Elliot Wave Theory

elliot_waveThe Elliot Wave Principle (also known as the Elliot Wave Theory) was developed by Ralph Nelson Elliott in the 1930’s. It claims that crowd behaviour produces patterns and trends we see in markets and the wave pattern is the result of mass psychology in our world. These patterns not only appear in stock markets, but anywhere humans make decisions in mass. For example house prices or fashion trends.

Basic Elliot Wave Pattern

The classic Elliot Wave consists of five waves – three impulse waves and two corrective waves. The pattern creates a shape that looks like a zigzag line or a lightning bolt to the upside or downside.

five_wave_pattern

In the five wave pattern there are always three waves that point in the direction of the current trend. These are called impulse waves (numbered 1, 3 and 5 on the illustration above). The other two waves are called corrective waves because they ‘correct’ or retrace in the opposite direction to the trend (numbered 2 and 4). For stock traders these waves are usually messy and more risky to trade than the impulse waves.

Wave 1

Wave one is the first impulse wave and it’s not immediately obvious as it unfolds. Some characteristics of this wave include the following:

  • This wave will break the previous trend, if the previous trend was downwards this wave will start a new upwards trend.
  • If this wave marks the beginning of a new upwards trend then usually news and sentiment surveys are universally bearish. If the wave is starting a new downtrend then news and sentiment surveys are usually universally positive.
  • Wave one often consists of profit taking as traders exit their positions from the previous trend.

Wave 2

  • Can retrace 23.6 percent to 100 percent from the start of wave 1. Most will retrace between 38.2 and 70 percent of wave 1.
  • Never retraces more than 100 percent of wave 1 (it never surpasses the starting point of wave 1)
  • Volume should be lower than wave 1

Wave 3

This is the most powerful wave, many stock traders will have been waiting for an opportunity to join the new trend when they spotted wave 2 ending.

  • Wave 3 often exceeds wave 1 by a ratio of 1.618:1.
  • Strongest and steepest wave.
  • Not always the longest wave in time duration.
  • Market and sentiment news now join the trend, if the trend is upwards news is now positive.

Wave 4

  • This corrective wave typically retraces 38.2 percent to 61.8 percent of wave 3.

Wave 5

This is the final impulse wave, the last leg of the current trend, and has the following typical characteristics:

  • Sluggish and not as dynamic as wave 3.
  • Volume is lower than wave 3.
  • Momentum indicators may show divergences.
  • Wave 5 can fail, forming a double top (or double bottom) with the peak of wave 3.
  • News and sentiment surveys overwhelmingly support the current trend, opposing views are ridiculed.

 quote-stock-prices-have-reached-what-looks-like-a-permanently-high-plateau-irving-fisher-62328

Corrective Waves (Waves 2 and 4)

This section will cover the two corrective waves (waves 2 and 4) in a little more detail. These corrective waves (also known as retracements and pullbacks) consist of three to five waves. The waves are labelled with the letters A, B and C. If the correction wave is a typical zig-zag correction it’s known as a simple correction. If the corrective wave does not look like a simple zig zag then it is called a complex wave, these can be difficult to spot and come in various forms described below.

Simple Correction

simple_corrective_wave

  • Simple corrective wave is also called a zigzag correction or an ABC correction.
  • Consists of three waves.
  • The length of wave B is typically 50 percent of wave A.
  • Wave B should not retrace more than 76.4 percent of wave A.
  • The length of wave C is usually 1 to 2.618 times wave A.

Complex Correction

Complex corrections can have up to five waves (labelled A, B, C, D and E). Generally there are three types of corrective waves: flat, triangular and irregular.

Flat corrections

In flat complex corrections each wave is identical in length. This particular pattern is also called a channel.

complex_flat_corrective_wave

Triangular corrections

In triangular complex corrections the waves form pennant patterns. These are the most common type of correction in wave 4.

complex_triangular_corrective_wave

 

Irregular corrections

In irregular complex corrections the waves create a broadening formation (a broadening wedge pattern). The

 

complex_irregular_corrective_wave

Alternating Rule

If wave 2 is a simple correction, expect wave 4 to be a complex correction. If wave 2 is a complex correction, expect wave 4 to be a simple correction.