Elliott Wave Channels
What Are Throw-Overs & Throw-Unders?
Keeping Control Of Scale
Back To The Importance Of Counting
Elliott Wave Theory isn’t new. In fact, it’s been with us for literally decades. It’s named for Ralph Nelson Elliott, who was a corporate accountant by trade, and who studied and wrote about price movements in the financial markets.
Some of his conclusions are patently obvious and can be seen with a quick glance at any stock market price chart. Price changes are not linear. You’ll never find an instance where price moves up or down in a straight line. Any time the price of an asset rises or falls, it does so in a “sawtooth” pattern, so for instance, if the price is trending upward, it will go up for a time, then retreat, then trend higher before retreating again, and so on.
Here’s the magic of Elliott’s work though: When you look at that price chart, it seems to be totally random. It’s just this crazy zig-zag of increases and decreases. Elliott discovered though, that there was a strange kind of order lurking behind the apparent chaos. That in fact, those zig-zags aren’t random, but predictable, and not only that, they tend to follow a few set, repeating patterns, IF you know what to look for.
It’s not just stock prices, either. Elliott Wave Theory applies to the price of any good or service sold and can even be applied to politics (polling data and the like) and can be used to explain and predict the rise in popularity of various pop culture phenomenon. Just like “the Golden Ratio” appears everywhere in art and nature, so too are Elliott Wave patterns evident in every aspect of human behavior.
Even more interesting is the fact that the patterns are fractal.
Look at an asset’s price during the course of any given day, you see a pattern. Zoom out and look at it over the course of a month, and the same predictable, repeating patterns emerge. Zoom out to the monthly view, same thing. No matter how much you zoom in or out, you see those same predictable, repeating patterns.
The same is true if you look within a “set” of waves. You find another set of waves just like them. And another. And then another, regressing infinitely. That’s incredible, and its implications are impossible to ignore. In a very real sense then, the argument could be made that Elliott discovered fractals long before Benoit Mandelbrot did in 1975.
Even more recently, scientists have concluded that pattern formation is a fundamental characteristic of any complex system, and financial markets certainly fall into that category. Thus, decades after Elliott first published, science has proven him to be correct.
Obviously, when Elliott first published his work, there was some serious pushback. There were a lot of people who simply scoffed at the idea, insisting there was no way it could be true.
Even so, over the intervening decades, there were a small number of investment professionals who made regular use of EWT analysis and kept the flame alive, but it was very much a fringe theory. That began changing in 1977, when Robert Prechter and A. J. Frost brought Elliott Wave Theory to a wider audience with the publication of the book “Elliott Wave Principle: Key To Market Behavior.”
The book quickly became a bestseller, and Elliott Wave Theory became much more mainstream. Having said that though, its highly subjective nature makes it a somewhat controversial topic even to this day. Defenders point to their own impressive track records born of using this powerful analytic tool, while detractors point out that it’s easy to make price data fit the model in hindsight.
Both positions are true. The bottom line though, is that a lot of investors have spent time mastering the methodology, and they’ve been rewarded with handsome profits. The proof, as they say, is in the pudding.
Again, we underscore that Elliott Wave Theory is highly subjective. You can see this play out by visiting an Elliott Wave discussion forum. Different people will reach different conclusions to the same data. Of course, as time goes by, you’ll gradually see a consensus form about each developing trend, but in the early stages, you’ll often see very smart, experienced people reaching wildly different conclusions.
Because of this, we don’t recommend relying solely on Elliott Wave Theory when conducting analysis to make investment decisions. It’s at its strongest when used in conjunction with other analytic tools.
Ultimately, nobody learns to use Elliott Wave Theory because it makes a great topic of conversation at parties, or because it’s a good addition to your resume. No, people spend time mastering this form of analysis for one reason: To make better investment decisions.
While it’s certainly not a crystal ball, once you wrap your brain around it and get comfortable using it, it can sometimes feel a bit like having a crystal ball. Its main value lies in helping you find good entry and exit points for making investments.
Having a good sense of how far a price increase will run and when the price is likely to turn south again is worth its weight in gold to an investor and will dramatically increase your profits. That is, after all, the name of the game, right? By anticipating the behavior of “the herd,” you can avoid becoming part of it. So that’s why it matters.
- Channels are essential to forecasting an analysis. Without them, you’ll find that your ability to make accurate predictions will be sorely limited, so get comfortable using them early on.
- To create a channel, you need a minimum of three data points to work with. So, for instance, allow the first three waves of an impulse pattern to develop, and use those points to draw your two parallel lines such that all three termination points touch them. This gives you an expected range that will give you some indication of how far (up or down) future waves are likely to travel.
- Check yourself. Once you’ve established the channel, see what wave 4 does. If it falls outside the bounds of the channel, you’ll need to reconfigure it to prepare for and make predictions about the behavior of wave 5.
- Sometimes, you will see what Elliott described as “throw-overs” and “throw-unders,” which indicate the presence of powerful market forces at work. This can also be predictive, in that if you see wave 2 or wave 4 of an impulse wave pattern dip slightly below the bottom line of your channel, it’s a strong indicator that wave 5 will rise to a point slightly above the upper line of your channel.
- Don’t be afraid to switch back and forth from arithmetic to semi-logarithmic scale if and as it makes sense to do so. While you may see some slight variations between the behavior of the lines within your channel, you’ll also note that they are broadly similar, and will give you the same basic information.
- Volume is (or should be) an important component of your forecasting toolbox. It’s useful both in terms of verifying wave counts and in projecting when, and sometimes where extensions will occur.
- In bull markets, you’ll see an expansion or a contraction based on how quickly the price changes. A good indicator that a correction is about to come to an end is that it will often be paired with a decline of volume, which signifies a decline in selling pressure. A low-point in volume is thus an excellent indicator that the market is about to turn around.
- Observationally, the volume of fifth waves below Primary degree tends to be somewhat lower than the volume seen in wave 3
- If you see a situation where the volume of wave five is equal to or greater than the wave 3 volume, it’s a sign that the fifth wave will experience an extension
- When looking at waves above Primary degree, the volume of the fifth wave is generally higher because the longer an expansion continues, the more players enter the market. In fact, Elliott observed that at the end of any given bull market (above Primary degree) the volume tends to be at a new all-time high
- If you’re struggling to correctly define and label waves, stop to review what you know about EWT and, taking into account all that you have learned so far, think about what the pattern “should” look like, then proceed accordingly. This is often a great help to people new to the theory, as it provides a certain amount of clarity about what you’re seeing.