Elliott Wave Theory
Welcome to our module on Elliott Wave Theory or the Elliott Wave Principle (EWP). Elliott Wave Theory is one of the more popular price action patterns used by advanced traders and is used by some of the top fund managers. It is closely related to the tenets of Dow Theory. 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 a trade in the direction of the trend.
In this module you will learn about the Immutable Elliott Wave rules, Elliott Wave Guidelines, Motive Waves, and Corrective Waves. We begin with an Introduction to Elliott Wave Theory.
An Introduction
Elliott Wave Theory was first put forward by a qualified accountant named Ralph Nelson Elliott (28 July 1871 – 15 January 1948) in the early 1930s. Elliott studied historical stock charts across various indices or averages on the New York Stock Exchange (NYSE) and in different time-frames, 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 13 patterns that recur in the market and saw 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. While these cyclic patterns are repetitive in appearance and sequence, they do not necessarily repetitive in time and altitude.
A Repetitive Wave Pattern
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 five waves that progress the larger trend, called a motive phase, and three waves of counter-trend movement called a corrective phase. In other words, during the motive phase price action moves in the direction of the larger trend, and the corrective phase price action move against the larger trend. The five waves of the motive phase are labelled with numbers: 1, 2, 3, 4, and 5, while the three waves of the corrective phase are labelled 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 that is labelled Wave 2. In other words, Wave 2 moves against the trend. Wave 3 then resumes the trend and is often the strongest impulse wave though it too is eventually interrupted by a counter-trend move that is labelled Wave 4. Finally, the Wave 5 moves up to the end of the trend. The three corrective waves of the 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 to reach the previous highs of the motive phase before giving way to Wave C, which again moves against the previous trend. The five waves of the motive phase and the three corrective waves of the corrective phase combine to form a complete cycle. Therefore, a new motive phase can be expected after the completion of Wave C.
Fractal Nature of Waves
Fractal Wave Structure
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 also follow the same five wave and three wave structure. In other words, Wave 1 would consist of a complete cycle of five smaller motive subwaves and three smaller corrective subwaves. Each successively smaller subwave 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 labelled, from largest to smallest as:
| Wave degree | Motive Wave Labels | Corrective Wave Labels | ||||||
|---|---|---|---|---|---|---|---|---|
| Grand Supercycle | [I] | [II] | [III] | [IV] | [V] | [A] | [B] | [C] |
| Supercycle | (I) | (II) | (III) | (IV) | (V) | (A) | (B) | (C) |
| Cycle | 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) |
| Minor | 1 | 2 | 3 | 4 | 5 | A | B | C |
| Minute | [i] | [ii] | [iii] | [iv] | [v] | [a] | [b] | [c] |
| Minuette | (i) | (ii) | (iii) | (iv) | (v) | (a) | (b) | (c) |
| Subminuette | i | 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 same direction of the wave of one higher degree, or the next larger trend. 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, subordinate Wave A and subordinate Wave C are motive waves while Wave B is a corrective wave.