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# Elliott Waves - Basic Principle

Now let’s see how this relates to the basic clean chart as displayed by MetaStock®…

If we link the tops of each bar we get a line that changes direction and sort of looks like ocean waves. Elliott quickly seized this similitude and defined a wave as: series of successive bars where each high is equal or higher than the preceding one and each low is higher than the previous one, conversely series of successive bars where each low is equal or lower than the preceding one and each high is lower than the previous one. If we apply this to our chart using the AlphOmega Absolute Elliott indicator, we get the following…

Already the waves are more discernible and steeper by the mere fact that we chose between the high and the low to connect the bars. We also observe that the rule as simply as it is stated does not answer all possible relationship between the bars. For example, inside days (the last bar has a lower high and a higher low than the previous) or outside days (the last bar has a higher high and a lower low than the previous) cause a dilemma as too which from the high or the low do we choose?

On top of this, this rule does not account for the direction of the trend within the bar itself, from the opening price what was the direction of the price? Did it go from high to low to close or something else? The later cannot be answered from the data downloaded, all that is certain is that the opening took place before the closing but we don’t know if the high was hit before the low or the reverse. However we can elect that when the close is higher than the open, the trend is bullish and it is bearish for the reverse situation. It may look trivial at this point but when you will be faced with making an entry, you will understand its importance.

Furthermore, when making projections for price, the results will be noticeably different. Note that the indicator has a set of rules to decide which of the high or low it should take, making it easier than remembering the individual rules. Back to our waves, could we trade on the basis of this information alone (from a technical analysis standpoint)? We certainly could but the whipsaws would be costly in commissions or brokerage fees. We need to filter or eliminate some of the swings; we need to look at a broader picture. Let’s apply the AOZZ indicator and use a 21% filter. The percent filter relates to the minimum retracement from a peak or trough (top or bottom) expressed as the price change over the initial price (price at the peak or trough). A picture is worth a thousand words…

Now this is a lot better in terms of number of swings! From this point on we will switch from a bar to a candlesticks presentation, why might you say? Because the open and close are hard to tell when the bars are squeezed together, moreover the candlesticks patterns will be easier to see. How can we use these waves to trade? It is quite obvious that if we enter at the trough and sell at the peak, we will do very well. If everything was that simple… alas look at the last bar… can you tell it is the bottom or trough? Of course, no you can’t tell and nor can I. We need to wait for the price to start going up before we know we had a bottom.

This means that we need to allow for some slippage at both ends and already we can assume that some waves will not be big enough to leave us with a gain. Is there a way to know from the start if the wave will be strong? This is where Elliott comes to help us by differentiating impulses from corrections and additionally giving us patterns that repeat frequently during trends. In Figure 3 we saw that a cycle was made of 8 waves, wave 1 to wave c; all the odd numbers are impulses hence 1, 3, 5, a and c, while all the even numbers are corrections so 2, 4 and b. Most of you already concluded that a correction will be smaller than an impulse; hence we will prefer impulses for trading. Our goal in trading is not to identify all possible wave configurations but to identify the trend and trade with it so we can make a profit by placing the appropriate orders. Remember that impulse waves alternate with correction waves. We want to trade impulses to minimize the number of trades and benefit from the strong price action of the dominating trend.

From the fractal effect mentioned above, we also know that a smaller pattern is nested into a larger wave, so we can adjust to a specific level of nesting to match our trading style. This is referred to as cycle or sensitivity selection since the filter used works from a percentage of price retracement.

Summary: Index