Fibonacci Analysis and Elliott Wave Theory

Elliott Wave Theory

Ralph Nelson Elliott referred to three important aspects of price movement in his theory:
pattern, ratio and time. Pattern refers to the wave patterns or formations, while ratio (the
relationship between numbers, particularly the Fibonacci series) is useful for measuring
waves. The relation between time and pattern can also be measured, though some
analysts find this less reliable.

In its most basic form the Elliott Wave Theory states that markets follow a repetitive
rhythm of a five-wave advance and a three-wave retreat. The advance waves are
denoted 1-2-3-4-5 and the retreat waves are denoted a-b-c. In the advance waves'
phase, waves 1, 3, and 5 move in the direction of the trend, while waves 2 and 4 are
correction waves. After the five-wave advance is completed, a three-wave correction
begins. In the correction waves' phase, waves 'a' and 'c' move in the direction of the
retreat, while wave 'b' heads in the opposite direction.

After a three-wave retreat is complete, another five-wave advance begins and so on,
until a reversal is prompted. It is possible to see then, that each five-wave advance can
be identified as a single advance wave. Similarly, when viewed from a larger
perspective, and vice versa, each wave can be broken down into smaller waves.

Along with describing a consistency in the formation of waves, Elliott Wave Theory also
addresses a consideration of degree. According to Elliott there are many different
degrees of trends ranging from a Grand Supercycle, spanning for decades; to a
subminuette degree, covering no more than a few hours. However, the eight-wave cycle
remains constant.
Note that waves 1-2-3-4-5 advance in the direction of the underlying trend, while waves
a-b-c move against it. In the chart shown here an uptrend is described and therefore the
advance waves are moving upwards. In a downtrend the descending waves will be
referred to in the form 1-2-3-4-5, with the ascending waves addressed as a-b-c.

The largest two waves,1 and 2 here, can be subdivided into eight lesser waves that in
turn can be subdivided into 34 even lesser waves. The two largest waves,1 and 2, are
only the first two waves in a larger five-wave advance. Wave 3 of that next higher
degree is about to begin. The 34 waves that constitute a cycle can be broken down
further to the next smallest degree which would result in 144 waves.

Ratio

One of the three important aspects of price movement, as mentioned above, is ratio.
That is the relationship between the size of an advance wave and the size of its
correction wave.

Charles Dow noticed that a correction wave usually erases one, to two-thirds of the
advance wave. Elliott fine-tuned this further by determining more precise targets, as
price action tends to move in relatively predictable ratios.

The number of waves comprising Elliott Waves' cycle – 1, 2, 3, 5, 8, 13, 21, 34, 55, 89,
144 – are not just ordinary numbers, but rather they are part of the Fibonacci Number
Sequence. This series of numbers forms the mathematical base for Elliott Wave Theory.
Fibonacci Analysis

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…

The Fibonacci sequence has a number of interesting qualities:

1. The sum of any two consecutive numbers equals the next number in the series.

2. The ratio of any number to the next number in the series approaches 0.618 after the
first 4 numbers.

3. The ratio of any number to its preceding number in the series approaches 1.618, or
the inverse of 0.618.

4. The ratio of alternate numbers approaches 2.618 (or its inverse, 0.382 if moving in
the descending order of the series).

While the Fibonacci ratios have been adapted to various technical indicators, their
utmost use in technical analysis remains the measurement of correction waves.

Elliott found that very often, correction waves extend to erase 0.382, 0.5, or 0.618 of a
preceding trend. However, when the trend resumes a price target for the next wave can
also be determined using Fibonacci ratios using a 138.2%, 161.8% or 200% extension
of the previous wave.

Fibonacci retracements can be used as SAR stop-and-reverse levels in order to time an

entry, take profit or set stop-loss levels. Once a Fibonacci level has been breached,
prices are likely to continue at least as far as the next Fibonacci level.

In reality it is not always so easy to spot the correct Elliott wave pattern, nor do prices
always behave exactly according to this pattern. Therefore it is advisable for a trader not
to rely solely on Fibonacci retracements, but rather to use them in conjunction with other
technical tools.