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Elliott Wave Theory Basics Elliott Wave Theory Basics
Founding father of the Elliot Wave Theory is Ralph Nelson Elliott who developed this theory in the late 1920’s. What he discovered is that... Elliott Wave Theory Basics

Founding father of the Elliot Wave Theory is Ralph Nelson Elliott who developed this theory in the late 1920’s. What he discovered is that while markets seem to behave in a chaotic manner, they are in fact traded in repetitive cycles. These repetitive cycles are caused by investor’s reactions to outside influences or mass psychological behavior. The upward and downward swings of mass psychological behavior always show up in the same repetitive patterns, which Elliott then divides further into patterns that he terms ‘waves’: The Elliott Wave theory is born. In the ’70 the Elliott Wave Theory gained huge popularity due to published work of Frost and Prechter. They published their legendary book “Elliott Wave Principle – Key to stock market profits”. In this book the authors were able to predict the bull market of 1970’s. On top of that was Robert Prechter able to predict the 1987 crash. The Elliott Wave Theory helps traders determine trend direction.

We live in a world of causalities, action leads to reaction. On financial markets it is the same. We know that every action creates an equal opposite reaction. Price movement up or down must be followed by a contrary move. These movements in price are divided into trends, corrections or sideways movements (which is discussed in the post General Market Movement). When a market is trending the main direction of price action is visible, a correction is a move against the current trend. In the Elliott-Wave theory these price movements are generally referred to as waves.  The idea of prices moving into waves is something we also seen in the Dow Theory. By recognizing the “fractal” nature of the market, Elliott was able to break down and analyze the market in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale keep repeating themselves. Elloitt found out that trading patterns are structured in the same way.

Basis idea

The Elliott Wave-Theory characterizes price action as waves. The basic cycle is build up out of 8 waves. These waves are built up from different patterns. An impulse wave is a move which goes with the main trend, and has 5 waves in its full pattern. While a move against the trend, labeled Corrective Wave, has 3 waves. The idea of fractals comes into play when we zoom in on each the impulse and corrective waves.

So an impulse wave consists of 5 waves. Of these 5 different waves, there are 3 impulse waves and 2 corrective. Each of the 3 impulse waves on this lower level also consists of 5 waves; 3 impulse- and 2 corrective waves. You can keep zooming in on lower levels. This way of looking at the market makes price action which seems chaotic at first, become structured and predictable.

 

 

 

 

The illustration shows the full 8 wave structure, with the impulse wave (which contains 5 waves (1 to 5)) and the corrective wave (which contains 3 waves (a-b-c)). In a bull market the impulse waves is pointing upwards, and the corrective wave downwards. In a bear market this is the other way around. There are additional shapes of corrective waves, but those will be discussed later on.

For the entire basis cycle to complete there are no rules on within what timeframe it should happen. Sometimes it can be quick, other times it takes a while. After the completion of a cycle, a new cycle starts.

So to summarize the basics of the Elliott Wave-principal is that the wave structure is built up of waves with different order. Wave-structures of the highest order are built up from lower order wave structures, which are built up from wave-structures of even a lower order, etc. etc. Once the 5-3 structure (impulse + corrective waves) is completes a new basic cycle starts.

 

 

 

Counting the waves

In order to get the right counting of the Elliott Waves there are strict rules of counting which should never be violated. These rules are:

  1. Wave(4) of the 5-wave impulse move is never allowed to retrace as deep that it moves back into the area of Wave(1). There is an exception on this rule, which occurs when there are so called ‘diagonals’. This will be discussed later on.
  2. Wave(3) is often the longest, but can never be the shortest.
  3. Wave(2) is never allowed to retrace more than 100% of the previous wave, Wave(1).

According to some Elliott Wave-analysts an additional rule is that Wave(4) is not allowed to be a more than 50% retracement of Wave(3). Only expectation is when Wave(4) is forming a diagonal, in that case a retracement of 61,8% is allowed.

Correct counting of the waves can become difficult when there are long periods of low volatility in the market or when patterns become complex. If that is the case it is advisable to take a step back and wait to see what pattern is truly forming.

There are a lot of different shapes in these wave-patterns. To determine which shape is the right one for current price action requires the trader to approach the price action with deductive reasoning. The clear rules tell you what is not allowed, so by applying them a shape is left that is the most likely for future price action. So this Wave-principal is more than many other techniques quite objective due to the clear set of rules.

The more volume that is traded in the currency pair, the more dominant role psychology of the mass is going to play a part, and the better the Elliott-principle works.

 

Impulse Waves

So far you should be familiar with what Impulse Waves are. Earlier we mentioned that a few inconsistencies can occur. The most common ones are:

  1. Extensions
  2. Truncated Fifths
  3. Wigs

Ad1: Extensions
Within one of the impulse waves there occurs a new 5-wave structure. So instead of the regular 5-wave pattern we get 9-waves. In almost every cycle extensions occur in the impulse waves, but commonly only in one of them. So if the Wave(1) and Wave(3) are of similar length, the Wave(5) is likely to be extended. On the other hand, if Wave(3) is extended, the Wave(5) is likely to be of similar length as the Wave(1).

In some occasions extensions within extensions can occur. When the Wave(5) is an extensions, then the next Wave(a) will in theory make a sharp retracement to the lowest price level of the Wave(2) of that extension.

Ad2: ‘Truncated fifths’ of ‘failure tops or bottoms’
A Truncated Fifth occurs when Wave(5) is hardly, or not at all, able to move above Wave(3). Such pattern is similar to a Double Top or Bottom pattern discussed in the Chart Reading post on Reversal patterns. If such patterns occur it signals strength or weakness in the market.

Ad3: Wig patterns of ‘diagonal triangles’
Similar to the wig patterns discussed in Chart Reading post on Continuation patterns, this pattern has a resistance- and support line that is converging towards each other. An ascending wig is a ‘bearish’ signal, which often takes place in the Wave(5) (sometimes Wave(c)) of a bull market and is likely followed up by a strong decline.
On the opposite a descending wig is a ‘bullish’ signal and often takes place in the Wave(5) or Wave(c) of bear market.

Wig patterns that happen at the end of an up- or downward trend are called ‘ending diagonals’. Sometimes a wig occurs in Wave(1) or Wave(a). In such cases we speak of a ‘leading diagonal’.

 

 

Corrective Waves

There are also different types of corrective waves. The four most common are:

  1. Zigzags
  2. Flats
  3. Triangles
  4. Double Threes or Triple Threes

Ad1: Zigzags
A zigzag in a bull market is a simple A-B-C-pattern, where the top B is clearly lower than the initial starting point of the A move. This pattern can divided into a 5-3-5-pattern. In a bearmarket this pattern is similar only opposite.

 

Ad2: Flats
A Flat is a A-B-C-pattern where B ends roughly at the same level as where A started. Also the C move will end lower than the where the A move ended. This pattern can be divided into a 3-3-5-pattern. Again in a bear market the pattern is opposite. What the market tells you with Flats is that the Wave(a) doesn’t have enough power to push the market down. Therefore ‘Flats’ do correct the market (much) less than ‘zigzags’ and often occur in a market that still has a lot of underlying uptrend potential.

 

Ad3: ‘Triangles’
Triangles are 5-wave patterns where it is likely that each of the 5 waves is taking shape in a 3-wave move (3-3-3-3-3); the total 5-wave pattern converts into smaller structures. There are 4 different kinds of triangles:

  • Ascending Triangle
  • Descending Triangle
  • Symmetrical Triangle
  • Reverse Symmetrical Triangle

As general rule of thumb is that triangles often occur in Wave(4) or Wave(b).

 

 

Ad4: ‘Double Threes’ or ‘Triple Threes’
This type of corrective wave occurs the least frequently. The pattern is often like two or three Flat structures stick together, just separated by one Wave, labeled as Wave(x).  The patterns is a A-B-C, A-B-C move. Wave(x) has often a zigzag shape. The Wave(b) is in the same direction as the primary trend and also is likely to occur in a 3-wave structure. The Wave(a) also has 3-waves, while Wave(c) often has 5-waves.

 

Different Elliott Wave Categories

The Elliott Wave Theory assigns a series of categories to the different waves. From largest to smallest, they are:

  • Grand supercycle
  • Supercycle
  • Cycle
  • Primary
  • Intermediate
  • Minor
  • Minute
  • Minuette
  • Subminuette

 

 

The Fifth-Wave Exit Method for Day Trading

Incorporating the Elliott Wave theory helps to determine good exit levels for swing and day trading. Executing an exit order on the fifth wave is often an ideal point to partially; if not totally, eliminate your trade position.

It is also highly recommended to use a logarithmic scale when trading. This should make it easier to determine exit points. On a logarithmic scale chart, the vertical spacing between two points corresponds to a percentage of change between the two. On a log scale chart, the vertical distance between let’s say 10 and 20 (which is a 100% increase) is the same as the vertical distance between 50 and 100.

 

Concluding

The Elliott Wave Theory needs a good amount of practice before you fully master it. The recognizing of the waves and counting can be done by following the strict rules. Mastering this theory will help increasing your trading accuracy and is another set to build confluence in trading.

 

Reference:

http://www.marketwatch.com/story/5-charts-to-help-unravel-the-elliott-wave-mystery-2015-06-08

http://www.investopedia.com/articles/technical/111401.asp

http://www.investopedia.com/articles/technical/111401.asp#ixzz48HReYF9f

 

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