Introduction
Elliott Wave Theory was developed by
R.N. Elliott and popularized by Robert Prechter. This theory asserts that crowd
behavior ebbs and flows in clear trends. Based on this ebb and flow, Elliott
identified a certain structure to price movements in the financial markets. The
article serves as a basic introduction to Elliott Wave Theory. A basic 5-wave
impulse sequence and 3-wave corrective sequence are explained. While Elliott
Wave Theory gets much more complicated than this 5-3 combination, this article
will only focus on the very basics.
Wave
Degrees
The labeling
convention shown above is a hybrid between that shown in the Elliott Wave book
and the Elliott tools from SharpCharts. In Elliott-speak, this labeling
convention is used to identify the degree or level of the wave, which
represents the size of the underlying trend. The upper case Roman numerals
represent the large degree waves, the simple numbers represent the medium
degree waves and the small-case Roman numerals represent the small degree
waves. The trends start with the largest degree (Grand Supercycle) and work
their way down to waves of lesser degree. For example, the Cycle wave is one
larger degree than the Primary wave. Conversely, the Primary wave is one lesser
degree than the Cycle wave. Wave 1 of (1) would indicate that Wave 1 is part of
a larger degree Wave (1). Wave 1 is a lesser degree than Wave (1).
In reality,
most chartists will only use 1 to 3 wave degrees on their charts. It can get
quite complicated trying to apply nine Wave degrees or even just using the
labeling convention in the order provided. Chartists using 1 to 3 wave degrees
can simply label the highest degree waves with upper case Roman numerals
(I,II,III,IV,V,a,b,c), the middle degree waves with numbers (1,2,3,4,5,A,B,C)
and the lowest degree waves with lower case Roman numerals
(i,ii,iii,iv,v,a.b,c). This provides three distinct groups for labeling various
waves.
Basic
Sequence
There are two
types of waves: impulse and corrective. Impulse waves move in the direction of
the larger degree wave. When the larger degree wave is up, advancing waves are
impulsive and declining waves are corrective. When the larger degree wave is
down, impulse waves are down and corrective waves are up. Impulse waves, also
called motive waves, move with the bigger trend or larger degree wave. Corrective
waves move against the larger degree wave.
The chart
above shows a rising 5-wave sequence. The entire wave is up as it moves from
the lower left to the upper right of the chart. Waves 1,3 and 5 are impulse
waves because they move with the trend. Waves 2 and 4 are corrective waves
because they move against this bigger trend. A basic impulse advance forms a
5-wave sequence.
A basic
corrective wave forms with three waves, typically a, b and c. The chart below
shows an abc corrective sequence. Notice that waves a and c are impulse waves
(green). This is because they are in the direction of the larger degree wave.
This entire move is clearly down, which represents the larger degree wave.
Waves a and c move with the larger degree wave and are therefore impulse waves.
Wave b, on the other hand, moves against the larger degree wave and is a corrective
wave (red).
Combining a
basic 5 wave impulse sequence with a basic 3 wave corrective sequence yields a
complete Elliott Wave sequence, which is a total of 8 waves. According to
Elliott, this complete sequence is divided into two distinct phases: the
impulse phase and the corrective phase. The abc corrective phase represents a
correction of the larger impulse phase.
These 8-wave
charts show two larger degree waves (I and II) as well as the lesser degree
waves within these larger degree waves. Waves 1-2-3-4-5 are one lesser degree
than Wave I. By extension, Wave I is one larger degree than Waves 1-2-3-4-5.
Waves a-b-c are one lesser degree than Wave II.
Fractal
Nature
Elliott Wave
is fractal. This means that wave structure for the Grand Super Cycle is the same
as for the minuet. No matter how big or small the wave degree, impulse waves
take on a 5-wave sequence and corrective waves take on a 3-wave sequence. Any
impulse wave subdivides into 5 smaller waves. Any corrective wave subdivides
into three smaller waves. The charts below show the fractal nature of Elliott
Wave in action.
Three Rules
Believe it or
not, there are only three rules when it comes to interpreting Elliott Wave.
There are many guidelines, but only three HARD rules. These are unbreakable.
Guidelines, on the other hand, are bendable and subject to interpretation.
Furthermore, these rules only apply to a 5-wave impulse sequence. Correction,
which are much more complicated, are given more leeway when it comes to
interpretation.
Rule 1: Wave 2 cannot retrace more than 100% of
Wave 1.
Rule 2: Wave 3 can never be the shortest of the
three impulse waves.
Rule 3: Wave 4 can never overlap Wave 1.
Wave 2 cannot
move below the low of Wave 1. A break below this low would call for a re-count.
Even though Wave 3 is typically the longest of the three impulse waves, there
is a specific rule that it cannot be the shortest. 1 or 5 can be longer than
Wave 3, but both cannot be longer than Wave 3. It is probably best to use
percentages or log scales when measuring Wave length. Elliott Wave indicates
that Wave 3 must exceed the high of Wave 1. Failure to exceed this high would
call for a re-count. Impulse moves are all about making progress. Failure to
exceed the high of Wave 2 would not be making progress. The third, and final
rule, is that Wave 4 cannot overlap Wave 1, which means the low of Wave 4
cannot exceed the high of Wave 1. Such a violation would call for a re-count.
Three
Guidelines
There are
numerous guidelines, but this article will focus on three key guidelines. In
contrast to rules, guidelines should hold true most of the time, not
necessarily all of the time.
Guideline 1: When Wave 3 is the longest impulse wave,
Wave 5 will approximately equal Wave 1.
Guideline 2: The forms for Wave 2 and Wave 4 will
alternate. If Wave 2 is a sharp correction, Wave 4 will be a flat correction.
If Wave 2 is flat, Wave 4 will be sharp.
Guideline 3: After a 5-wave impulse advance,
corrections (abc) usually end in the area of prior Wave 4 low.
The first
guideline is useful for targeting the end of Wave 5. Even though Wave 5 could
be longer than Wave 3 and Wave 3 could still be longer than Wave 1, chartists
can make initial Wave 5 projections once Wave 4 ends. In a larger uptrend,
chartists simply apply the length of Wave 1 (percentage change) to the low of
Wave 4 for an upside target. The opposite is true for a 5-wave decline. The
percentage decline in Wave 1 would be applied to the high of Wave 4 for a Wave
5 estimate.
The guideline
of alternation (2) is useful for determining the time of correction for Wave 4.
After a sharp decline for Wave 2, chartists can expect a relatively flat
correction for Wave 4. If Wave 2 is relatively flat, then chartists can expect
a relatively sharp Wave 4. In practice, Wave 2 tends to be a rather sharp wave
that retraces a large portion of Wave 1. Wave 4 comes after an extended Wave 3.
This Wave 4 marks more of a consolidation that lays the groundwork for a Wave 5
trend resumption.
The third
guideline is useful for estimating the end of a Wave II correction after a Wave
I advance. Waves I and II are the larger degree waves. Waves 1-2-3-4-5 are
lesser degree waves within Wave I. Once the Wave II correction unfolds,
chartists can estimate its end by looking at the end of the prior wave 4
(lesser degree wave 4). In a larger degree uptrend, Wave II would be expected
to bottom near the low of lesser degree Wave 4. In a larger degree downtrend,
Wave II would be expected to peak near the high of lesser degree Wave 4.
Elliott Wave personality and characteristics
Elliott wave analysts (or Elliotticians) hold that each individual wave has its own signature or characteristic, which typically reflects the psychology of the moment. Understanding those personalities is key to the application of the Wave Principle; they are defined below. (Definitions assume a bull market in equities; the characteristics apply in reverse in bear markets.)
Five wave pattern (dominant trend) | Three wave pattern (corrective trend) | |
---|---|---|
Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts. | Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets. | |
Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern. | Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative. | |
Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1. | Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond. | |
Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three (see Fibonacci relationships below). Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend. | ||
Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received). |
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