Fibonacci and Fifth Waves

02/11/03 08:00:06 AM

by David Penn

When does an Elliott fifth wave end? Often, when a Fibonacci ratio says so.

Security: @BP
Position: N/A

One of the more common ways to determine when a fifth wave will be over in an Elliott five-wave series is to use a trend channel. This relatively simple and straightforward approach calls for casting a trend channel (a set of parallel lines running alongside the major highs and lows of the trend) so that the top of wave one and the top of wave three touch the top line of the channel, and the bottom of wave two and the bottom of wave four touch the bottom line of the channel. While not necessarily precise, this method does give a general approximation of where a fifth wave will conclude.

However, an even better (or, at a minimum, complimentary) method is provided by Robert Fischer in his text, Fibonacci Applications and Strategies for Traders, which I highly recommend for those interested in extending the capacities of their own Elliott wave analysis. While it has been long known that Elliott wave theory and Fibonacci analysis are kindred methodologies in many respects, Fischer's book does a good job in highlighting some of the ways that traders can make this compatibility practical in their own trading and investing.

Fischer provides two methods for determining the extent of a fifth wave in an Elliott five-wave series. As compelling as both methods are when used separately, combining the two helps the trader develop a range for the likely extent of the fifth wave, which can be more helpful than a single number. Method one involves measuring the length of wave one, multiplying that value by the Fibonacci ratio of 1.618, and then adding that number to the value at the top of wave one. As an example, I will use the weekly continuous futures contract for the British pound.

The British pound's five-wave bull market from its bottom late in the second quarter of 2001.

Graphic provided by: TradeStation.

The British pound bottomed in the spring of 2001, and from that time made a five-wave advance over the following year and a half. The question for pound bulls is where the last segment of this five-wave advance will end. Using Fischer's method, we can take the size of the first wave (1.3180 to 1.4353) of 0.1173 and multiply it by 1.618 for a value of 0.1898. This value can then be added to the value at the top of the first wave (1.4353) for an upside target of 1.6251.

Method two involves taking the value of the waves from the bottom of wave one to the top of wave three and multiplying that number by 0.618--another Fibonacci ratio. Here, we note that the top of wave three is at 1.5625. Thus, we would multiply 0.618 by 0.2445 (i.e., 1.5625 - 1.3180) for a value of 0.1511. This number, added to the value at the top of wave three gives us an upside target for the fifth wave of 1.7136.

We now have a price range of 1.6251 to 1.7136 for the extent of the current fifth wave in the British pound. While this range presents no hard and fast limit, it does provide an idea of when the risks of reversal become exceptional, and can serve as a sort of alert--perhaps in concert with other reversal-spotting techniques such as overbought indicators, chart patterns, 2B tests or 1-2-3 trend reversal set-ups, etc. With the weekly continuous futures British pound contract currently trading at 1.6244, those on the long side of the pound might want to consider taking some of their gains (and the gains on the long side of the pound have been substantial in 2002) off the table. The more fearless among these pound bulls may even consider taking some of those gains and parlaying them into an attempt at even greater gains during the ride down.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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