\) Wiley Traders Advantag TTL reyes acts UNVEILING THE lel: 1 ote) NLD Boe Neuen eB IUWILEY TRADER’S ADVANTAGE SERIES John F. Ehlers, MESA and Trading Market Cycles Robert Pardo, Design, Testing, and Optimization of Trading Systems Gary Klopfenstein and jon Stein, Trading Currency Cross Rates Robert Fischer, Fibonacci Applications and Strategies for Traders Fibonacci Applications and strategies or Traders Hobert Fischer Series Editor: Perry J. Kaufman John Wiley & Sons, Inc. New York * Chichester * Brisbane * Toronto « SingaporeThis text is printed on acid-free paper. Copyright © 1993 by John Wiley & Sons. Inc. All rights reserved. Published simultaneously in Canada, Reproduction or translation of any part of this work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright owner is unlawful. Requests for permission or further information should be addressed to the Permissions Department, Jchn Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance 1s required, the services of a competent professional! person should be sought, From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. Library of Congress Cataloging tn Publication Data: Fischer, Robert, 1941 June 17— Fibonacci applications and strategies for traders / by Robert Fischer. p. em. — (Wiley trader’s library} Includes index. ISBN 0-471-58520-3 1. Speculation. 2. Stocks. 3. Commodity exchanges. 4. Fibonacci numbers. I. Title. Il. Series HG6041.F573 1993 332.f4—de20 Printed in the United States of America 1OS9S7654321 0 Ye To Jens and Claudius, who graciously tolerated my absences, and who were missed over the many years more than f can ever say.aden ACKNOWLEDGMENTS In 1977 Mr. Joachim Bahr-Volirath of Germany introduced me to the principles of Elliott and Fibonacci. Without the generous sharing of his knowledge—the foundation for this book, I could never have pro- ceeded. Thank you, Mr. Bahr! After my 1983 Fibonacci seminars, I was fortunate to meet Homer Russell. Homer did an incredible job creating the software on the loga- rithmic spiral and time analysis used in this book. Without Homer’s programming skills, most of the substantiation of the theory would not have been possible, Even though the knowledge and the programs have been in place since 1985, it took until 1992 for me to put the loose ends together. It started with a visit to Omega Research, Inc. in Miami. Bill Cruz gave me the necessary support to print most of the charts with TradeSta- tion, one of the leading on-line technical information systems. More importantly, I got to know Samuel Tennis. Sam is a senior software technician with Omega Research. His programming skills made it possible for me to analyze corrections and extensions in a way never before possible. Sam’s personal engagement contributed substantially to this book. My biggest problem was getting mentally organized to write this. My son, Jens, a student at the University of Cologne, Germany, was of * Vil *vill * ACKNOWLEDGMENTS invaluable help in getting me started and guiding me through the con- cepts from one chapter to the next. Working so closely with my son was truly the great reward of this book. Germany is far away and writing in a second language is any- thing but easy. Whenever I had a chapter drafted, I gave it to Anne Cavanagh, With her indepth knowledge of the markets and her writ- ing skills, she helped to get this book finished. Mr. Perry Kaufman and I have come a long way together. We col- laborated on my first work in 1979, but this time Perry gave me so much more. It is his flair for the written word that shapes this book— not to mention his patience and continued drive for perfection (which hurt at times, but made me work even harder). Thank you, Perry! RF. PREFACE This book deals with the most fascinating subject in stock and com- modity analysis. It is the integration of Nature’s Law (seen as a behav- ioral phenomenon} into price studies to create a serious and reliable investment tool. New discoveries with the Fibonacci summation series open the window for a price-time analysis that can pinpoint tops and bottoms with a stunning accuracy. For 50 years, R.N. Elliott has remained a legend for legions of analysts. Without his ideas, this book could never have been written. His brilliant deductions include: * Market swings are a reflection of human behavior. * Human behavier can be related to a phenomenon of nature. * Nature’s law can be measured by using the Fibonacci summation series. From his findings, published in The Wave Principles, Elliott claims that he can forecast price movements. Here we separate ourselves from Elliott. We consider this impos- sible and will prove it. Because of the wave count, the Elliott concept becomes highly subjective. *ix sx * PREFACE Instead, we approach the markets by focusing strictly on the Fibonacci summation series and ignoring the wave count. This re- moves all subjectivity and replaces the uncertainty with definitive, tested rules. The introduction of entry and exit rules makes disci- plined, even automatic trading possible. The book begins with an indepth study of the Fibonacci summa- tion series, emphasizing the Fibonacci ratio. It is always surprising to learn that major achievements in the fields of natural science, nuclear theory, radio, and television have this ratio in common. The Fibonacci ratio 1s not just a numbers game but one of the most important mathe- matical presentations of natural phenomena ever discovered. We apply this ratio as a geometric tool to equity and commodity price swings using techniques never seen before. The Fibonacci ratio is best used in forecasting correction targets. However, different strategies are presented, including a very short- term approach for those investors who do not want to hold a position longer than one or two days. A computer study was used to confirm the validity of this strategy. In addition, the Fibonacci ratio is used to analyze price targets on extensions. Extensions happen in run-away markets, An invest- ment entered at the end of the extension is considered the safest strat- egy in the Elliott concept. I introduced the idea of time analysis in 1983 at a seminar in Chicago, Nine years later, with the aid of a computer, it is now possi- ble to show that this analysis is a valid investment alternative. The final chapter introduces the logarithmic spiral, the invest- ment tool that takes a lot of imagination to believe in. Even though we now have a computer program to draw the spirals, it took us many years to understand it and to develop rules that make it easy to use for investment decisions. This spiral is the link between Nature's Law and human behavior, expressed in the price pattern of stocks and com- modities. Price patterns don’t happen by accident. The logarithmic spiral allows us to analyze market swings both “price and time” with a precision never seen before. This book is intended to be educational. Within the size limits of this book, the concepts are presented thoroughly with detailed exam- ples. I hope that you find these ideas as exciting, enlightening, and useful as I have. ROBERT FISCHER Chicago, [linois THE TRADER’S ADVANTAGE SERIES PREFACE The Trader’s Advantage Series is a new concept in publishing for traders and analysts of futures, options, equity, and generally all world eco- nomic markets. Books in the series present single ideas with only that background information needed to understand the content. No long in- troductions, no definitions of the futures contract, clearing house, and order entry. Focused. The futures and options industry is no longer in its infancy. From its role as an agricultural vehicle it has become the alterego of the most active world markets. The use of EFPs (exchange for physi- cals) in currency markets makes the selection of physical or futures markets transparent, in the same way the futures markets evolved into the official pricing vehicle for world grain, With a single tele- phone call, a trader or investment manager can hedge a stock portfolio, set a crossrate, perform a swap, or buy the protection of an inflation index. The classic regimes can no longer be clearly separated. And this is just the beginning. Automated exchanges are pene- trating traditional open outcry markets. Even now, from the time the transaction is completed in the pit, everything else is electronic. “Program trading” is the automated response to the analysis of a * xi *xi « THE TRADER’S ADVANTAGE SERIES PREFACE computerized ticker tape, and it is just the tip of the inevitable evolu- tionary process. Soon the executions will be computerized and then we won't be able to call anyone to complain about a fill. Perhaps we won't even have to place an order to get a fill. Market literature has also evolved. Many of the books written on trading are introductory. Even those intended for more advanced audi- ences often include a review of contract specifications and market mechanics. There are very few books specifically targeted for the ex- perienced and professional traders and analysts. The Trader’s Advan- tage Series changes all that. This series presents contributions by established professionals and exceptional research analysts. The authors’ highly specialized tal- ents have been applied primarily to futures, cash, and equity markets but are often generally applicable to price forecasting. Topics in the series will include trading systems and individual techniques, but all are a necessary part of the development process that is intrinsic to im- proving price forecasting and trading. These works are creative, often state-of-the-art. They offer new techniques, in-depth analysis of current. trading methods, or innova- tive and enlightening ways of looking at still unsolved problems. The ideas are explained in a clear, straightforward manner with frequent examples and illustrations. Because they do not contain unnecessary background material they are short and to the point. They require careful reading, study, and consideration. In exchange, they con- tribute knowledge to help build an unparalleled understanding of all areas of market analysis and forecasting. I first met Robert Fischer through his manuscript, Stocks or Op- tions? Programs for Profits (Wiley, 1980). It has originally been pub- lished in German and he was struggling to make the concepts clear to English-speaking readers. I was impressed by his intense desire to com- municate that information to others. I helped him with the translation because of my belief that every author wants the quality of his or her publication to be the very best. Robert has always been fascinated by the patterns that continu- ally appear on price charts. Long before his options book, he had de- voured all the information available on Elliott’s wave principles. He traded Elliott’s method for years, always looking for ways to improve its consistency and remove subjectivity. When he began to realize the importance of Fibonacci numbers within chart analysis, you could see the electricity in his research. He THE TRADER’S ADVANTAGE SERIES PREFACE ¢ xiii absorbed the subtleties of Fibonacci ratios, studying plants, architec- ture, and human behavior. In 1983, 1 attended the Fibonacci Sem1- nars where Robert introduced the use of fume goal days as a method of forecasting based on Fibonacci ratios. Everyone was enthralled by the concept that human behavior often favored certain proportions. While most traders now embrace Fibonacci retracement levels of 38 percent, 50 percent, and 62 percent, Robert was still far ahead of them by ap- plying these ratios to forecasting event days. He added depth and con- i cy to chart trading. eet he was still eahappy with the results. I watched Robert search to find a solution that was more accurate and yet consistent with what he believes is the underlying behavioral force in the market. Then he found the logarithmic spiral, one of the most sophisticated phenomenon in nature. Integrated into his analysis, it combines both price and time in a dynamic way. In the mid-1980s, I was asked to program the formulas so that these logarithmic spirais could appear on a screen along with the price chart. A trader would be able to sit and watch price movement as it reached a support or resistance level indicated by the spiral. Being good at math, I underestimated the difficulties and was soon swim- ming in pages of formulas. And, this was before I got to the point of deciding whether to rotate the spiral] clockwise or counterclockwise. Fortunately, it was just then that Robert found Homer Rus sell. I made a graceful exit, but was disappointed that Homer didn’t seem to need any of my equations. It wasn’t long before the logarithmic spiral program was operational. In this book, Robert Fischer covers all of the important steps that resulted in combining Elliott and Fibonacci in his unique way, bring- ing it to the point of its development today. It is filled with new ideas and clear expectations. Until you reach the very end, the techniques require no mathematical skills. After that, a computer program pro- vided in Appendix B will do the rest. I am very pleased that Robert has been able to write this book. [ know of no one with a better understanding of Elliott’s method and Fibonacci’s principles, and no one who has worked harder to put them together. PERRY J. KAUFMAN Vermont dune 1993CONTENTS CHAPTER 1 THE FIBONACCI RATIO The Fibonacci Summation Series The Divine Proportion in Nature The Fibonacci Ratio in Geometry CHAPTER 2 THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL Elliott’s Market Patterns Fibonacci Ratio Trend Channels Summary CHAPTER $3 WORKING WITH A 5-WAVE PATTERN Predicting the End of Wave 5 Using a Trend Channel Predicting the End of Wave 5 with Fibonacci Ratios The Amplitude of Waves 1, 2, and 3, and the Fibonacci Ratio 0.618 Investing with Options Summary CHAPTER 4 WORKING WITH CORRECTIONS Rules That Are Reliable When Not to Invest Size of Corrections * xv © oh oS — 14 14 20 21 25 26 29 33 40) 42 45 46 49 50x¥i ¢ CONTENTS Corrections in a Long-Term Trend Corrections in a Short-Term Trend Big Corrections and Trend Changes Use of the Options Market Summary CHAPTER 5 WORKENG WITH EXTENSIONS Extensions in Wave 3 Extensions in Wave 5 Using the Options Market Summary CHAPTER 6 MULTIPLE FIBONACCI! PRICE TARGETS Combining Daily 5-Wave Patterns and Weekly Corrections Combining Extensions and Corrections Summary CHAPTER 7 TIME ANALYSIS Time Goal Days Trading Using Time Analysis More on the Structure of Time Goal Days Review Additional Rules Summary CHAPTER 8 COMBINING PRICE AND TIME Concept of Combining Price and Time A British Pound Example Summary CHAPTER 9 THE LOGARITHMIC SPIRAL The Concept of the Spiral More on the Structure ef the Spiral Working with the Spiral Summary APPENDIX A THE GOLDEN SECTION COMPASS APPENDIX B SPIRAL EQUATION AND COMPUTER PROGRAM INDEX oa 54 68 7 7 oa & 7 7 87 93 9 oe a 95 $5 100 102 103 104 106 113 121 122 124 127 127 130 132 133 134 138 152 161 163 165 167 Fibonacci Applications and Strategies for Iraders1 THE FIBONACCI RATIO FHE FIBONACCI SUMMATION SERIES Let your imagination soar. Think of the universe, the constellations, the galaxy. Contemplate the beauty and form of al! the wonders of na- ture; the trees, the oceans, flowers, plant life, animals, and even the microorganism in the air we breathe. Give further thought to the achievements of man in the fields of natural science, nuclear theory, medicine, radio, and television. It may surprise you to learn that all of these have one thing in common—the Fibonacci Summation Series. in the thirteenth century, Thomas of Aquinas described one of the basic rules of aesthetics—man’s senses enjoy objects that are prop- erly proportioned. He referred to the direct relationship between beauty and mathematics, which is often measurable and can be found in nature. Man instinctively reacts positively to clear geometrical forms, in both his natural environment and in objects created by him, such as paintings. Thomas of Aquinas was referring to the same prin- ciple that Fibonacci discovered. Fibonacci, a mathematician, lived in 1175. He was one of the most illustrious scientists of his time. Among his greatest achieye- ments was the introduction of Arabic numerals ta supersede the Ro- man figures. He developed the Fibonacci summation series: 1, 1, 2, 3, 4, 8, 18, 21, 34, 55, 89, l44, . | * 1 +2 * THE FIBONACCI RATIO This mathematical series develops when, beginning with 1, 1, the next number is formed from the sum of the previous two numbers. But what makes this series so important? The series tends asymptotically (approaching slower and slower) toward a constant ratio. However, this ratio 1s irrational, that is, it has a never-ending, unpredictable sequence of decimal values stringing after it. It can never be expressed exactly. If each number in the series is divided by its preceding value (e.g., 13 + 8), the result is a ratio that oscillates around the irrational 1.61803398875 ... , being higher one time and lower the next. But never in eternity can the precise ratio be known to the last digit. For the sake of brevity, we will refer to it as 1.618, This ratio had begun to gather special names even before Luca Pacioli (a medieval mathematician) named it the Divine Proportion. Among its current day names are the Golden Section, the Golden Mean, and the Hatio of Whirling Squares. Kepler calied the ratio “one of the jewels in geometry.” Algebraically it is generaily designated by the Greek letter phi (@ = 1,618), The asymptotic tendency of the series, its ratio’s ever-tightening oscillation around the irrational phi, can be best understood by show- ing the ratios of the first few entries in the series, This example takes the ratio of the second entry to the first, the third te the second, the forth to the third, and so forth: L:1 = 1.0000, which is lower than phi by 0.6180 2:1 = 2.0006, which is higher than phi by 0.3820 3:2 = 1.5000, which is lower than phi by 0.1180 oOo: = 1.6667, which is higher than phi by 0.0486 8:5 = 1.6000, which is lower than phi by 0.0180 As we continue in the Fibonacci summation series, each member wu] divide into the next one by a closer and closer approximation of phi which can never be reached. We will see later that the individual numbers in the Fibonacci summation series can be seen in commodity price movements. The swings of the ratios around the value 1.618 by either higher or lower numbers will be found in the Elliot Wave Principle described as the Rule of Alternation. Man subconsciously seeks the Divine Proportion; it satisfies his comfort level, Dividing any number of the Fibonacci sequence by the following number in the series asymptotically approaches the ratio 0.618, which THE DIVINE PROPORTION IN NATURE * 3 is simply the reciprocal of 1.618 (1 + 1.618). But this 1s also a very un- usual, even remarkable phenomenon. Since the original ratio has no end, this ratio must also have no end. Another important fact is that the square of any Fibonacci num- ber is equal to the number in the series before it, multiplied by the number after it, plus or minus 1. 52 -(3 x Bi+1 B82 =(5 x 13)-1 1382 =(8 Xx 21)4+1 Plus and minus continua! ly alternate. Again this phenomenon 1s an 1m- plicit part of the Elliott Wave Principle called the Rude of Alternation, It states that complex corrective waves alternate with simple ones, strong impulse waves with weak impulse waves, and so on, THE DIVINE PROPORTION IN NATURE It is remarkable how many constant values can be calculated using the Fibonacci sequence, and how the separate figures of the sequence recur in so many variations. However, it cannot be stressed too strongly that this is not just a numbers game but the most important mathematical presentation of natural phenomena ever discovered. The following illus- trations depict some interesting applications of this mathematical sequence. The Pyramid of Gizeh Many people have tried to penetrate the secrets of the Pyramid of Gizeh. It is different from the other Egyptian pyramids because it is not a tomb, but rather an unsolvable puzzle of figure combinations. The marvelous ingenuity, skill, time, and labor used by the designers of the pyramid to erect a perpetual symbol demonstrates the supreme importance of the message they desired to convey to posterity. That era was preliterary and prehieroglyphic and symbois were the only means of recording inventions. The key to the geometrical and mathematical secret of the Pyra- mid of Gizeh, so long a puzzle to mankind, was actually handed to Herodotus by the temple priests when they informed him that the pyramid was designed in such way that the area of each of its faces was equal to the square of its height (Figure 1-1).4 © THE FIBONACCI RATIO Area of triangle 356 x 440/2 = 78,320 Area of square 28) x 280 = 78,400 Figure 1-1 Structure of Pyramid of Gizeh. One edge of the Pyramid of Gizeh is 783.3 feet long, the height of the Pyramid is 484.4 feet. The length of one sideline divided by height leads to the phi ratio 1.618. The height of 484.4 feet corresponds to 5,813 inches (5-8-13)—figures from the Fibonacci sequence. These interesting observations give a clue that the pyramid was designed to incorporate the phi proportion 1.618, Modern scientists tend towards the interpretation that the ancient Egyptians built it for the sole pur- pose of transmitting knowledge they wanted to preserve for coming generations. Intensive research at the Pyramid of Gizeh has shown how far advanced mathematical and astrological knowledge was at that time. With respect to a]l proportions in and around the pyramid, the number 1,618 played the most important role. The Mexican Pyramids Not only are the Egyptian pyramids built according to the perfect pro- portions of the Golden Section, but the same phenomenon is found in the Mexican pyramids. It is conceivable that both the Egyptian and the Mexican pyramids were built at approximately the same time by people of common descent, Figures 1—-2a and b give an example of the importance of the incorporated proportion, phi = 1.618. A cross-section of the pyramid {Figure 1-24) shows a structure shaped as a staircase. There are 16 steps in the first set, 42 in the sec- ond, and 68 in the third. These numbers are based on the Fibonacci ratio 1.618 in the following way: 16 x 1.618 = 26 16 + 26 = 42 26 X 1.618 = 42 42 x 1.618 = 68 THE DIVINE PROPORTION IN NATURE * 5 a | kit ‘a an _ 1 OF oe oe a + My Fiest apn Roo S HF ! arte Ba “a0 py Ramp ia step wire 1 |] fff rl lid | | | STEP woot rf ae STU g Bu +74 : a2r3 4 SAME At : * 203 SUN PYRAMID - 3/7 =18 | 5 mt =5 SO 4/pe24 - CT) ess i= ~< ane | —) wal Le | Fe | = oe ts WJ WEST rota, ste? wots Je! FAST SECOMD ADOSADO BESTS punaps 3 =1.62-¢ (a) The Basccne 126 2792 f =— it ELEVATION ABOVE Mian SEA4 LEVEL HUN ABS 49 29 al io 640 Zz. _it 68 _ _ 2 -1059-Vz2 0 B= 1.62 = ¢ (b) figure 1-2 Number phi = 1.618 incorporated in the Mexican pyramid. (Source: Mysteries of the Mexican Pyramids, by Peter Thomkins (New York: Harper & Row, 1976) p. 246, 247. Reprinted with permission.) The Plants A different representation of Fibonacci numbers 18 found in the number of axils on the stem of a plant as it develops. An ideal case can be seen 1n the stems and flowers of sneezewort (Figure 1-3). A new branch springs from the axil and more branches grow from the new branch. When the old and new branches are added together, a Fibonacci number is found in each horizontal plane. The golden numbers come into view again if we examine the oc- currence of petals of certain common flowers. For example:6 © THE FIBONACCI RATIO Soy eoeod © fo 6 6 8 —_ 13 i” am ©, ry rJ ‘1 rs 8 os Ya, Y 3 a + a 1 Figure 1-3 Fibonacci numbers found in the flowers of sneezewort. (Source: The Divine Proportion, by H.E. Huntley (New York: Dover, 1970} p. 163. Reprinted with permission.) Tris 3 petals Primrose 5 petals Ragwort 13 petals Daisy 34 petals Michalmas Daisy 55 and 89 petals The number and arrangement of the florets in the head of a mem- ber of the composite family is a particularly beautiful example of golden numbers found in nature. We were looking for laws that worked in the past and therefore have the highest probability of continuing to work in the future. In the Mibonacci ratio, we seem to have found such a Jaw. THE FIBONACCI RATIO IN GEOMETRY The existence of the Fibonacci ratio in geometry is well known, but applying this ratio as a geometric tool to commodity prices with spi- rals and ellipses has never been done before. The reason is that it 1s necessary to use the power of computers to apply the logarithmic spi- ral and logarithmic ellipse as an analytic tool. THE FIBONACCI! RATIO IN GEOMETRY ri Both the spiral and ellipse have unusual properties consistent with the Fibonacci ratio in two dimensions, price and time. It is very likely that the integration of spirals and ellipses will elevate the inter- pretation and use of the Fibonacci ratio to another, much higher level. Up to now the Fibonacci ratio was used for measurement of correc- tions and extensions of price swings. The time element forecast was seldom integrated because it did not seem to be as reliable as the price analysis. By including spirals and ellipses in a geometric analysis, both price and time analysis can be combined accurately. The Golden Section of a Line The Greek mathematician Euclid related the Golden Section to a straight line (Figure 1-4). The line AB of length L is divided into two segments by point C. Let the length of AC and CB be a and 5, respec- tively. If C is a point such that L-a equals a:b, then C is the Golden Section AB. The ratio L:a or a :6 is called the “Golden ratio.” In other words, the point C divides the line AB into two parts in such a way that the ratios of those parts is 1.618 and .618. A, a C b B be | }-—_—__, — __. Golden cut Figure 1-4 Golden section of a line. The Golden Section of a Rectangle In the Great Pyramid, the rectangular floor of the King’s chamber il- lustrates the Golden Section (Figure 1-5). A “Golden Rectangle” can best be demonstrated by starting with a square—the basic area of the Pyramid of Gizeh. Side AB of the square ABCD in Figure 1-5 is bi- sected, With the center FE and radius EC, an arc of a circle is drawn cutting the extension of AB at F Line FG is drawn perpendicular to AF, meeting the extension of DC at G. Then AFGD is the Golden Rectangle. According to the def. inition, the Golden Section Rectangle is 1.618 times longer than it is wide. The ratio of its proportions is therefore phi: 1.618:1Boe THE FIBONACCI RATIO D CG G Figure 1-5 Golden section of a rectangle. Greek architects and sculptors incorporated this ratio into their work. Phidias, a famous Greek sculptor, made use of it; the propor- tions of the Parthenon at Athens illustrate this. Built in the fifth cen- tury B.C., it is based on a triangular pediment, which is still intact. Its dimensions exactly fit into the Golden Rectangie. [t stands as an ex- ample of the aesthetic value of this unique shape. The Logarithmic Spiral The only mathematical curve to follow the pattern of growth is the /og- arithmic spirai, expressed in the spira mirabilis or the nautilus shell (Figure 1-6). The logarithmic spiral is called the most beautiful of mathematical curves. This spiral has been a common occurrence in the natura] world for millions of years. The Golden Section and the Fibonacci series are all associated with this remarkable curve. Figure 1—6 shows a radiograph of the shell of the chambered nau- tilus (nautilus pompilius). The successive chambers of the nautilus are built on the framework of a logarithmic spiral. As the shell grows, the size of the chambers increases, but their shape remains unaltered. We will demonstrate the geometry of the logarithmic spiral us- ing the Golden Rectangle ABCD (Figure 1-7) with AB: BC = phi: i. Through point £, called the “Golden Cut” of AZ, line EF is drawn per- pendicular to AB cutting the square AkFD from the rectangle. The remaining rectangle EBCF is a Golden Rectangle. If the square EBGH is lopped off, the remaining figure HGCF is also a Golden Rectangle. Assume that this process is repeated indefinitely unt! the limiting rectangle O is so small that it is indistinguishable from a point. iF at a K. a a * = “3 ne we + i) ame THE FIBONACCI RATIO IN GEOMETRY * 9 Figure 1-6 Logarithmic spiral. (Source: The Divine Proportion, by H.E. Huntley (New York: Dover, 1970) p. iv, Reprinted with permission.) The limiting point O is called the pole of the equal angie spirai, which passes through the Golden Cuts D, EF, G, J... (the sides of the rectangle are nearly, but not completely, tangential to the curve). The relation of the Fibonacci series is evident from Figure 1-7, for the spiral passes diagonally through opposite corners of successive squares, such as DE, #G, GJ, . . . . The lengths of the sides of these squares form a Fibonacci series. If the smallest square has a side of length d, the adjacent square must also have a side of length d. The a F J Figure 1-7 Geometry of the logarithmic spiral. (Source: The Divine Proportion, by H.E. Huntley (New York: Dover, 1970) p. 101. Reprinted with permission.)JO « JHE FIBONACCI RATIO Figure 1-8 Logarithmic ellipse. (Source: The Divine Proportion, by H.£. Huntley (New York: Dover, 1970) p. 71. Reprinted with permission.) next square has a side of length 2d (twice as long), the next of 3d, and soon, forming the series Id, Id, 2d, 3d, 5d, 8d, 18d, . . . whichis ex- attly the Fibonacci Series J, 1, 2, 3,5, 8, 78... . Two segments of the spiral may be different in size, but they are not different in shape. The spiral is without a terminal point; while growing outwards (or inwards) indefinitely, its shape remains un- changed. The logarithmic spiral is the link between the Fibonacci Summation Series and the World of Nature. The Logarithmic Ellipse Important curves are found in nature. The most significant to civi- lization include the horizon of the ocean, the meteor track, the parabola of a waterfall, the arcs traced in the sky by the sun and the crescent moon, and the flight of a bird. An ellipse is the mathematical term for an oval. Each ellipse can be precisely designated by only a few characteristics. The extreme form of an ellipse is the parabola (Figure 1-8), which can be repre- sented mathematically as: yv? = daox Point P is equidistant from a fixed point F' (the focus) and a fixed line ZM (the directrix). The curve is symmetrical about the axis. toe ape 2 STE oe a 2 THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL Ralph Nelson Elliott was an engineer. After a serious illness in the early 1930s, he turned to the analysis of stock prices, especially the Dow Jones Index. After a number of remarkably successful forecasts, Elliott published a series of articles in Financial World Magazine in 1939. In these, he first presented his contention that the Dow Jones Index moves in rhythms. According to Elliott, everything moves with the same pattern as the tides—low tide follows high tide, reaction fol- lows action. Time does not affect this scheme, because the structure of the market in its entirety remains constant. In this chapter we will review and analyze the following concepts of Elliott: ¢ Nature’s Law * The “Secret of the Universe” * The Wave Principle * Interpretative market letters. The focus of this section will be on the main areas of Elliott’s work that have long-lasting value. Even if we do not agree with some * J1 «#72 © THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL of Elliott’s findings, he must be admired for his ideas. We know how difficult it is to create a new concept without the technical support we have available today. When we began to study Elliott’s work in 1977, it was a tremendous struggle to get the data needed for an indepth anal- ysis. How much more difficult must it have been for Elliott when he started his work! With the computer technology available today, we have the ability to test and analyze quickly, but it is still necessary to have Elliott’s ideas in order to begin. Elliott wrote, “Nature’s Law embraces the most important of all elements, timing. Nature’s Law is not a system, or method of playing the market, but it is a phenomenon which appears to mark the progress of all human activities. Its application to forecasting 1s revolutionary.”* Elliott based his discoveries on Nature’s Law. He notes, “This law behind the market can only be discovered when the market is viewed in its proper light and then is analyzed from this approach. Simply put, the stock market is a creation of man and therefore re- flects human idiosyncrasy” (Elliott, p. 40). This chance to forecast price moves motivates legions of analysts to work day and night. We will focus on the ability to forecast, and try to answer whether or not it is possible, Elliott was very specific when he introduced his concept. He said, “All human activities have three distinctive features, pattern, time and ratio, all of which observe the Fibonacci summation series” (Elliott, p. 48). Once the waves can be interpreted, the knowledge may be applied to any movement as the same rules apply to the price of stocks, bonds, grains, cotton, and coffee. The most important of the three factors is pattern. A pattern is always in progress, forming over and over. Usually, but not invariably, you can visualize in advance the type of pattern. Bllott describes this market cycle as, “. . . divided primarily into ‘Bull Market’ and ‘Bear Market” (Elliott, p. 48). Figure 2-1 subdi- vides the bull market inte five “major waves” and the bear market into three major waves. The major waves 1, 3, and 5 of the bul] market as subdivided into five “intermediate waves” each. Then each of the in- termediate waves 1, 3, and 5 subdivides into five “minor waves.” *The Complete Writings of ALN. Biliott with Practical Application from JR. Aili, IR. Hill, Commodity Research Institute, N. Carolina, 1979 (subsequent references will cite Elliott}, p. $4. MB 22 “ FHE ELLIOTT WAVE PRINCIPLE INA NUTSHELL = 13 Minor waves © Figure 2-1 Eliiott subdivided the “perfect” stock market cycle into major, inter- mediate, and minor waves. The problem with this general market concept is that, most of the time, there are no regular 5-wave swings. More often, the 5-wave swing is the exception. To fine tune the concept, Elliott introduced a series of market patterns which take care of almost every situation. The most important ones are described next.14 © THE ELLIGTT WAVE PRINCIPLE IN A NUTSHELL ELLIOTT’S MARKET PATTERNS The 5-Wave Swing If the market rhythm is regular, wave 2 will not retrace to the be- ginning of wave lt, and wave 4 will not correct lower than the top of wave 1. If it does, the wave count must be adjusted (Figure 2-2). ' 3 a Lon Enna (b) (c) Figure 2-2 {a} Erroneous counting in a 5-waye up-swing; (b) correct counting in a 3-wave up-swing; (c) erroneous counting in a 5-wave up-swing; (d) correct counting in a 5-wave up-swing. Corrections Each of the corrective waves 2 and 4, can be subdivided into three waves of a smaller degree. The correction wave 2 and corrective wave 4 alternate in pattern. Elhott called this the rule af alternation. This means that, if wave 2 is simple, wave 4 will be complex, and vice versa. This is shown in Figure 2-3. (a) (5) Figure 2-3 (a} Wave 2 is simple; wave 4 is complex; (b) wave 2 is complex; wave 4 is simple. ELLIGTT’S MARKET PATTERNS » 15 With this remarkable observation, Elliott linked Nature’s Law with human behavior. In the sunflower, pinecone, or pineapple there are spirals that alternate by first turning clockwise and then counter- clockwise. This alternation repeats itself in the corrective wave 2 and Wave 4, There are three types of corrections: 1, Zigzag in a dewntrend (the opposite for the uptrend). (a) Minor . (b} Intermediate ¢ (c} Major 2, Flats in a downtrend (the opposite for the uptrend). i Cc (a) Minor (b} Intermediate (c) Major 3. Triangles in an uptrend or downtrend. (a) Uptrend (b) Downtrend “The student cannot be certain that a triangle is forming until the fifth wave has started,” observed Elliott (p. 53). This makes it very difficult to forecast price moves.16 © THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL Elliott noticed that the standard type of corrections were not enough to cover all market actions. Therefore he added the complex corrections, which he describes as: 1. Minor correction of three waves 2, Double sideways correction with seven waves Elliott made the statement, “It is possible however to know when elongated wave c will occur by understanding the rule of alternation” (p. 51), It is not clear that it is possible to forecast wave c; and if it were, it is not obvious that this rule is of any value for the investor. The corrections are so complex that it is impossible to determine, in advance, any of the following essential points: * The length of wave c ¢ The current state of the correction (i.e., is this a simple, double or triple formation) ° What wave will come next. Elliott never indicated either a definitive entry or exit rule to use when trading. This means that the trader must use subjectivity and initiative to implement Elliott's ideas. ELLIOTT’S MARKET PATTERNS © 17 Extensions “Bxtensions may appear in any one of the 3 impulse waves wave 1, 3, or 5 but never in more than one” (Elliott, p. 55). Figures 2-4 and 2-5 show extension for uptrends and downtrends, respectively. (a} (b} Figure 2-4 (a) First wave extension in uptrend; (b} third wave extension in up- trend; (c) fifth wave extension in uptrend. (a) (b} ° ic} Figure 2-5 (a) First wave extension in downtrend; (b) third wave extension in downtrend; (c) fifth wave extension in downtrend. “It will be noted that in each instance there are a total of 9 waves, counting the extended wave as 5 instead of 1. On rare occasions an extended movement will be composed of 9 waves, all of equal size” (Elliott, p. 55). For example, Figure 2-6 shows an uptrend and down- trend, each consisting of nine waves. According to Elliott, extensions have the following characteristics: ¢ They occur only in new territory of the current cycle; they do not occur in corrections.18 * THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL (a) {b) Figure 2-6 (a) 9-wave extension in uptrend; (b) 9-wave extension in downtrend. e They are doubly retraced, that is, a correction will pass over the same ground twice, down and up. * If extensions occur in wave 3, double retracement will be satis- fied by wave 4 and wave 5. All of the possibilities that E] hott introduced and described in his publications have not been shown here, The purpose of this re- view was to show the essence of Elliott’s ideas and follow them as they become more intricate. In its most complex stages, it is even dif- ficult for an experienced Elliott follower to appiy these rules to real- time trading. Elliott admitted, “Corrections in bull and bear swings are more difficult to learn” (p. 48). The problem seems to be that the complex na- ture of the wave structure does not leave room to forecast future price moves in advance. It looks perfect in retrospect. The multitude of rules and situations described by Elliott can be used to fit any price pattern after the fact. But that is not enough. FIBONACCI RATIO Elliott is given the most credit for introducing the Fibonacci summa- tion series as an investment tool. He wrote, “Later I found that the ba- sis of my discoveries was a law of Nature known to the designers of the Great Pyramid ‘Gizeh’ which may have been constructed 5000 years ago. Fibonacci visited Egypt and on his return disclosed a Summation Series” (Elliott, p. 42). Chapter 1 presented the series: FIBONACCI RATIO «+ 19 1,1, 2, 3, 5, 8, 13, 21, 34,55, 89, 144... Dividing any number of the Fibonacci sequence by the next higher number in the series causes the series to converge asymptoti- cally to the ratio: 1.618 (1:1.618 = 0.618) Elliott recognized the importance for this summation series and he wrote, “From experience I have learned that 144 is the highest number of practical value. In a complete cycle of the stockmarket, the number of minor waves is 144.” The breakdown of this complete cycle is shown in the Table 2-1. The entire Fibonacci summation series is employed here. Elliott stated, “The length of waves may vary, but not the number of waves, The numbers of this series are useful in timing the waves, both ad- vancing and declining” (pp. 45, 129). The general application of this principle is that a move in a par- ticular direction should continue until such time that it completes a number consistent with the Fibonacci summation series, This phe- nomenon is best illustrated in Figure 2-7. A move that extends itself beyond 3 days should not reverse until 5 days are reached. A move that exceeds 5 days should last 8 days. A trend of 9 days should not finish before 13 days, and 80 on. This basic structure of calculating trend changes applies equally for hourly, daily, weekly and monthly data. But this is only an “ideal model,” and one must never expect commodity prices to behave in such a precise and predictable manner. Elliott noted in his Nature’s Law that devia- tions can occur in both time and amplitude, and individual waves are not likely to always develop in this regular pattern. Table 2-1 Bull Bear Number of Market Market Total Major waves 5 3 8 complete waves Intermediate waves 21 13 34 complete waves Minor waves 89 55 144 complete waves20 © THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL 13 ——-> Figure 2-7 Fibonacci Summation Series integrated into the complete cycle of the stock market from Elliott. TREND CHANNELS To make his analysis more definitive, Elliott tried to solve the timing problem with trend channels, parallel lines drawn across the bottom and top of a price move. The trend channels are used only to forecast the end of wave 5. In an upwards movement of five waves, a base line is drawn across the bottom (the end) of waves 2 and 4. Then a parallel line is drawn through the highest point wave 3 (Figure 2-8). Elhott noted, “Usually wave 5 will end approximately at the par- allel line, when [an] arithmetic scale is used. However, if wave 5 exceeds the parailel line considerably and the composition of wave 5 indicates that it has not completed its pattern, then the entire movement, from the beginning of wave 1, should be graphed on semi-log scale. The end of wave 5 may reach, but not exceed, the parallel line” (p. 60). Ifthe same figures were graphed on both scales, the pictures would appear as in Figure 2-9. 5 Vt SUMMARY * 21 (a) {b) Figure 2-9 (a) Wave 5 exceeds the parallef line of trend channel on arithmetic scale; (b) wave 5 touches paraflel iine of trend channel when graphed on semi-log scale. SUMMARY The Elliott Wave principles are brilliantly conceived. They work per- fectly in “regular” markets and give stunning results when looking back at the charts. The most significant problem is that market swings are irregular. This makes it difficult to give definitive answers to ques- tions such as: * Are we in an impulse wave or corrective wave? * Will there be a fifth wave? * Is the correction flat or zigzag? e Will there be an extension in wave 1, 3, or 5?22 « THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL Ellictt said, “Fhe Principle has been carefully tested and used successfuliy by subscribers in forecasting market movements” (p. 107). In another place he mentioned, “Hereafter letters will be issued on com- pletion of a wave and not await the entire cycle. In this matter, students may learn how to do their own forecasting and at no expense. The phe- nomenon and its practical application become increasingly interesting because the market continually unfolds new examples to which may be applied unchanging rules” (p. 137). My own work with the Elliott concept, fram many different an- gles over 15 years, does not support the contention that the wave struc- ture has forecasting ability. The wave structure is too complex, especially in the corrective waves. The rule of alternation is extremely helpful, but this does not tell us, for example, whether to expect: ¢ A correction of 3 waves. * A double sideways correction. ¢ 4 triple sideways movement. It is even more unlikely that any 5-wave pattern can be forecast. The integration of extensions in wave 1, wave 3, or wave 5 complicates the problem even more. The beauty of working with the Elliott concept is not the wave count. We can only agree when J. R. Hill writes in his practical applications, “The concept presented are extremely useful but have literally driven men ‘up the wall’ as they try to fit chart pat- terns to exactness in conformity with the Elliott wave” (Elliott, p. 33). Ellicott is focused on pattern recognition. His whole work is stream- lined to forecast future price moves based on existing patterns. He does not appear to have succeeded in this area. Elliott expressed uncertainty about his wave count himself when he wrote in different newsletters, “The five weeks sideways movement was devoid of pattern [-—] a feature never before noted” (Elliott, p. 167). “The pattern of the movement across the bottom is so exceedingly rare that no mention thereof appears in the Treatise. The details baffle any count” (p. 165). “The time ele- ment [Fibonacci sequence] as an independent device, however, continues to be baffling when attempts are made to apply any known rule of se- quence to trend duration” (p. 180). “The time element is based on the Fi- bonacci Summation Series but has its limitations and can be used only as an adjunct of The Wave Principle” (Elliott, p. 186). Elliott did not realize that it 1s not the wave count that is impor- tant, but the Fibonacci ratio. It is the Fibonacci ratio that represents SUMMARY © 23 Figure 2-10 Forecasting price move from point B to point C not possible. Nature’s law and human behavior. This is what we try to measure in the market swings. While the Fibonacci ratio is constant, the wave count is confusing. By studying Eiliott’s publications carefully, a rule with forecast- ing value can be identified as “A cyclical pattern or measurement of mass psychology is 5 waves upward and 3 waves downward, total 8 waves. These patterns have forecasting value—when 5 waves upward have been completed, 3 waves down will follow, and vice versa” (El- liott, p. 112). We could not agree more with this statement. Most likely, Elliott did not realize that his strategy had taken a complete shift. Elliott tries to forecast a price move from point B to point C based on market pat- terns. We consider this impossible, and Elliott has never given a rule that showed that he was able to do this mechanically (Figure 2-19). E]}iott’s latest statement takes exactly the opposite strategy. In- stead of forecasting a price move from point B to point C, he waits to the end of a 5-wave move, because 3 waves in the opposite direction can be expected (Figure 2-11). Forecasting is possible Figure 2-11 Forecasting price move after the end of a 5-wave cycle possible.24 © THE ELLIOTT WAVE PRINCIPLE IN A NUTSHELL We totally agree with Elliott’s approach here and will comple- | ment the idea with additional rules in later sections. We will also in- r troduce other investment strategies closely related to the Fibonacci ratio. Elliott never worked with a geometric approach. We will intro- | duce logarithmic spirals as an investment tool. We strongly believe that this is the solution to the problem of combining ‘price and time.’ | This has never been done before. The concentration will be on Fibonacci. The following chapters | will work with daily and weekly data. Research shows that intraday i data can be applied where only daily data has been used thus far. More historical tests are needed before definitive rules can be set. oO | NT WORKING WITH A 5-WAVE PATTERN Returning to Elliott’s original work, one of his most important state- ments is, “A cyclical pattern or measurement of mass psychology is 5 waves upward and 3 waves downward, total{ing] 8 waves. These patterns have forecasting value—when 5 waves upward have been completed, 3 waves down will follow and vice versa” (p. 112). This appears to be the only time that Elliott gave a definitive rule with forecasting value, and many times the market behaves exactly as this pattern dictates. In this chapter, we will analyze this great observation of Elliott, combining it with additional rules to give definitive entry and exit points. Consistent with the Elliott concept, the end of the fifth wave is considered to be a safe point to invest. The rare case of an “extension in the 5th wave” will be explained later. The five waves can be seen in charts of any time period, whether intraday, daily, weekly, or monthly. The greatest problem for the in- vestor is waiting for the end of the fifth wave. To identify the five-wave swing, we must return to Elliott who said: * Under normal circumstances, wave 5 appears similar to wave 1. * Most of the time, wave 3 is the longest wave. * Wave 4 should not touch the top of wave 1 in an uptrend. es 25 «626 © WORKING WITH A 5.WAVE PATTERN 79.80 1" | Hl aT i i hk I Ih 74.31 , 10 er 4 ihre | \ i \ i lg ! il Ml yh | i b2 61.95 : i I HT vi ! - | | | tl 5.25 54 i SHISS FRANC | =35/90.M 63.1- 2.90 4.64)= 68.2 T= 9.21 RATIO= .618 DIR=+1 Figure 3-1 $-wave swing on weekly Swiss franc chart from 07-07-89 to 06-30- 92. (Source: TradeStation, Omega Research, Inc.) Following this path, the weekly chart of the Swiss franc was cho- sen to demonstrate a 5-wave swing (Figure 3-1). In Figure 3—1, the 5-wave swing is comprised of: ¢ Wave 1 from 79.80 to 70.12 « Wave 2 from 70.12 to 74.31 * Wave 3 from 74.31 to 61.95 * Wave 4 from 61.95 to 70.48 * Wave 5 from 70.48 to 55,25 PREDICTING THE END OF WAVE 5 USING A TREND CHANNEL Elliott tried to forecast the end of wave 5 by working with trend chan- nels. In an upward movement of five waves, a base line is drawn across the ends (lowest prices) of wave 2 and wave 4. A parallel line is then PREDICTING THE END OF WAVE 5 USING A TREND CHANNEL * 27 Figure 3-2 Upper line of the trend channel is penetrated. drawn across the highest point of wave 3 (Figure 3-2). When the five waves are complete, there are a number of options for entering the market. The following cases show the different possibilities for invest- ing at the time wave 5 ends. Case 7 “Usually wave 5 will end approximately at the parallel line, when an arithmetic scale is used” (Elliott, p. 60). If a trade is entered when the upper line of the trend channel is touched, it runs the risk of the market going even higher. Elliott never gave a solution for protecting an investment against the risk of a wrong analysis. Case 2 “If wave 5 exceeds the parallel line considerably and the composition af wave 5 indicates that it has not completed its pattern, then the en- tire movement, from the beginning of wave 1, should be graphed on a semi-log scale. The end of wave 5 may reach, but not exceed the paral- lel line” (Elliott, p. 60). If the market price reaches the trend channel of a semi-log chart (Figure 3-3a), it is positioned at a very good point to invest, but only when combined with the conservative entry and exit rules introduced later. The only problem is that this situation is very rare and not likely to be reached. Waiting until the price touches the upper trend line runs the risk of missing the move entirely (Figure 3—3b).26 © WORKING WITH A 5-WAVE PATTERN (a) (b) Figure 3-3 (a) Trendline on semi-log chart is touched; (b} trendline on semi-log chart is not touched. Case 3 “When 5 waves upward have been completed, 3 waves down will fol- low.” (Elliott, p. 112}. Using this approach, we would: * Wait for 5 waves to be completed. * Wait for the a,b correction. ¢ Invest when wave c penetrates the base line. This strategy is shown in Figure 3-4. This is a very conservative ap- proach, and the pattern can be found over and over again in the charts. The advantage of this strategy is that: * The market has already changed trend direction at the time of entry, and * There is still good profit potential, measured by the combined amplitude of all five waves. (For example, Figure 3—5 shows how powerful this signal can be in the Japanese yen.} Figure 3-4 Complete cycle of 5 impulse waves and 3 corrective waves. PREDICTING THE END OF WAVE 5 WITH FIBONACCI RATIOS * 29 31060 $020 \ uot | I IW l,- a I p> \ | 1880 , . it 7780 ", . a a 7100 l| \ 1b20 1 , : ily! O4 05 Ob ot ee Bh 11 19 26 oy lt 18 25 0) 08 15 za 30 G7 14 21 25 O85 12 tS fe Db 13 20 2 JAPANESE YEN @9/92.D RATIO: .618 DIR-+1 Figure 3-5 Daily chart Japanese yen from 01-01-92 to 07-25-92. Sell signal at an a-b-c correction. (Source: TradeStation, Omega Research, Inc.) The disadvantage of this strategy is that: ° The trading opportunity can be missed if there is no a-6-c correc- tion, and ¢ It is valid only for major moves. Smaller swings can often have corrections that are too small to be profitable. PREDICTING THE END OF WAVE 5 WITH FIBONACCI RATIOS The end of wave 5 may also be identified by integrating the Fibonacci ratios into the analysis. We have already learned that there are two ratios in the Fibonacci Summation Series, 1.618 and 0.618, that can be used. By integrating the Fibonacci ratios into the 5-wave pattern, shown in the weekly chart of the Swiss franc (see Figure 3-8), price goals can be calculated. But even before that can be done, the swing size must be defined.30 *¢ WORKING WITH A 5-WAVE PATTERN Swing Size A price swing 1s continuous movement in one direction. Because prices often move up and down in very small increments, it is necessary to ignore some of this “noise” by eliminating all movement that does not continue in one direction for at least a minimum point value. If, on successive days, the Swiss franc were to move +50, +100, —30, —10, +70, —20, +25, and the minimum swing size was 50 points, we would only see an upwards move of 185. The 40 and 20 point reversals were less than the 50-point filter; therefore, they are ignored. A minimum swing size is needed to make the best use of the F1- bonacci ratios. For that reason, intraday charts and examples are not used in this book. Shorter time intervals contain more “noise,” that is, price movement that is random and therefore not. predictable. In addi- tion, the magnitude of that noise is relatively large compared to the swing size possible during a short interval. The inclusion of more noise would obscure the useful information and make analysis ineffective. Elliott noted, “In fast markets, the daily range is essential, and the hourly useful, if not always essential. On the contrary, when the daily range becomes obscure, due to slow speed and long duration of waves, condensation into weekly range clarifies” (p. 139). The intent of this book is not to present empirical tests for every commodity, but to present a concept with adequate convincing data. As a guideline for examples, the minimum swing size for a daily chart of the Swiss franc, Deutsche mark, or Japanese yen will be 100 basis points. For the British pound, it will be 200 basis points. When using PREDICTING THE END OF WAVE 5 WITH FIBONACCI RATIOS * 31 Confirmed high Close below the low of the highest day Figure 3-6 Confirmation of a swing high. is the most essential element. What to buy is important, but when to buy is more important,” (p. 84) he never gave a clear rule for entering and even more important, for liquidating a position. Consider a perfect 5-wave count within a 200 basis point up- swing. It would be unrealistic to expect a profit from a short position following the strategy described in case 3. The reason for this is as follows: The minimum correction allow- able using the Elliott concept is 38% (the transformed Fibonacci ratio 0.618) of the total amplitude of a 5-wave cycle. This strategy leaves only a small profit margin for a move of 200 basis points. Yet it is a perfect strategy—one of the best in all of Ellictt’s work. If we have a larger amplitude of 1,000 basis points, | weekly charts, the swing size will be twice the size of that used on | the daily chart. | Confirmation of the Swing Highs and Lows 2 : : thats i dae ge Ch "ae . * Mirae, tea 2 wa ry . |: A swing high or low is confirmed when there is a counterswing of at least the minimum swing size in the opposite direction. For example, the minimum swing size is 100 basis points, prices must decline by at least 100 points (without being interrupted by a net upwards move of 100 points} te confirm a swing high. This is shown in Figure 3-6. ae aK 3 a af a on a “ir ¥ at ae Ls Minimum Amplitude of the Total Five Swings Elliott noted that after a 5-wave swing pattern there will be a 3-swing correction. But this approach only makes sense if the amplitude of the 5-swing pattern is reasonably big. Even though Elliott noted, “Timing (a} (b) Figure 3-7 {a) 200-point swing with 38% retracement; (b} 1000-point swing with 38% retracement.32 © WORKING WITH A 5-WAVE PATTERN waiting for the end of wave 5 and selling into the a-b-c correction is a very interesting strategy (Figure 3—7). This pattern can be seen in the markets over and over again. Wave Tf and the Fibonacci Ratio 1.618 Elliott never gave definitive rules to apply his concept to the markets. We will try to introduce rules that make the Elliott concept safer to trade. The weekly Swiss franc (Figure 3—8) will be used as an exam- ple of how the Fibonacci ratio can be used with wave 1. Whenever there is a 3-swing pattern, the extreme point of wave 5 can be calculated using the Fibonacci ratio 1.618 (Figure 3-9). It is not possible to know whether this extreme point will ever be reached, but we do know that this precalculated price level is very important should the prices reach this level. The following shows how to calculate the end of wave 5 using the ratio 1.618 applied to the weekly Swiss franc chart (Figure 3-8): Start of wave 1 79.20 9.08 x 1.618 = 14.69 Bottom of wave 1 70.12 70.12 — 14.69 = 55.43 price Difference $3.03 points target Then, the real time bottom of wave 5 was 55.25. 1" 79.20 | f y} 1.0 , "4 | Al 1 ith IH mp | QL r My Lf 70-82 | i Ht 1.618 il hay fl b2 : Ny lI fh : y ou S525 ey wl ee ee ee § _55.25 Oa Tt (p20 fe 24 BS OS 12 19 22 Fe 30 DA DS FOF oa ba Oe a Te te an oy £4 Be Be O98 ] SWISS FRANC §=(SU/90,.W 63.1- 2,90 4.64)= 68.2 T= 9.11 RATIO: .618 DIR=+! Figure 3-8 Weekly chart Swiss franc from 07-07-89 te 06-30-92. The ratio 1.618 is used with wave 1 to calculate the end of wave 5. (Source: TradeStation, Omega Research, Inc.} WAVES 1, 2, AND 3, AND THE FIBONACCI RATIO 0.618 * 33 (a) Figure 3-9 (a) The ratio 1.618 is used with wave 1 to calculate the end of wave 5; (b) the ratio 1.618 is used with wave a to calculate the end of wave c ina correction. THE AMPLITUDE OF WAVES 1, 2, AND 3, AND THE FIBONACCI RATIO 0.618 Whenever the peak of wave 3 is established, the end of wave 5 can be precalculated using the ratio 0.618 (Figure 3-10). How do we know that the peak of wave 3 is established? ¢ Wave 3 must to be longer than wave 1, and ¢In an uptrend, wave 4 should not go lower than the bottom of wave 2 (the opposite for a downtrend) {Figure 3-10). Figure 3-10 The total amplitude of the wave 1, 2, 3, is used with the ratio 0.618 to calculate the end of wave 5.34 © WORKING WITH A 5-WAVE PATTERN By analyzing the weekly Swiss franc chart, the end of wave 5 can be calculated based on the total amplitude of the first three waves multiplied by 0.618 as follows: Start of wave 1 79.20 Bottom of wave 3 61.95 Difference 17.26 points 17.26 x 0.618 = 10.66 61.96 — 10.66 = 51.29 price target Two price targets can then calculated for end of wave 5, using the two ratios 1.618 and 0.618: Amplitude of wave 1 x 1.618 = oo.20 (see p. 32) Amplitude of all 3 waves x 0.618 = 51.29 Do we know whether the forecasted price level will ever be reached? Absolutely not. We can never know in advance whether these levels will be reached. But should these levels ever be reached, there is an excellent chance of a trend change. It is better when the precalculated price targets are close. But in reality this happens very rarely. Most of the time there is a price target band—the difference between the two targets (55.25 and 51,29)—as seen in Figure 3-8. Whenever this price band exists, the trader must decide where and when to enter the market. The entry rule must be integrated into the analysis. To complete the strategy, a stop-loss rule must also be introduced, as well as a re- entry rule, profit target and trailing stops. Each of these steps will be described in detail. Entry Rule. Whenever a 5-wave swing has been identified, a confir- mation of the trend change must occur before entering the market. The following two situations are possible: i. After waiting for the precalculated price targets to be reached, the market reverses a little too early and the trade is missed. We do not want “chase” the price. 2. After waiting patiently, the buy order gets filled in the failing market. Instead of reversing exactly at the precalculated price, the market keeps falling. WAVES 1, 2, AND 3, AND THE FIBONACCI RATIO 0.618 © 35 These dilemmas can never be totally solved, but our experience tells us that the effect can be smoothed by working with an entry rule. The trade-off in working with an entry rule is that part of the move which we want to capture must be sacrificed. But it has the advantage of not entering the market too early and not suffering losses that re- sult from an extension in wave 5. (This case will also be discussed in more detail later.) The entry rule is based on the findings of Elliott, which indicate that, after every 5-wave pattern, there is an a-b-e correction, or a double retracement. Once wave a and wave b are completed, we can sell into wave c if the previous valley is broken (Figure 3-11). The opposite is true for a buy signal.) (a) (b) Figure 3-11 (a) After the end of a 5-wave pattern, we can sell into wave Cc; (b) after the end of a 5-wave pattern, we can buy into wave c. This is a very conservative approach. In our opinion, it is one of the most important of Elliott’s discoveries. This pattern can be found on the daily chart of the Japanese yen (Figure 3-12) as it develops. The approach is conservative because it has the disadvantage that the trend change might be completely missed if there is no a-6-c correction, but a strong trend reversal instead. More aggressive in- vestors who want to buy may do better entering an order in advance of the point where the close is higher than the high of the low day (and the opposite for a sell signal), as shown in Figure 3-13. Again, this is a more aggressive approach. It runs the risk of get- ting stopped out when there is a wave 5 extension. A trader must be36 * WORKING WITH A 5-WAVE PATTERN 3070 mn wat ad ye iy a | 71%b0 my si . i . h | “280 Mt, | I | | veo yt i Mh 1 { f y ul pth || 2 720 ! i 7540 | | 74bo i a ‘| 380 ft ol OF ik oY D5 Ob o ali ZB O04 tt 15 26 O84 it 18 ES OF Of 18 23 90 O17 14 2] 74-05 12 14 2a Ob 13 20 2 JAPANESE YEN 89/92.D RATIO= .618 DIR=+1 ii Figure 3-12 Sell signal after an a-b-c correction. (Source: TradeStation, Omega i Research, Inc.) ; prepared for a string of losing trades when a double or triple correc- tion follows the end of the 5th wave. The selection of entry rules de- pends on the risk preference of the investor. ‘| 1 Stop-Loss Rule. Whenever a position is entered, it should be protected if with a stop loss. One way of placing a stop loss is to use a price square. This technique can be applied to all commodities, all charts, and is easy to use. i { f Cl high Low of I Het ran tiate sign 5. highest day ‘i 1 | i lowest day tut Ly | i 1 High of ; es it Yt" t : Close | Mf i + tty than low of Lowest ; \t 9 highest day (a) (5) Figure 3-13 (a) Buy signal when the close is higher than the high of the lowest day; (b) sell signal when the close is lower than the low of the highest day. WAVES 1, 2, AND 3, AND THE FIBONACCI RATIO 0.618 * 37 One price square stop loss er One week in time Figure 3-44 Stop loss a “square” above/below the entry point. To create a price square, measure the distance of five business days (for a daily chart) or five weeks (on a weekly chart). Apply this distance “in time” to the price scale, that is, take the horizontal time measurement and use the same distance vertically for a price stop loss. This gives the stop loss in points on every chart (Figure 3-14). Because the same measurement is used for both horizontal and verti- cal, the result is considered a “square.” Place the stop loss (the price square}: * Above the high of the highest day prior to the short signal, or * Below the low of the lowest prior to the long signal. The market must close above/below the square to be stepped out. There are times when the result of this stop-loss rule is a price that is too far from the entry point for a trader, who would rather get stopped out more frequently with small losses than take fewer large losses. One solution is to place the stop loss one tick above/below the previous peak/valley after entering the market (Figure 3-15). Neither of the stop-loss selections is better or worse than the other, It is the risk preference of the individual investor which deter- mines which stop is better one. The most important strategy is to be consistent. Once a strategy is chosen by some tested method, stick with it. Figure 3-15 Stop loss above the previous peak.