Nitty-Gritties of the Harmonic Elliott Wave theory that make it a superior trading tool.

This is the final part 3 of the article “The classic Elliott Wave theory is dead — Long Live the Modified and Better Elliott Wave theory!”.

Part 1. Why the classic Elliott Wave theory is useless in trading.

Part 2. What is the Harmonic Elliott Wave and how it is different from the classic version of the Wave Principle.

In the previous two parts of this article I explained what an amazing discovery made R.N.Elliott when he noted that markets not only follow similar patterns but those patterns are also subdivided into fractals, similar patterns of smaller size.

The main challenge for Elliott was to identify the most common features of that repeating pattern in order to propose formal rules that would define that pattern and make possible to use that discovery in practical trading and investing. His method was to break down that pattern into major components, waves, label them and check if those waves follow specific relationship to each other. It may sound simple but it is always a challenge to describe a natural phenomenon in a pain language of formal rules.

Apparently Elliott intuitively liked the simple and elegant solution. He came up with a theory that waves 1, 3 and 5 inside the repeating five wave fractal have internal structure identical to the same five wave fractal (see the chart 1 below).

In the first part of this article I explained that this perfect theory demanded too much from imperfect markets. Then Elliott had to introduce a number of exceptions from the original rules to explain those “deviations”. And those numerous exceptions made the rules too vague and left too much for subjective interpretations.

Then in 1990s Ian Copsey, a veteran FX trader and analyst, proposed a simple change to the five wave fractal that became a game changer. He introduced a slightly modified five wave fractal ( see the chart 2 below) and developed a new set of rules and called that new version “the Harmonic Elliott Wave theory”.

In this article we will get our hands dirty and will see in a step-by-step fashion how two traders would count a rally using those two different tools, the classic Elliott Wave theory (“EWT”) and its modification, the Harmonic Elliott Wave theory (“HEW”).

Let me tell you a story about two traders, John and David. Both trade using wave analysis. But John practices the original Elliott Wave theory while David lost faith in the traditional approach and switched to the modified version. In this story we will be watching how each trader treats every single move in the market. For simplicity let’s assume that we are dealing with a new trending move up that is starting after a large corrective move down. So the story begins when the market has just made the first move up off a major low.

There is a dramatic difference how the classic and modified theories treat the first move up off a major low (see the chart 3 above ). The classic theory proclaims that the first move up subdivided into five waves of a small degree is the first confirmation of termination of the preceding corrective wave of a larger degree. In addition, the classic theory treats such an impulsive move up as a wave ( i ) up. That classification of that initial move up as a wave ( i ) up has an important implication. That implies that the following corrective a-b-c structure would set up a stage for the wave 3 up, normally the strongest part of the rally. On the chart 4 below you can see how John, who practices the Classic Elliott Wave theory, anticipates the very next move up in a wave 3 up.

However, on the chart 5 below you can see that the market leaves John disappointed because the next move fails to stretch to 161.8% extension of the first move up that he counted as a wave 1 up. The good news for John is that he has got that expected move up. However, the move is much smaller than he expected. In this particular case on the chart 5 below the second move up was in equal in size to the initial one.

Now lets look at the same price structure through the eyes of David, a trader who practices the Harmonic Elliott Wave theory (see the chart 6 below). As soon as he gets an initial move up subdivided into five smaller subwaves (labelled as the blue (a) ) followed by a corrective a-b-c move down (labelled as the red ( b ) ) he expects another five wave move up either equal in size to the initial one or a slightly longer one. That moves up should make a new higher high over the top of the initial wave up labelled as ( a ). This trader knows that the second move up off a major low would usually extend either to 114.6% or 123.6% of the first move up in wave ( a ).

Now let’s see how both traders react to the second move up. John, who practices the classic Elliott Wave theory did not get what he had expected. He thought that after the initial move up ( counted as 1 up in blue) followed by a corrective a-b-c move down ( counted as 2 down in red) the next move would be a strong rally in wave 3 up (see the chart 5 above ). Instead he got another rally that was faded again with another corrective a-b-c down structure ( look at the left panel of the chart 7 below ). John has been practicing wave analysis for a while and he knows that it may be an extended structure of the wave 3 up. That means a case when the wave 3 up itself is clearly subdivided into five smaller waves. And he labels that second move up as wave ( i ) of 3 up and wave ( ii ) of 3 down. At this point John gets even more excited because that so called “1–2-( i )-( ii )“ setup promises start of a strong rally in wave ( iii ) of 3 up. John reloads call options again in hope to make money on a quick acceleration of the long expected rally.

In contrast, when price makes another move up and stops at 100% extension of the first move up in wave ( a ) ( the count on the right of the chart 7 above), David, who practices the HEW, treats that move as a confirmation of his count. He knew that wave 3 is not coming at the second move off a major low. His expectations about an extent of the second rally were reasonably limited and he knew where that rally would most likely stop, at 114.6%, 123.6% or 100% extensions of the first rally counted as ( a ) up. When price plays out a corrective a-b-c down structure David confidently counts the first (a) -(b)-(c) move off the major low as wave 1 up and the correction that followed as wave 2 down. Note that by that point John, who practices the classic Elliott Wave theory had to recount his chart and adjust his expectations about market intentions while David only became more confident about scenario in play because the market has been nicely following the five wave fractal as proposed by the Harmonic Elliott Wave theory.

Now let’s see what Mr.Market delivers next. We get another move up to a new higher high but once again this move can hardly be counted as a breathtaking heart of the rally, the strongest part in five wave fractal counted as wave 3. And again John, who expected that monster rally, is not only getting upset again but most likely he looses money he bet on call options. Because that weak and slow rally is not strong and fast enough to switch the sentiment of the market participants into a rally mode when traders feel euphoric and price for call options skyrockets.

At this point a regular trader who practices the classic Elliott Wave theory finally gets discouraged and stops expecting that monster rally at all. This is one of the paradoxes of how mass psychology works in financial markets. As long as the crowd expects a monster rally Mr.Market keeps the price at bay.

However, our trader John who has been practicing the classic EWT long enough knows that he still can expect that monster rally. And to accommodate to that scenario he has to adjust his count again. He brings up to life so called “double extended wave 3” fractal (see the chart 8 below ).

Under that fractal the first move off the low was wave 1 up, the second move off the low was wave ( i ) of 3 and the third move off the low was wave i of ( i ) of 3. Does that sound awkward and complicated to you? Sure it does!

If you look at the chart 9 below, you will see that according to the Harmonic Elliott Wave theory in each five wave fractal there are three major waves in the direction of the trend: 1, 3 and 5. And each of those waves are subdivided into three waves of a smaller size or ”degree”, A up, B down and C up. In the vast majority of cases wave C is stronger than wave A. And in 100% cases wave C of 3 can not be shorter that wave A of 3.

David knew that typically wave ( a ) of 3 targets 114.6% or 123.6% of wave 1 up projected from the lowest point of wave 2 down ( see the chart 10 below ). This is why when Mr.Market played another rally to a new higher high to 123.6% extension David got another confirmation that his count was right from the beginning!

David at this point could confidently predict that upcoming corrective a-b-c- move down would be a corrective wave ( b ) of 3 which would finally set the stage for that long awaited “monster” part of the rally in wave ( c ) of 3 up. The regular five wave fractal under the Harmonic Elliott wave has been protecting David from unrealistic expectations about Godzilla type rally that could make you rich soon.

Believe it or not but any trader who practices the classic version of the Elliott Wave theory is obsessed about catching that monstrous move up in wave 3. There are two reasons for that. First, the classic version does not offer any tools to predict targets of those moves preceding and following the wave ( iii ) of 3. There is no commonly accepted extensions that are supposed to nail the top of wave ( i ) of 3 and i of ( iii ) of 3. Moreover, those “extended” and “double extended” structures of the wave 3 are optional! That simply means that even the best traders proficient in the classic Elliott Wave theory do not expect to see those structures after the first move up off a major low. They are forced by the market to bring up to life those extended structures to be able to count those moves making nominal new highs but being smaller in size than wave 3.

The modified Harmonic version of the Elliott Wave theory does not have so many variations in store. It has a legacy five wave fractal that perfectly explains a trending move either in up or down direction not requiring a trader to keep adjusting his count. The huge negative consequences of those “adjustments” and “recounting” is that they kill traders’ confidence. First, any trader who tried to learn the classic Elliott Wave theory quickly comes to conclusion that it is too subjective and thus impossible to learn. Second, he faces a problem of his mentor trader proficient in the classic version not sharing with him specific technical tools of trading waves, like exact extensions that could nail completion of impulsive waves 1, 3 and 5. A mentor would offer a perfect count in the hindsight. However, once you try to follow his count in the course of development of the five wave fractal you will quickly realize that he changes his counts so often that it makes the whole process useless in trading!

I used to practice the classic version of the Elliott Wave theory for several years. I used to be a part of a large community of traders who believe that wave analysis would benefit their trading. Once I learned the rules and typical fractals offered by the classic EWT I started to trade my own analysis and publicly post my charts on one of the most popular sites dedicated to Elliott Wave theory. For a long time I was puzzled why the host, the founder of the site did not try to develop the theory. Why he would not collect important observations about repeating fractals and extensions to make the theory more useful in trading. At first, I mistakenly came to conclusion that he did not want to reveal his sacred knowledge and kept it for himself and his crew. After having practiced the better modified version of the Elliott Wave theory I think I know the explanation. He simply did not have any extra stuff to share. Not because he was lazy or not smart enough to notice something important that could help his followers. But because the theory he practiced was flawed!

Let me give you an example. Let’s imagine you download from the web a math model that is supposed to be able to predict the traffic for every hour of the next day. It has a number of inputs including temperature, expected precipitations, day of the week, month, and even GDP growth and unemployment rate. The model has manually adjustable weights so you can fine tune it to be more accurate in your predictions. You decide to run a prediction business. Every day you post predictions for your client who subscribed to your service. Sometimes you nail the actual traffic really well but sometimes your predictions is nowhere close to what your clients faced on the roads. Then you try to adjust weights to make more accurate predictions. But the story repeats itself. Again you do nail some days but you are still terribly wrong for other days. What is the root cause of those failures? Is that you who can not find the right weights and finally fine tune the model? No, the real problem is the wrong model! You can keep changing the weights of inputting data for years and you will never be able to make it work better!

After several years in that business you will probably realize that you should start using the model not for predicting the traffic but rather for explaining your customers why the traffic was so bad yesterday. Essentially, now you pivot from a business of prediction to a business of entertaining your customers!

Now lets come back to our study and check how David is dealing with that tricky market. David counted the first move up off the low as wave ( a ) of 1 and the second move off the low as wave ( c ) of 1 (please see the chart 11 below ). David knew that according to the Harmonic Elliott Wave theory the third impulsive move up off the major low is a wave ( a ) of 3, the starting and weaker part of the rally in wave 3 up.

The legacy five wave fractal proposed by Harmonic Elliott Wave perfectly describes a structure of the strongest part of the rally wave 3. The wave 3 is subdivided into three waves, ( a ) and ( c ) in direction of the trend and a corrective wave ( b ) in between. David who trades the HEW could easily predict what is going to happen next. After the first leg up in wave ( a ) of 3 tops out at one of those common extensions you should expect a corrective looking pullback down that normally subdivides into three smaller waves a, b and c (red labels on the chart 11 below).

This is when the stage is set for the “heart of the rally”, the wave ( c ) of 3 up.

The Harmonic Elliott Wave theory is much more useful in helping you to “read” charts without need to employ any indicators. It provides you with a clear path for the strongest part of the rally in wave 3. Both parts of the wave 3 in subwaves ( a ) and ( c ) should be subdivided into five smaller waves (see the chart 11 below ). Not only you can envision the path but you can also predict possible destinations of that rally by finding clusters of fibs with confluence of two specific extensions.

First, you use the same extensions of the wave 1 up not only to track wave ( a ) of 3 but also wave ( c ) of 3 up. For example, if wave ( a ) of 3 normally tops at 114.6% or 123.6% extensions of wave 1 then wave ( c ) of 3 stretches to 176.4%, 185.4% or 223.6% extensions of the same wave 1 up!

Second, in any of the five waves of the legacy five wave fractal wave ( c ) relates to wave ( a ) by specific ratios derived from Fibonacci numbers. For instance, wave ( c ) of 3 normally stretches to 123.6%, 176.4% or 223.6% of the wave ( a ) of 3 (those projections ratios are shown in grey color on top of the wave 3 on the chart 11 below).

What makes the Harmonic Elliott Wave easy to apply is that its legacy Five Wave fractal that offers a special look of the strongest part of the rally. It suggests subdivision of the wave 3 into two legs with specific relation to each other. When the classic theory says “the wave 3 can not be the shortest wave” the modified Harmonic version of EWT provides you with an efficient and precise toolbox to predict and navigate every subwave within the wave 3.

As soon as you see in the middle of the trending move two distinctive most powerful segments where the second segment of the rally is longer and has a steeper slope you know that those two waves are waves A of 3 and C of 3 up!

No lets come back for a minute to John and check how he has been handling that same rally with the help of the Classic Elliott Wave theory.

The good thing is that the Classic and the Harmonic versions of the Elliott Wave theory identically recognize that important top as the top of the wave 3. But as you can see by comparing the chart 11 and the chart 12 the micro paths to the top look very different in those two counts suggested by alternative theories. The problem with that “double extended” count suggested by the classic theory is that it comes without any reliable repeating extension levels. That essentially means that you will know that the wave 3 has completed after a significant drop in the first corrective wave ( a ) down ( red labels on the chart 12 above). An analyst who practices the classic version will be able to explain in the hindsight that wave 3 had played out all the micro waves and completed the whole micro structure of the double extended wave 3 up. But he would not be able to confidently point to a cluster of fibs as a potential reversal zone! And the Harmonic Elliott Wave theory lets you set the high probability target at the very start of that explosive part of the rally in wave (c) of 3 up.

Again, the problem is not that analysts who practice the classic version are not aware of the extension tool. The problem is that the price ordinary follows a flexible a-b-c fractal rather than a perfectly looking in theory but rigid five wave pattern. Trying to fit the actual chart with all its noisy micro moves into that rigid template of five waves inside each impulsive wave they loose connection to a natural rhythm of the market. This is why you see so many strange looking wave counts posted by people who recently started to practice the classic version of the EWT. Their waves 1, 3 and 5 may be equal in size or wave 1 may be the longest wave. That is a sign that they have to press the count even when after it becomes clear that price is reluctant to follow that perfect rigid five wave fractal proposed by R.N.Elliott.

That is also a sign that they missed the key point about the core tenet of the Elliott Wave theory. The Elliott Wave theory is not about labels or counts. You can count waves with any numbers or symbols! You only need those numbers to align the actual chart with the legacy five wave fractal. As long as you label similar waves on the chart and the model in one way you do not violate any rules.

The Elliott Wave theory is about paying attention to prevailing sentiment of the market participants. It’s about discovery that the price goes up parabolic when the majority of traders including taxi drivers is convinced that it is time to buy that stock. And the reason why it happens in the second part of the wave 3 but not in wave 1 is in the very nature of human society. This when wave 3 tops and when everyone who could buy finally buys that stock. For instance, this is exactly how Bitcoin topped in its wave 3 in December 2017. You may go back to the part 2 of this article and read how I attempted to explain the very nature of the five wave fractal by the Diffusion of Innovation theory popularized by Everett Rogers in 1960s.

Now let’s come back to the market where both traders have been tracking a pullback after wave 3 has topped. Both versions of the Elliott Wave theory treat corrective structures in the same way. But the huge difference is how strict they are with regards to defining a critical support for the corrective wave 4. The Harmonic EWT does not allow wave 4 to violate the lowest point of the wave (b) of 3 (see the chart 13 below). If that level gets violated by a pullback then then your whole count is invalidated. That clear rule is a great protection in case you went long based on the wrong bullish count. That helps you to protect your capital without hesitating and double questioning your decision. You have to quickly bail out of your long position in case your bullish count got invalidated.

Now lets see if the classic Elliott Wave theory offers you such an efficient tool of setting a hard stop loss. According to R.N.Elliott, the wave 4 can not enter into the territory of the wave 1 (please see the chart 14 below). First, if you compare now the last two charts you will see that the stop set by the Harmonic Elliott Wave is much higher. That protects your capital better. Second, the classic version is not that strict about that rule because there is an exception. In the Leading Diagonal and Ending Diagonal structures that rule does not apply at all!

Here comes the most interesting part of the story! When the top of the wave 3 is followed by a corrective decline structured as ( a ) down, ( b ) up and, finally, ( c ) down a trader, who practice either the classic or modified version of EWT, faces two scenarios. The first scenario is bullish because it assumes those three waves down were all of the wave 4 down. That implies that a new rally in wave 5 up has to follow. The second scenario is a bearish one because it assumes that this (a)-(b)-(c ) decline was only the first leg down in wave A of 4 down.

Now let me show you why a trader practicing the Harmonic Elliott Wave is less susceptible to making the wrong choice between those two scenarios.

David, who practices the Harmonic Elliott Wave expects a continuation of the rally in wave ( a ) of 5. He knows that this rally is normally has an impulsive structure and subdivided into five waves of a smaller degree. And he also knows that this wave ( a ) of 5 normally targets the previous top made by the wave 3 up. In majority of cases that wave ( a ) of 5 is not strong enough to make a sustainable break over the top of wave 3 and it follows by a corrective wave ( b ) of 5 down that should never violate the starting point of that rally. In other words, the critical support for the next pullback in wave ( b ) of 5 will be the lowest point of the wave 4 down.

The basic scenario for any trader armed with the Harmonic Elliott Wave theory is that an impulsive wave A of 5 follows a corrective wave 4 down. That is why David is confidently tracking five smaller waves off the low made by the wave 4 down and expects that rally to target the previous high.

In contrast, the classic Elliott Wave theory just does not have that pattern in its toolbox! John has two options, it is either a corrective wave B up (the second leg of a corrective wave 4 down) or its wave 5 up that normally should stretch well past the top of the wave 3 up.

For some reason, traders who practice the classic theory always tend to the bearish scenario. They keep guiding their followers that the first (a)-(b)-(c ) drop off the top of the wave 3 up was not deep enough or was too fast and therefore it was just the first leg down in wave A of 4. They stubbornly try to get a-b-c structure in that rally off the low of the wave 4 down to justify that the rally is a bull trap (see the chart 16 below). When finally the rally tops either right at the top of the wave 3 or a bit under it they call the top of the wave B of 4 up under so called regular flat corrective structure. Or in case when the rally extends to a new higher high over the top of the preceding rally in the wave 3 they still call it a corrective wave B up under an expanded or running flat corrective structure.

Both schools expect a decline off that top but they have very different expectations with regards to structure and depth of that decline.

Because John has a bearish bias and treated that rally as a corrective wave B he would expect to get the final wave C of 4 down. That wave is supposed to have an impulsive structure meaning that it has to be subdivided into five smaller waves. That C wave down is supposed to either retest the low made by the first leg of wave A of 4 (under a regular flat corrective structure ) or even break under that low ( under an expanded flat corrective structure ). Please see the chart 17 below to see John’s bearish expectation regarding a path and target for that expected wave C of 4 down.

However, in the vast majority of cases that drop makes only three waves down and stops (see the chart 18 below).

David, who has been following the Five Wave fractal as proposed by the Harmonic Elliott Wave theory gets what he expected. He gets a corrective decline in wave (b) down of 5 up. Because he considered the previous corrective wave as a completed wave 4 down he knew that a new corrective move down off the top of the wave ( a ) of 5 should make a higher low. That is actually a very important advantage of the modified version of the Elliott Wave theory over the original theory. It proposed that every new corrective wave should make a higher low meaning that it should stop over the low made by the previous corrective wave ( see the chart 19 below ). That structure is of vital importance in trading because it lets you keep moving your stop higher helping to secure a profit, better protect your capital and get important confirmation about the validity of the impulsive structure after each pullback.

Because the classic Elliott Wave theory acknowledges the Five Wave fractal with only two corrective waves 2 and 4 it can’t provide a trader with a similar way to move up protective stops. R.N.Elliott said that a corrective wave 4 can not enter the territory of the wave 1. But it can if that structure is the Ending Diagonal or Leading Diagonal. Essentially with that exception you do not have a rule at hand to use as a stop.

David knows that the Five Wave fractal will be 100% completed when the final wave ( c ) of 5 makes a new higher high. Because that final rally should also have an impulsive structure David can closely track its micro structure to precisely pinpoint a moment when the final micro wave c of v of that final bigger wave ( c ) of 5 gets terminated. You can watch my latest video explaining how such a simple technique may help you nail a bottom in such a volatile and difficult to predict trading instrument like TVIX, an 2x VIX Short-Term ETN tracking the S&P 500 VIX Short Term Futures Index.

But let’s see how John reacted to that unexpected bullish reversal after a lower high was made. As you may recall, John expected the final wave C of 4 to make a new lower low or at least to retest the low made by the previous drop. His plan was to go long when price gets a lower low completing wave C of 4. When price reverses its course after a shallow pullback and makes a new higher high many traders practicing the classic EWT would stubbornly insist its still an unusually strong fake out rally. This is when you normally see wounded bears to become vocal in their displeasure about abrupt premature termination of the move down.

But John understands that it is time to forget about that wave C of 4 and forget about lower lows. At this point the market forces him again to change his count. Now he finally acknowledges that the corrective wave 4 down was completed long ago ( see the chart 20 above ) and the rally in the final wave 5 up to a new high has been well under way.

But now John faces a new problem. The classic Five Wave fractal under the original Elliott Wave theory proposed the final wave 5 up to have an impulsive structure. But looking at the move off the low of the wave 4 down John sees just a bunch of a-b-c’s, waves subdivided into three waves, not five. And this is when a miracle happens and John starts to count impulsive waves in the same way as David does under the rules set by the Harmonic Elliott wave theory! John does not have a choice but to count that last move up as an Ending Diagonal, an exception introduced by R.N.Elliott for numerous cases when price refused to follow his perfect five wave fractal. Under this pattern every wave is subdivided into a-b-c’s, in the exact way how the Harmonic Elliott Wave theory always treats them…

Finally, when John starts to count the last rally as the Ending Diagonal he is able to pinpoint the top (see the chart 21 below ).

And David calmly counts another five waves up in the final wave ( c ) of 5 to nail the top as well (see the chart 22 below ).

But looking back you may see that the method employed by David was much more straightforward and was much less confusing. Because David followed rules proposed by the Harmonic Elliott Wave theory he was not forced by the market to update his counts several times. Moreover, David was even able to trade confidently an internal structure of the heart of the rally in wave 3 up using its (a)-(b)-(c ) subdivision which does not exist under the classic Elliott Wave theory. David could better protect his gains and capital but moving up a stop with completion of each successive corrective wave. Those are only a few advantages of the Harmonic version over the classic version of the Elliott Wave theory I could describe in a short (not really short at this point) article.

I wrote this article for my followers who many times asked me about difference between the original and modified versions of the Elliott Wave theory. There are much more tricks and useful reliable and repeating extensions and projections that work well under the five wave fractal proposed by the Harmonic version of EWT. To help my followers to learn this methodology I recorded a video course that became a best selling course on Udemy educational platform.

In conclusion, I want to reassure you that you can easily switch from the classic to the modified version as I did. Believe me you will never regret of doing that! If you never practiced the wave analysis before you are even in a better position! In any case it will not take you a lot of time and efforts to start practicing it. I encourage all my students to join my private educational chat and start posting their own analysis.

The sooner you start walking along the right path to mastery the sooner you will see improvements in your trading!

It is literally as easy as A-B-C…

Send me your questions to castawaytrader@gmail.com

Follow me on @twitter, stocktwits or facebook.

CastAwayTrader Market Analysis

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I trade and teach others to trade with Harmonic Elliott Waves. Follow me on Twitter and read my analysis on www.CastAwayTrader.com

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