ELLIOTT WAVE THEORY BASICS

Like many things Elliott Wave theory can be simple or complex, it's up to you. The basic premise is that high volume, free markets (no Government intervention over the long haul) are subject to the individual investors hopes (greed) and fears en masse. These emotional capitulations are reflected graphically at any point of any day by price. Portraying these swings in chart form provides a picture of the current market psychology. In the earlier part of this century Ralph Nelson Elliott promulgated tools with which to interpret the chart patterns and hence, the name of the theory. This page shows the bare minimum. If you want to learn more get this FREE 10 lesson tutorial.

ELLIOTT WAVE IMPULSE PATTERN

The major trend in every time frame takes the form of five waves (impulse wave) which, once complete, are corrected by three waves. The following is a bull market description: Wave One (W.1) is up and Wave Two (W.2) is down correcting W.1. When W.2 is finished, W.3 again moves upward followed by a downward W.4 that corrects W.3. The final upleg is labeled W.5 ending the entire swing. The corrective W.2 and W.4 normally retrace W.1 and W.3 by a Fibonacci relationship.


elliott wave theory impulse wave

ELLIOTT WAVE CORRECTIVE PATTERNS

Now that five waves have been completed in the direction of the major trend, they too will be corrected in a three wave retracement. To avoid confusion with the numerically labeled five wave impulsive sequence, letters are used to represent the three wave corrective swings. Within the same bull swings W.A is down, W.B is up and W.C is again down.

FIBONACCI RATIOS ARE IN CORRECTIVE PATTERNS

Fibonacci relationships are evident in corrective waves too, both internally and externally. Internally as to how W.A, W.B, and W.C relate to one another and externally by the way the entire corrective process relates to the previous five wave swing. A Flat is distinguished from the more common Zig-Zag by the depth of W.C in relation to W.A.


elliott wave theory corrective pattern

The area that often provides the most challenge is the corrective patterns. They range from a simple A-B-C pattern to the more complex double and triple A-B-C combinations ("threes") and triangles that converge or expand in five overlapping legs.

elliott wave double three

triangle pattern

For the most part, the most complex patterns occur in W.4 just before the final push in W.5. Old timers say that if you don't know where you are in the wave count it's probably a 4.

Here are rules and guidelines that govern the entire process. The distinction is that the rules are inviolate while the guidelines are high percentage applications.

ELLIOTT WAVE RULES

  • Movements in the direction of the main trend of the market occur in 5 waves (impulse waves) while corrective waves are always three wave affairs.
  • W.2 can never retrace more than 100% of W.1. If that happens, the impulse interpretation was incorrect.
  • W.3 is never the shortest wave in terms of price. It does not have to be the longest, but in such a case either W.1 or W.5 must be shorter.
  • W.4 cannot overlap W.1.
  • In recent years there has been a trend to accept an overlap on a range (bar) chart but not a closing (line) chart. The author knows of no such distinction by Mr. Elliott. Practitioners of the "modern" rules permit diagonal patterns with overlaps in W.1 and W.5 but not in W.3. The occurrences are primarily related to the various commodities and to individual stocks which are more volatile and swing independent than historical indexes such as the Dow with years of trend.

ELLIOTT WAVE GUIDELINES

  • Alternation is a common theme. A classic example compares W.4 with W.2. Alternation implies that if W.2 was a simple corrective sequence (A-B-C) then W.4 will likely be complex (double three, triangle, etc.) pattern. Alternation basically tells you what not to look for. In this case don't look for a simple W.4.
  • W.3 is generally the longest (price-wise) and strongest (technically) of the impulse waves.
  • When W.3 is the longest wave, W.1 and W.5 tend toward equality in both price and time.
  • Retracements tend to halt at the prior fourth wave of lessor degree. This statement simply means that once a five wave sequence is done it becomes the next larger degree impulse wave, say a W.1. The correction that follows (larger W.2) will be three waves into the zone of the prior w.4 which is a component of, and therefore a degree smaller (lessor) than, the completed W.1.

ADDITIONAL SOURCES OF INFORMATION

The definitive source for understanding the theory is "The Elliott Wave Principle", by A. J. Frost and Robert Prechter, Jr. Two other good sources for utilizing the theory to trade are "Dynamic Trading" (which includes an excellent software package), by Robert C. Miner and "Trading Chaos", by Dr. Bill Williams. Besides "Dynamic Trading", two of the best available Elliott software programs are "ELWAVE", by Prognosis Software Development and "Advanced GET", from Tom Joseph at Trading Techniques, Inc.  See Elliott Wave Fractals to find out how Advanced GET does not implement pure Elliott Wave theory.

Alas, commercial quality Elliott Wave software is not cheap.

THE ELLIOTT WAVE IS A REPEATING FRACTAL

When a five wave sequence is complete it can be labeled a larger W.1 and the three wave correction can be labeled the larger W.2. Thereafter, the process begins anew on the next level. Of course you can investigate higher or lower levels at any time to help clarify a wave count and market position. That's one of the beauties of Elliott Wave theory. In fact, it's essential to understand where you are on all levels at all times to apply wave counting correctly. Harmony at all degrees is a prerequisite.

An oft-heard complaint is that the pattern can always be seen in hindsight but not so well in the present moment. Admittedly, there are times when the pattern is much more lucid than at other times. Referring back to the very first sentence of this article, when those situations occur, it may be best to wait until the wave form clears up before forcing a particular count; don't make it more complex than it has to be.

One consolation is that even then, the pattern offers objective price levels at which to confirm or rebut an ongoing interpretation. Those objective levels are determined based upon the unique, time-tested rules. A sensible plan when the waters get muddy is to look for clarification at a higher degree. Moving up in time when the pattern becomes cloudy provides the overall perspective from which to begin addressing the lower level options.

YOU ONLY GAIN IN KNOWLEDGE WHAT YOU GIVE IN TIME



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