The man behind the Elliott Wave theory, Ralph Nelson Elliott, discovered that crowd behavior trends in recognizable patterns. In his research, he found the same recurring pattern regardless of the market and the time. This eventually led him to develop the theory that became Elliott Wave Principle. Elliott detected thirteen patterns or waves that occur periodically in the market and are repetitive in shape and form.
The big thing to take away from Elliott Waves is that the markets are fractal in nature, which means that you’ll find the same patterns repeating on lower time-scale (lesser degree). Since trading with Elliott Waves is a massive endeavor, and by far the most complex trading method that you’ll ever use, this article is an attempt to introduce you into a few of the principles of the theory.
The Basic Elliott Wave Pattern
One of the most important and basic principles of Elliott Waves is that a trend typically occurs in five waves: three up and two down (see Figure 1). After the 5th wave, the trend reverses and corrects the prevailing trend in three big corrective waves. The market doesn’t move in a linear fashion and the purpose of having a 5-wave move is to allow for variations.
In Elliott wave theory, there are two types of wave:
- Motive Waves (waves 1,3 and 5; A and C); Tends to be smooth and strong
- Corrective Waves (waves 2 and 4; B); Tends to be messy and choppy.
Each of the waves 1, 3 and 5 tends to be an impulsive wave (five waves) itself and each decline (corrective waves) in an uptrend is going to happen in three waves. This serves to reinforce the idea that we’re moving in a trend.
A genuine Elliott Wave pattern must satisfy three important rules for the five wave move to be confirmed:
- Wave 2 never retraces more than 100% of Wave 1. Usually, the retracement is between 50% and 61.8% of wave 1.
- Wave 4 never retraces more than 100% of wave 3. Usually, declines between 38.2% and 50% of wave 3.
- Wave 3 always travels beyond the end of wave 1 and it’s never the shortest one; Wave 3 will normally extend 161.8 x wave 1.
All these rules are just to ensure that you make progress in a trend which is a more detailed version of the Dow Theory which states that we move in several big swings. Other guidelines to keep in mind are as follows:
- Usually, wave 1 and 5 tend to have the same length in price and time;
- Corrective wave A and wave C tend to be the same length.
- The waves must be symmetrical in both time and price;
- The law of alternation, if wave 2 is a simple EW pattern wave 4 must be a complex EW pattern and vice versa.
A very useful trading application is channeling. If you put a 1-3 channel line (connect the peaks of wave 1 and 3) you can sometimes identify the bottom of the fourth wave by extending that line from the second wave.
Corrective Elliott Wave Patterns
Unlike impulsive waves, Corrective waves pan out or sub-divide in three sub-waves and has the primary objective to correct the motive waves. Usually, the Corrective waves are labeled using letters and we can distinguish three different types of corrective wave structures:
- Flat EW pattern: It’s made up of three waves A, B and C of higher degree that follows a 3-3-5 wave structure, where wave A subdivides in 3 waves, wave B into 3 waves and wave C into 5. We can distinguish three different types of flats: Regular, Irregular or Expanded and Running flat.
- Zig-Zag EW pattern: It’s made up of three waves A, B and C of higher degree that follows a 5-3-5 wave structure, where wave A subdivides in 5 waves, wave B into 3 waves and wave C into 5. Zig-Zags have a sharp look and occur normally in the wave 2 of an impulsive wave.
- Triangles EW pattern: It’s made up of five waves A,B, C, D, E of higher degree that follows a 3-3-3-3-3 wave structure, where all five waves are subdivided into 3 sub-waves. We can distinguish three different types of triangles: Contracting, Barrier and Expanding.