Ralph Nelson Elliott discovered the Elliott wave theory in the 1920’s, but it didn’t attract attention at that time. It was brought to limelight by Robert Prechter when he predicted the bull market of the 1980’s (both in stock and gold) with the Elliot wave. The Elliot wave theory comprises three aspects pattern, ratio and time, along with impulse waves and corrective waves.
Elliot wave: Pattern
The Elliott wave pattern suggests that any market trend (bull or bear) is of the form 5-3 wave.
Impulse waves move in the direction of the trend and corrective waves push against the trend.
Wave within a wave!
So far so good! But, this is where things get complicated.
According to Elliott wave theory, markets move in cycles for years and there are several degrees of a cycle.
The five (1-5) waves of a cycle constitute the one single wave in the next higher degree of the cycle.
The three (abc) waves constitute the one corrective wave in the next higher degree of the cycle.
The grand cycle wave exists for years (say for 100 or even 200). The subminuette and minuette degrees are the ones that exist in hourly charts.
Pattern: Impulse Waves
The 1,3,5 waves of the Elliot wave are the impulse waves.
The waves 2 & 4 are correctives since they correct the waves 1 and 3 respectively.
Each impulse wave comprises of the 5-waves (1-5) of the next lower degree cycle.
The corrective waves 2 & 4 will have only 3 waves.
Pattern: Corrective Waves
The waves a & c has five (1-5) down waves.
The wave b has only 3 waves.
The corrective waves (‘abc’) will be of the form 5-3-5.
Rule Set #1: Elliott wave theory
In a bull cycle, a 5-wave correction should not occur. The 5- wave correction only marks the end of a cycle and the beginning of a new cycle.
The 5-wave movement is usually followed by another 5- waves unless, otherwise, it is the fifth wave. The only exception to this rule is when triangular corrections are formed. (The corrective waves is itself a detailed topic which we’ve discussed here).
Elliott Wave: Ratio
The second most crucial aspect of Elliott wave theory is the ratio. Each wave’s length is interdependent. Fibonacci retracement plays a more significant part in the Elliot wave too. The impulse waves and corrective waves need to be appropriate in ratio and proportion to constitute an Elliott wave.
Identifying wave 1 at the outset is difficult.
At this stage, investor psychology will be to go with the prior trend.
The wave 2 is never lower(uptrend) than the wave 1.
At most times, investors are caught off-guard by the surprise reversal.
Hence, there is no definite ratio for wave 2. However, it usually retraces to anywhere between 50% to 61.8% of wave 1. It retraces even beyond 61.8% but never goes beyond wave 1.
Wave 3 of the Elliot wave extends up to 161.8% of wave or beyond.
When wave 3 cuts the high of wave 1, is the point in which traders realize a trend shift and try to hop in at the highs. It is the reason for the extended runs.
If wave crosses 161.8% extension, the next resistance is around 261.8% extensions. It is the longest among the impulse waves.
It is usually the shortest of all the 5 waves.
It goes through more of a time correction rather than price correction.
Hence, it’s very shallow and retraces up to 38% or 50% of wave 3.
The 61.8% Fibonacci value plays a pivotal role in wave 5.
Wave 5 often runs to a length of 61.8% of wave 1.
If wave 3 extends beyond the 1.618 extension, then there is a high probability for a truncated wave 5.
The extended wave 5 is the sum of 161.8 % of wave 1 and wave 3.
If wave 3 is interrupted at 1.618 extension of wave 1, then there is a good chance for an extended wave 5.
The corrective wave is a detailed topic and hence it is discussed in length here.
Rule Set #2: Elliott wave theory
Among the three waves(1,3 & 5), only one wave has an extended run, which in most cases is the third wave. In commodities, wave 5 is the extended wave usually.
Wave 3 is never the shortest of the 3 waves(1,3 & 5).
Wave 4 never overlaps wave 1 unless it’s a triangular corrective wave. It acts a strong support for the next degree of waves too.
Elliott wave: Time
When compared with the other two aspects, time is the least important factor in Elliott wave theory. This concept conceptualizes the Fibonacci Time targets and predicts when a specific move happens.
The Fibonacci numbers 13,21,34,55,89,144 and so on. According to the Elliot wave time concept, the significant movement, especially the top or bottom, happens in any one of these days.
As the saying in technical analysis goes, “Don’t try to time the market,” the time concept is often overlooked in the Elliott wave theory. However, when it does combine with the other concepts, it presents beneficient intraday setups.
The psychology behind Elliot wave
R.N Elliott formulated the Elliott wave theory taking the investor psychology into account. The wave 1 is purely coincidental and investors are not aware of a market reversal. The wave 2 is the act of desperation to take the market down. But, when wave 2 reverses, investors and traders are usually in the state of a denial. The crossing of wave 3 above wave 1’s high, triggers the nightmare of ‘fear’ in every bear. Conventional bears get out of their short position whereas the bold hold their guns.
Wise bulls mark their entry with ‘optimism’. As the market moves strength to strength, even the bravest bears take cover out of ‘panic’. Now, positive news also begins to flow and more bulls hop in out of ‘greed’. The wave 4 is profit booking wave, due to ‘content’ bulls exiting. It is usually marked by low volume and ‘hope’ from bears on taking it down. However, as it bounces in the form of wave 5, bulls relish their ‘euphoria’. The greedy bulls regret their decision when the market plunges with wave ‘a.’ The ‘desperate’ bulls try to revive the trend in the form of wave ‘b.’ When wave ‘c’ onsets, they fathom in denial. Alas, when wave ‘c’ cuts wave “a’s” low, the bulls exit out of panic and bears enter with optimism. Thus, the cycle of impulse waves and corrective waves of the Elliot wave continues.
Elliott wave theory is based on the notion of Dow theory and Nature’s Law of Fibonacci values. Hence, its occurrence is inevitable and unavoidable in the trading markets. However, many from trading fraternity consider it as a post-analytical tool rather than a pre-analytic. It has covered all its bases certainly, a real-time application is tough at times. If you ought to trade the impulse waves rather than corrective waves, then Elliot wave assists you in the best way possible with entry and exit points.