Sunday, May 18, 2014

Elliott wave ambiguity on the S&P 500 chart

Private Trader went live in June 2007 and will mark its 7th birthday next month. Long-time readers will know that the the site has never been about definitive answers but rather about exploring methods for trading that, in the end, always raise new questions.

It has never gained a mass following, which is unsurprising, given the technical and often arcane nature of its explorations. To date Private Trader is approach 305,000 page views

The site began by testing a collection of popular technical measures, such as the MACD, as well as closed-source methods, such as Person's Pivot Study, the PPS, and gradually evolved into the present mix of Elliott wave analysis of charts that have produced bull or bear signals according to the Turtle trading rule set, filtered by historical odds of a successful trade in the direction of the signal.

Private Trader through the seven years has operated according to a Zen Buddhist maxim: The journey is the reward. But, being a bastion of pragmatism, Private Trader has also put trading signals into action through real trading, and reported on the results.

Although the journey truly is the reward, a winning trade feels pretty good, too.

Today's discussion has a potential impact on both the journey and practical trading.

The Elliott Wave Principle, which is an important component of how I analyze stocks, has always contained a great deal of ambiguity.

It was developed in the 1930s by R.N. Elliott, an accounting for railroads in Mexico and Central America who ended up running a consulting business in New York City as, the post Crash of 1929 era, he studied the cycles of the markets in an attempt to make sense of their seemingly senseless flucations between boom and bust.

One critic, David Aronson, an adjunct professor at the Zicklin School of Business in New York, wrote in his 2006 book Evidence-Based Technical Analysis, that the Elliott Wave Principle "has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. I contend this is made possible by the method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong."

I've applied the Elliott Wave Principle to enough charts to have learned that Aronson is entirely correct. Counting Elliott waves basically comes down to dropping down a degree in order to accomodate a few simple rules.

Although Aronson compares Elliott to the pre-Copernican astronomers in what I'm sure was intended as a devastating critique, I consder the comparsion to be compliment.

After all, the pre-Copernicans, with their Earth-centered universe and proliferation of planetary cycles, were able to use their model of the universe in practical applications for thousands of years. They predicting eclipses, the motions of the planets, the tides and the phases of the Moon.

True, the pre-Copernican model wasn't a description of the actual physical structure of the Solar System, but it worked.

And today, when we analyze the markets, we have no idea why they move as they do. In a very real sense, market analysis in 2014 is in its pre-Copernican era.

Elliott, like astronomy before Copernicus, may not be an accurate description of why markets actually move. But to an extent, it works, and for my purposes, is the best tool available.

Below is a chart of the S&P 500 index with two Elliott-wave counts of the market from the Great Depression low in March 2009, which is marked in red.

Click on chart to enlarge.
S&P 500 20 years weekly bars
One, the main count with larger numbers and letters, sees the rise from 2009 as being a five-wave subdivision within an A wave correction to the upside that is, in turn, part of a three-wave correction to the upside. In other words, the correction is what Elliott called a Zig-Zag.

The alternative count, with smaller numbers and letters, sees the rise as being a series of three-wave structures within what Elliott called a Flat, with those three-wave structures forming a chain of such structures as it forms a Double or, possibly, even a Triple.

Both are corrections within wave 4 {+5} to the downside, itself being a correction of the long rise that ended in Mach 2000.

I've tended to use the main count in my analysis. In that, I diverge from the most famous Elliottician of our era, Robert Prechter, whose work I've followed for decades. More about his excellent work is available at his website,

His most famous work is a textbook, The Elliott Wave Principle, which is my daily companion as I try to navigate the markets.

Prechter discusses this precise issue in the section "The `Right Look'" on page 77 of his textbook, in which he shows how a pattern can be counted either as an impulse wave with numbers or as a series of corrective waves, with letters.

He warns that it is "extremely dangerous" to accept wave counts that produce "disproportionate wave relationships or a mis-shapen pattern".

And indeed it is. However, disproportion and incorrect shapes are in the eye of the beholder. Seeing them is a matter of art, not mathematics, in my opinion.

I think that either count was valid up until mid-February 2013. At that point the wave B {+4} correction to the upside exceeded the start of wave A {+4}, the march 2000 peak of 1552.87.

A B wave can certainly do that, but it is quite strange within a zig-zag, which has a more directional impulse. It does happen within flats.

Also, the nature of the 2000 peak is important to the deciding how to count what follows.

If it was the end of a 3rd wave, then that implies a corrective count -- the A-B-C waves -- within the 4th-wave decline that follows. 

If the 2000 peak was the end of a 5th wave, then the S&P 500 is in a new wave 1 {+5} to the downside whose internal count is in the nature of an impulse wave to the downside, suggesting numbered waves, 1 through 5.

Also, there is the Rule of Alternation. Fourth waves tend to differ from 2nd waves of the same degree. If the 2nd wave was a Zig-Zag, then the 4th will tend to be a Flat or a Triangle, and the reverse is also true.

The count from 1784, of which wave 3 {+5} is a part, was pieced together by Prechter by combining the British and American stock markets. The conclusion that the S&P 500 is presently within a 4th wave correction probably influenced the Prechter shop's thinking, since waves in that position tend more toward flats and triangles.

However, his count show what I would label wave 2 {+5} to have been a Flat, implying that the present wave 4 {+5} would play out as a Zig-Zag.

The main count implies a greater price rise, with wave 3 {+2} producing a downside correction, to be followed by wave 5 {+2}, which will complete the present wave A {+3} one degree. That wave of higher degree will in turn correct as wave B {+3}, and then push up to the most robust wave in the series, C {+3} to the upside.

The alternate count implies that the S&P 500 is near its high in a sideways correction that will move to downside as wave B {+3}.

I would have picked up on the ambiguity sooner if I worked more often with charts of higher degree. My main attention is generally focused on the three-year chart and 90- or 180-day chart, with the occasional passing glance at the 20-year chart.

Most of my positions last for only a month or so. Within that time frame, the main count and the alternate count have similar implications: A fairly significant correction lies ahead and perhaps will begin quite soon.

However, the main count shows the symbol to be in the 3rd wave of a 3rd wave at smaller degrees of analysis, where the waves have a duration lasting from weeks to months. The 3rd wave is the middle wave of a five-wave series and can be seen as a reasonable entry point.

The alternate count shows the symbol to be in the final wave of a series at the {+2} and {+1} degree, also covering weeks to months. That count introduces far more caution into the analysis.

In terms of theory, I'm inclined to agree with Prechter and his team that the break above the March 2000 high strengthens the case for the alternate count, and I shall be working that insight into my future analysis.


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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