Elliott Wave Theory

The Elliott Waves Theory or Elliott Wave Principle (EWP) is one of the more popular price action patterns used by advanced traders and is used by some of the top fund managers. However, it is not a straight forward pattern that can be read with absolute clarity in real time. What it does provide is good risk/reward opportunities to enter in the direction of the trend.

Elliott Wave Theory was first put forward by a qualified accountant named Ralph N. Elliott in the early Twentieth century. It is closely related to the tenets of Dow Theory. Elliott studied the historical movement of the Dow Jones averages and noticed the presence of a repetitive cyclic pattern that he first described in booklet entitled The Wave Principle in 1938 and elaborated on in Nature's Law: The Secret of the Universe in 1946. Elliott identified these as natural cycles in collective investor psychology, or crowd psychology, that moves from optimism to pessimism and back again and is reflected in the price chart.

Elliott Waves
Elliott Wave Structure

In Elliott's theory, the market price moves in a repetitive wave pattern, a term borrowed from Dow Jones who likened the movement of stock prices to the ebb and flow of ocean waves. Elliott's wave pattern alternates between a five wave of progress, called a motive phase, and a three wave of counter-trend movement called a corrective phase. The five wave of the motive phase are labeled with numbers 1, 2, 3, 4, and 5, while the three waves of the corrective phase are labeled with letters A, B, and C. The first wave in the motive phase, Wave 1, moves in the direction of the emerging trend only to be interrupted by a counter-trend move labeled Wave 2. Wave 3 resumes the trend and is often the strongest wave but it too is interrupted by a counter-trend move in Wave 4. Finally, the Wave 5 moves up to the end of the trend. The three wave corrective phase takes over with Wave A marking the end of the previous trend. Wave B attempts to re-establish the previous trend but fails as Wave C again moves against the previous trend. In this way, the five waves of the motive phase and the three waves of the corrective phase combine to form a complete cycle.

Elliott found these waves in all time-frames and discovered that a wave structure was fractal, meaning that the wave structure would consist of smaller subordinate waves or subwaves that form the same five and three wave structure. Each successive smaller wave structure is a wave structure of a lower degree, though these structures do not necessarily correspond to a smaller time-frame and may appear in the same time-frame as the larger wave structure. Elliott identified several degrees of wave structures, which he classified and labeled, from largest to smallest as:

Wave degreeMotive Wave LabelsCorrective Wave Labels
Grand Supercycle[I] [II] [III] [IV] [V] [A] [B] [C]
Supercycle(I) (II) (III) (IV) (V) (A) (B) (C)
Primary[1] [2] [3] [4] [5] [A] [B] [C]
Intermediate(1) (2) (3) (4) (5) (A) (B) (C)
Minor1 2 3 4 5A B C
Minute[i] [ii] [iii] [iv] [v] [a] [b] [c]
Minuette(i) (ii) (iii) (iv) (v) (a) (b) (c)
Subminuettei ii iii iv v a b c

It is important to note that motive waves do not always indicate a bullish price advance and a corrective wave does not always indicate a bearish price decline. Instead, motive waves move in the direction of the wave of one higher degree. Thus, in a motive wave, the subordinate waves 1, 3, and 5 are also motive waves while the subordinate waves 2 and 4 are corrective and move against the direction of the wave of a higher degree. Similarly, in a corrective wave, Wave A and Wave C are motive while Wave B is corrective. Note: motive wave are sometimes called impulse waves, but the two terms are not synonymous. A motive wave can be either an impulse wave or it can be a less common diagonal triangle.

Immutable Elliott Wave Rules

Elliott Wave Theory has only three simple rules that apply to impulse waves and should never be broken:

  1. Wave 2 may not retrace beyond the start of Wave 1 regardless of whether it is an impulse wave or a diagonal triangle. Should Wave 2 move beyond the start of Wave 1 then what was assumed to be Wave 1 and Wave 2 still are part of a corrective phase.
  2. Wave 3 need not be the longest wave but it may not be the shortest of the three motive waves, namely waves 1, 3 and 5. Wave 3 is normally, but not always, the strongest and longest of the motive waves. It cannot be the shortest.
  3. Wave 4 may not penetrate the price territory of Wave 1, except when is part of a diagonal triangle. On leveraged markets, such as futures and ForEx markets, Wave 4 may not close beyond the close of Wave 1. Leveraged markets tend to have moments of volatility that create spikes between the high or low of the bar and the actual close. These short lived spikes often have little technical value.

When one of these rules is broken, it indicates that an error has been made in wave counting and the wave count needs to be reassessed.

In addition to these rules are a few guidelines that are typical of Elliott waves but do not always occur and thus are guidelines rather than rules. These guidelines include extension, truncation, alteration, channeling, and equality.

Elliott Waves and Fibonacci

In Nature's Law Ralph Elliott stated that the Fibonacci sequence is the mathematical basis for the Wave Principle. The Fibonacci summation series is the basis for the wave count in Elliott Wave Theory. There are 5 motive waves and 3 corrective waves in one complete cycle. Thus a complete cycle consists of 8 waves (5 motive waves and 3 corrective waves). The subordinate waves also reflect the Fibonacci summation series as 21 subordinate waves make up the motive wave (5-3-5-3-5) while 13 subordinate waves make up the corrective wave (5-3-5). Together they make 34 subordinate waves. The sum of the subordinate waves of a lesser degree will also end in a Fibonacci number.

Elliott Waves are also related by Fibonacci proportions. R.N. Elliott explained that both impulsive and corrective waves adhere to specific Fibonacci proportions, with the three motive waves tending to be related by Fibonacci ratios of equality, 1.618, or 2.618, while corrections often retrace to the 38.2% or 61.8% Fibonacci retracement levels of the preceding motive wave.

The 3 Rules of Elliott Waves

There are only three simple rules in Elliott Wave Theory that apply to impulse waves and should never be broken. The rules are:

  1. Wave 2 may not retrace beyond the start of Wave 1. If it does, then it is part of a corrective phase.
  2. Wave 3 cannot be the shortest of the three motive waves, namely waves 1, 3 and 5. It does not need to be the longest of the three, but it cannot be the shortest.
  3. Wave 4 must not penetrate and overlap the price action of wave 1, except in the case of a diagonal triangle.

In addition to these three rules are a few guidelines that are typical of Elliott waves but do not occur in every 5-3 wave cycle. These guidelines include the extension of impulse waves, truncation of the fifth wave, alteration of the shape and length of the corrections at waves 2 and 4, and channeling of the motive wave.

Elliott Waves and Price Projections

There are a number of price projections that can be based on Elliott Wave Theory. The common price projections are as follows:

  • Wave 2 is usually a deep retracement of Wave 1 and usually ends at the 61.8% or 78.6% Fibonacci retracement levels. However, it cannot retrace beyond the start of Wave 1 as it would then still be part of a correction and the wave count will be invalid.
  • Wave 4 tends to end in the region of Wave 4 one lesser degree, i.e., in the region of subwave 4 of Wave 3. However, Wave 4 is also usually a protracted sideways correction, especially when Wave 2 was a sharp correction.
  • The guideline of equality states that Wave 1 and Wave 5 tend travel the same approximate distance. This guideline can be used to determine where Wave 5 is likely to end, based on the length of Wave 1. The same guideline applies to Wave A and Wave C and can be used to determine the possible end of Wave C, based on the length of Wave A.

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Wealth Warning

Trading equities, options, derivatives, currencies, commodities or any other financial security can offer significant returns BUT can also result in significant losses if the market moves against your position. It requires a strong commitment to skill development, knowledge acquisition, and emotional control. It should be treated as a business with a clear business plan, a risk analysis, and set of attainable goals. The risk associated with trading the vagaries of the stock markets is probably the most important consideration as it has a profound effect on emotional control. You should not trade the stock markets with money you cannot afford to lose as there is considerable exposure to risk in any stock market transaction.

Furthermore, the past success of any trading method, strategy, or system is only indicative of future success. Under no circumstances should past success be construed as a guarantee of future success!