have a good
the trend
trade and start to protect profits.
is up.
2
This causes a pullback in the prices
and is called Wave 4. Wave 2 was a
vicious sell-off, Wave 4 is an orderly
profit taking decline.
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While profit taking is in progress, the majority of traders are still convinced the trend is up. They were either late in getting in on this rally, or they have been on the sideline.
They consider this profit taking decline as an excellent place to buy-in and get even.
On the end of Wave 4, more
buying sets in and the prices
3
Profit
start to rally again.
taking
decline
Vicious
4
sell-off
1
2
The Wave 5 rally lacks the huge enthusiasm and strength found in the Wave 3 rally. The Wave 5 advance is caused by a small group of traders.
While the prices make a new high above the top of Wave 3, the rate of power, or strength, inside the Wave 5 advance is very small when compared to the Wave 3 advance.
Finally, when this lackluster buying
5
interest dies out, the market tops
out and enters a new phase.
3
Rally with
Price makes
great strength
new highs.
4
However,
strength in
1
rally is weaker
in comparison
to the third
wave rally.
2
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Indicator To Provide Elliott Wave Counts
The examples of five wave impulse patterns shown on the previous page are very clear and definitive. However, the markets are not that easy all the time. It becomes almost impossible and very subjective to identify Waves 3 and 5 from looking at price charts alone. The price chart fails to show the various strengths of the waves. The following illustration is used to discuss this concept. Two drivers left the same town at the same time in different vehicles. Driver A drove within speed limits all the way, while Driver B exceeded the speed limit .
DRIVER A —
ALWAYS WITHIN SPEED LIMIT
DRIVER B —
TOOK A
DIFFERENT ROUTE;
EXCEEDED THE
SPEED LIMIT.
Both drivers took the same amount of time and traveled the same distance. However, the two drivers used different strategies to arrive at their destination. While Driver A proceeded at a normal speed, Driver B drove like a bat-out-of-Hades, so to speak. An observer at the other end would be unable to tell the difference between the two drivers driving patterns. To a casual observer, both left the same time and arrived at the same time. This is the same problem we face when we try to distinguish between Waves 3 and 5. Wave 5 makes new highs; a trader looking at price charts may not be able to tell the difference between a Wave 3 or Wave 5. However, the internal price pattern of Wave 3 is much stronger in comparison to that of Wave 5. Therefore, we need to use an internal strength measuring indicator to tell the difference.
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Indicator To Provide Elliott Wave Counts
To keep tab of the Elliott Wave logic, we require an indicator that measures the rate of price change in one wave against the rate of price change in another wave. Standard indicators fail to perform this comparison. They merely compare price against price and fail to compare the rate of price action. After years of research, the Elliott Oscillator was developed. The idea of the oscillator is described below.
An Elliott Oscillator is basically calculated
from finding the difference between two
Wave Three
Rate of price
moving averages. If we were to use a small
increase is
much faster
moving average and a large moving average,
the difference between the two will show
the rate of increase in prices.
Small moving aver-
age representing
The small moving average represents the
Difference
current prices
current price action, while the larger moving
is large in
average represents the overall price action.
Wave 3
When the prices are gapping up inside a
Wave 3 the current prices are surging; the
Large moving average
difference between the small and large mov-
representing
ing averages is great and produces a large
price actions
oscillator value.
However, in a Wave 5 the cur-
rent prices are not moving up at
a fast rate and, therefore, the
Wave Five
difference between the small
and large moving averages is
minimal. This produces a
Rate of price increase is slow
smaller oscillator value.
The analogy is similar to the
Difference is very
two drivers.
small in Wave 5
Wave 3 is like Driver B who
accelerates beyond speed lim-
its and has a higher rate of
speed, while Wave 5 has a
slow, dragging price action.
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Elliott Oscillator: Step-By-Step Illustration —
We will use the same chart for illustration. When the prices rally above the top of Wave 1, the Elliott Oscillator is making new highs. Notice also the gapping action. The current rally is labeled Wave 3.
Finally, the buying subsides in Wave 3. Traders begin to take profits. However, the general public is eagerly waiting for a neutral area to buy into this market. When the Elliott Oscillator pulls back to the zero level, or slightly below, the market is entering a neutral area.
Sample Price Bar Chart
5
3
1
Prices making
4
new highs, but
no lasting strength
2
Small and Large Moving Average
Small MA
represents
Current prices
current
moving with slower
price
rate shows wave
five
Larger MA represents overall price
Current prices moving up rapidly
shows wave three
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Once Wave 4 is over, buying comes in from traders who missed the entire Wave 3 rally.
The prices move to new highs. However, the rally does not have the fast rate of price increase that was seen in Wave 3. This difference in the rate of price is picked up by the oscillator and can be easily identified. MORAL OF THE STORY: Always let the Elliott Oscillator track Elliott Wave counts.
Sample Price Bar Chart
5
3
1
Prices making
4
new highs, but
no lasting strength
2
Small and Large Moving Average
Small MA
represents
Current prices
current
moving with slower
ø
price
rate shows Wave
Five
õ Larger MA represents overall price
Current prices moving up rapidly
shows Wave Three
The Elliott Wave Oscillator
Prices making new
Majority accepting the trend
highs without strength
ø
ø
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Five Wave Impulse
Identifying a five wave impulse
(up) using the Elliott Oscillator,
(UP)
which is part of the software.
3
5
Strength
in rally
ö
Divergence
Elliott
Oscillator
pulls back
to zero
÷
5
3
õ New
New
highs
Phase
with
4
less
strength
õ
Labeled as
õ Rally
Wave Four
with strength
because
1
labeled
oscillator
as Wave
pulled back
Three
to zero
2
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Identifying a five wave
Five Wave Impulse (DOWN) impulse (down) using the
Elliott Oscillator, which is
2
part of the software.
Labeled as
1
Wave Four
because
oscillator
pulled back
÷ to zero
Decline
ö
4
with strength
New Phase
ø
New
3
ö
lows
with less
strength
5
õ Elliott
Oscillator
pulls back
to zero
Divergence
5
3
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The Elliott Oscillator
Minimum Pull Back Required
Historically, 94% of all Wave 4 sequences that have ended in a Wave Five making a new high or a new low, had the Elliott Oscillator pull back at least 90% from the Wave 3 peak.
90%
5
3
4
Elliott Oscillator
(not shown to any scale)
Divergence
0
Minimum
90% Pullback
Required
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The Elliott Oscillator
Maximum Oscillator Pull Back
Just as it is important for the Oscillator to pull back to the zero line (or at least 90% of the Wave 3 Oscillator as discussed on the previous page) it is just as important that the Oscillator does NOT pull back more than 38% of the Wave 3 Oscillator on the other side of the zero line.
90%
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