Elliott Wave Theory
In the 1930s, Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognizable patterns, leading him to come to the conclusion that progression in markets unfolds in “waves”, and these waves recur in market price data. Elliott wave theory is a method of technical analysis that focuses on the structural development of impulsive moves taking on a five wave form. Although wave principle is a powerful technical analysis forecasting tool- that is not its primary value. Elliot wave is governed by human’s social nature and the repetitive tendencies of human choices and decision making, therefore making the trend development predictive. The primary value of the Wave Principle is that it provides a context for market analysis- a gauge of overall price movement.
Basic principles
-Each set of waves is ingrained within a larger set of wave that follow the same impulse/corrective pattern, described in fractality
-The markets progression unfolds in waves
-Waves are patterns of directional movement
-There are two modes of wave development: motive and corrective
The Five Wave Pattern
-In markets, progress ultimately takes the form of five waves (progress refers to a trend)
-Three of these waves, labeled 1, 3 and 5 are impulsive moves following a trend
-The three trend following waves are separated by two counter trend movements (corrective), labeled 2 and 4
-The two interruptions are a requisite for directional movement to continue
Major Invalidations to Wave Theory
-Wave 2 never moves beyond the start of wave 1
-Wave 3 is never the shortest wave
-Wave 4 never enters the price territory of wave 1
wave mode
The fundamental idea for Wave Principle is that action in the same direction as the overall trend (larger degree wave), develops in 5 waves. While reaction, or counter-trend moves against the larger degree wave develop in three waves.
Five waves to progress; three waves to regress
motive waves
A motive wave refers to a trend movement that coincides with the overall directional momentum of price. Motive waves do not only form during an uptrend, just as corrective waves do not only form during a downtrend.
-Motive waves are labled with numbers
-Motive waves subdivide into waves of five, and always move in the same direction as the trend of one larger degree
-Wave 3 is the strongest of the motive waves
-Wave 5’s generally produce weaker trend movements as the larger degree Wave comes to an end
Rules for a Motive Wave
- Wave 2 must not retrace more than 100% of Wave 1
- Wave 4 must not enter into Wave 3 territory
- Wave 3 must exceed the Wave 1 high
corrective waves
Corrective waves develop in two scenarios. One being during a larger degree motive wave. The other after the completion of a full cycle motive wave (full cycle referring to a 5 wave structure). Within a motive wave, waves 2 and 4 are corrective waves. After the 5 wave structure finishes, completing the larger degree motive wave, the larger degree count is then in corrective mode. In this case waves A and C are motive waves because they move in the same direction as the larger degree wave.
Wave 2 is always a steep correction and usually takes the form of a zig-zag structure. Wave 4 is always a flat correction and will take the form of one of the images above
Wave 2- steep
wave 4- flat
Important terms
Alternation (guideline of): If wave two is a sharp correction, wave four will usually be a sideways correction, and vice versa.
Apex: Intersection of the two boundary lines of a contracting or barrier triangle.
Corrective Wave: A three-wave pattern, or combination of three-wave patterns, that moves in the opposite direction of the trend of one larger degree.
Diagonal: A wedge-shaped pattern containing overlap that usually occurs as a fifth or C wave and occasionally occurs as a first or A wave. Subdivides 3-3-3-3-3.
Double Three: Combination of two simple sideways corrective patterns, labeled W and Y, separated by a corrective wave labeled X.
Double Zigzag: Combination of two zigzags, labeled W and Y, separated by a corrective wave labeled X.
Equality (guideline of): In a five-wave sequence, when wave three is the longest, waves five and one tend to be equal in price length.
Expanded Flat: Flat correction in which wave B enters new price territory relative to the preceding impulse wave.
Failure: See Truncated Fifth.
Flat: Sideways correction labeled A-B-C. Subdivides 3-3-5.
Impulse: A five-wave pattern that subdivides 5-3-5-3-5 and contains no overlap.
Irregular Flat: See Expanded Flat.
Motive Wave: A five-wave pattern that moves in the same direction as the trend of one larger degree, i.e., any impulse or diagonal.
One-two, one-two: The initial development in a five-wave pattern, just prior to acceleration at the center of wave three.
Overlap: The entrance by wave four into the price territory of wave one. Not permitted in impulse waves.
Previous Fourth Wave: The fourth wave within the preceding impulse wave of the same degree. Corrective patterns typically terminate in this area.
Running: Refers to a flat or triangle in which wave B goes beyond the start of wave A, and wave C does not go below the end of wave A.
Sharp Correction: Any corrective pattern that does not contain a price extreme meeting or exceeding that of the ending level of the prior impulse wave; alternates with sideways correction.
Sideways Correction: Any corrective pattern that contains a price extreme meeting or exceeding that of the prior impulse wave; alternates with sharp correction.
Third of a Third: Powerful middle section within an impulse wave.
Thrust: Impulsive wave following completion of a triangle.
Triangle (barrier): Same as contracting triangle but the B-D trendline is horizontal. May be termed “ascending” or “descending” depending on direction.
Triangle (contracting): Corrective pattern, subdividing 3-3-3-3-3 and labeled A-B-C-D-E. Occurs as a fourth, B or Y wave. Trendlines converge as pattern progresses.
Triangle (expanding): Same as contracting triangle but trendlines diverge as pattern progresses.
Triple Three: Combination of three simple sideways corrective patterns labeled W, Y and Z, each separated by a corrective wave labeled X.
Triple Zigzag: Combination of three zigzags, labeled W, Y and Z, each separated by a corrective wave labeled X.
Truncated Fifth: The fifth wave in an impulsive pattern that fails to exceed the price extreme of the third wave.
Zigzag: Sharp correction, labeled A-B-C. Subdivides 5-3-5.
Per elliotwave.com