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Analytical Toolbox: Elliott Wave in ProfitSource

By Clare White, CMT, Optionetics.com | Thu March 22, 2012 2:26PM PT


EWA describes a wave structure that is based on crowd behavior and continually repeats itself. This fractal nature results in smaller waves building a more complex, similar structure on a larger scale. EW analysis can be broken into basic rules and guidelines: 

Three rules for EWA:

  •  Wave 2 cannot retrace Wave 1 by 100%
  • Wave 3 cannot be the shortest from a return standpoint (versus 1 & 5)
  • Wave 4 cannot retrace Wave 3 by 100%

Three additional guidelines that help assess a wave structure include the following:

  • Wave 3 is often the longest
  • When Wave 2 is more complex, Wave 4 tends to be more simple (alternation)
  • Fibonacci relationships often exist across the waves (price & time)

In particular, alternation helps when assessing a potential Wave 4.

For those interested in greater detail on traditional EW analysis, consider reading Frost & Prechter’s, “The Wave Principle”.


Elliott Waves in ProfitSource

ProfitSource [PS] uses a statistical calculation for time and price considerations when generating projections [TAPP] which may be different from a more pure Elliott Wave [EW] count. The primary distinction between a traditional EW wave structure and the statistical oriented PS wave structure seems to be the abbreviated Wave 1 & Wave 2 counts that appear once the prospect of Wave 3 is identified. An analyst may be more concerned with identifying the proper potential structure once a second push in the direction of the trend occurs; however, at best even a pure EW analyst has to acknowledge that alternate counts are possible as things unfold.

While PS follows the rules provided above, the early appearance of Waves 1 & 2 creates an artificially long Wave 3 that may allow an excessive Wave 4 retracement. The user really needs to determine if their focus is on count reliability using PS techniques or if their analysis requires an approach more consistent with the guidelines provided. An individual can even decide to apply one or the other depending on their specific purpose.

A strong benefit to the PS  EW tool is the ability to back-test the counts generated by the PS technique. Traders who approach the market in a more systematic manner are probably more interested in the robustness of the system than the underlying psychology for the EW counts. Back-testing a set of rules and assessing the results is far more important than how precisely EW counts in PS track an approach that follows the traditional analysis.


Time and Price Projection [TAPP] Lines

Since there is no better place to go than the source, the following includes specific details from the PS user guide follow to help compare and contrast the methods.

“Once a strong impulse and corrective wave patterns have been identified, it becomes possible to extrapolate the trend into the future, and make projections of possible price targets on the price chart.

These projections can only be made for the 4th and 5th waves, the full extent of the 3rd wave must be known before the projections can be made.

These projections are referred to as time and price projections because they plot projection lines based on ranges of dates and prices generated using the same data and calculations used to identify the Elliott waves.”

The TAPP tool also uses a statistical calculation as the default, but a Fibonacci calculation is available if preferred.

In addition, users can identify a specific number of past data points to analyze or construct a standard or long-range [LR] EW structure. Again from PS:

“The Elliott Wave Long Range Hi-Lite is calculated, plotted and displayed in exactly the same way as the Elliott Wave Hi-Lite. The purpose of the Elliott Wave Long Range Hi-Lite is to analyze the same wave formation using a longer wave length. Often this will result in an Elliott Wave being included in one or more of the Elliott Wave Long Range's individual waves.

Since only one Hi-Lite can be applied to a chart at one time, having a separate Elliott Wave Long Range Hi-Lite allows for it to be overlaid on a chart already containing a normal Elliott Wave Hi-Lite.”

So basically the LR EW seeks a bigger wave structure than one that will appear when the standard EW Hi-Lite is selected.


Current Weekly EW Charts

Last week charts for the Dow Jones Industrial AverageSM (INDU) and SPY, the ETF that tracks the S&P 500® Index, were displayed with standard and long-range PS EW counts. In addition, an alternate count for INDU was provided using an approach that is more true to the traditional analysis. Two different issues arise as a result of the analysis:

  1. If the wave counts displayed are invalidated as a result of a Corrective Wave that fully retraces Wave 3 for INDU & SPY, what other roadmap maybe be available?
  2. Can PS counts be favored over a more traditional approach when completing an analysis?

The response to the second question is really a personal one the individual needs to make. The only caveat is to keep in mind the analysis does not represent a pure technique; however, it is based on a valid, systematic technique.


If INDU & SPY Wave Structures Invalidated

Figure 1 is a weekly log chart of QQQ, the widely traded ETF that tracks the NASDAQ-100® Index (NDX), with an INDU overlay from late 1999 to Mar 2012. By using a log scale you can see the gains made by the QQQ’s far outpaced those for the INDU heading into the tech bubble and as a result the declines for the QQQ’s also overshot what was experienced by INDU.


fig 1 qqq-indu

Figure 1 Weekly Line Chart for QQQ with INDU Overlay & Volume (log scale)


Even the rally from the 2002 lows saw tempered improvement for tech oriented indexes such as QQQ with the ETF failing to make new highs in 2007 as both INDU and SPY did. This was also followed by a relatively less severe decline into the 2009 low and a move above the 2007 peak that was reached in 2010 for QQQ. Neither of the other two broad indexes has been able to surpass its 2007 high at this point. Figure 2 displays a similar chart as Figure 1 with an SPY overlay.


fig 2 qqq-spy

Figure 2 Weekly Line Chart for QQQ with SPY Overlay & Volume (log scale)


Since the techs have lead the way a bit, analysts may want to consider the potential wave structure being formed when viewing standard EW or LR-EW counts in PS. Figure 3 provides the LR-EW on a weekly line chart for QQQ with the Oscillator below.


fig 3 qqq ew

Figure 3 Weekly Line Chart for QQQ with Long Range Elliott Wave Counts & its Oscillator


The Apple Effect

Although Nasdaq completed a re-weighting of the NDX index in May 2011 due to an overweight in Apple (AAPL) at approximately 20%, the stock is one again having a significant impact on QQQ movement. The re-balance brought AAPL down to an approximate 12% weighting. As of mid-March 2012, AAPL represented the following weight in the three indexes/ETFs discussed:

  1. INDU: 0%
  2. QQQ: 18.4%
  3. SPY: 4.9%

So while the wave structure displayed in Figure 3 for QQQ provides an EW that is most consistent between traditional and PS techniques, the bigger question may be what will Apple do? Is movement in one stock sufficient to lead broader sectors with it?


Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.


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