Elliott Wave Theory Basics Explained

Learn Elliott Wave Theory Basics

Elliott Wave Theory Basics ExplainedElliott Wave

When investors and traders first discover, and have Elliott Wave theory basics explained to them, there are various reactions:

  • Disbelief - that market movements can follow patterns and are often predictable by technical analysis methods
  • Joyous irrational exuberance - at having found the holy grail, a crystal ball to foretell the future
  • And finally the correct, and useful response - here is a valuable new tool that I should learn how to use.

Just like any system or structure found in the natural world, the closer you look at its wave patterns, the more structured complexity you see. It is structured, because natures patterns build on themselves, creating similar forms at progressively larger sizes. You can see these fractal patterns in botany, geography, physiology, and the things humans create, like roads, residential subdivisions and - as recent discoveries have confirmed - in market prices. 

Natural systems, including Elliott wave patterns in stock market charts, evolve through time, and their forms are defined by interruptions to that growth.

Here's what we mean by that. When your hands are first formed in the womb, they look like round paddles growing equally in all directions. Then, in the places between your fingers, cells ceased growing or died off, and growth was directed to the five digits. This structured progress and regress is essential to all forms of growth.

The fact that this punctuated growth appears in market data is only natural - as Robert Prechter, Jr., the world's best known Elliot wave expert and president of Elliott Wave International, says, Everything that thrives must have setbacks.

Learn Elliott Wave Theory Basics

We have all heard the phrase 'one step forward and two steps back' to describe a situation where we feel as though we are going nowhere, or achieving nothing.

R.N. Elliott's observations were that as the market progresses, prices tend to ebb and flow in wave like moves. Impulsive, flowing moves would consist of 5 waves followed by an ebbing back, in a more corrective period where prices seem to struggle to get anywhere, and consisting of 3 waves.

Each wave then develops within part of a larger cycle. The complete cycle is composed by those 2 parts and each cycle is part of an ever expanding matrix of interlinking cycles of various degrees of trend.

Learn Elliott Wave Theory Basics
In the basic Elliott wave formation, impulsive waves are labelled with the numbers 1,2,3,4,5, and corrective waves are labelled with the letters a,b,c.

As we can see in the chart above, impulsive waves will gain a lot of ground whereas in corrective waves, prices tend to struggle to get anywhere. Corrective waves are more of a sideways consolidation or range bound move that occurs when the market wants to hold on the ground that has been gained.

It is important to remember that these charts are showing 5 waves up and 3 waves down as in a positive market, but impulsive waves also occur when markets are declining.

An impulsive move in a declining market will take the form of 5 waves down and 3 waves up.

Impulse Waves

Impulse waves are powerful moves composed of 5 sub waves that drive the market in the direction of the larger trend. Within the larger impulse wave, the 5 waves subdivide into 5,3,5,3,5 formations and are labelled 1,2,3,4,5.

Waves 1,3 and 5 are the impulse waves and are powerful, driving moves which are interrupted by the waves 2 and 4 corrective and consolidating phases, creating the wave like structure. 

  1. The smart money enters the market - The trend has changed but the market remains uncertain.
  2. Retraces some of the first wave back testing the previous extreme - the initial burst has petered out but the market does not seem to to have enough energy to resume the previous trend.
  3. Mass participation causes prices to explode in the direction of the new trend as the market accepts that the trend has reversed. 
  4. Quite often a shallow retrace of the Third wave as the market consolidates its gain and investors start taking profits.
  5. Distribution phase - Profit taking increases as the last man standing is forced into accepting that the trend has changed and is forced to liquidate his positions - Capitulation!  
An impulse wave itself always sub divides into 5 waves to a lesser degree, so the important factor for an Elliott Wave analyst in recognising that the trend has reversed is to be able to count 5 waves in the internal sub divisions of the move.
Wave construction is always the most important factor in wave recognition so let's look at the subdivisions within an impulse wave.

Wave 1 (Impulse)

First waves subdivide into 5 smaller waves and can be either slow but steady, grinding away and relentlessly moving against the trader convinced the previous trend is still underway, or they can be sharp and decisive blowing those traders out of the water.
First waves can also take the form of a Leading Diagonal which involves an overlap of waves 2 and 4 but these must still subdivide into 5,3,5,3,5  formation.

Example of an Impulse Wave: Elliott Wave Theory BasicsLeading Diagonal Impulse Wave

Wave 2 (Corrective)

Second waves subdivide into 3 smaller waves and are often sharp and deep, retracing much of the wave 1.

Many traders are still convinced that the previous trend is still in effect. Generally speaking, second waves will be very deep and are most likely to retrace much of the first wave if that was a slow grinding move. Very sharp and powerful first waves can lead to a very shallow wave 2.

It is very important to remember that wave 2s never retrace more than 100% of wave 1. If prices move beyond the origin of wave 1, it is a clear signal to the Elliott Wave analyst that his analysis is wrong.

Wave 3 (Impulse)

Third waves subdivide into 5 smaller waves and are usually the largest and most powerful. These waves are on high volume and are broad ranging with mass participation as the new trend becomes clear.

 Wave 3s are never the shortest impulse wave and are most likely to extend.Learn Elliott Wave Theory Basics

Wave 4 (Corrective)

Fourth waves subdivide into 3 smaller waves. Elliott Fourth waves are often very complex moves and tend to be sideways and range bound moves frustrating bulls and bears. 

Wave 5 (Impulse)

Fifth waves subdivide into 5 smaller waves and are distribution phases. These usually display a weakening of the trend in prices, breadth and on volume. They can be long and drawn out as the market 'tops' or 'bottoms' but at times they can be very sharp 'spike' like moves.

Fifth waves can take the form of and Ending Diagonal and involves the overlap of waves 2 and 4 but the differ from a Leading Diagonal which can appear in the wave 1 position, in that they subdivide into a 3,3,3,3,3 construction.

Corrective waves

Corrective Elliott waves retrace part of the previous trend......Corrective Waves

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