Elliott Wave Theory
Contents
Introduction
Elliott Wave Theory was developed by Ralph Nelson Elliott and published in his book entitled "The Wave Principle" in 1938. The theory is based on the idea that the behavior of financial markets changes in recognizable patterns. Elliott identified eight waves that are constantly repeated: five waves are in the direct of the trend, and three, against the trend.
5-3 Wave Pattern
According to Elliott Wave Theory, market prices move in typical patterns that are represented by eight waves: five waves are a basic trend, and three waves are a counter trend.
The first five waves are marked with numbers (1 - 5), the following three, with letters (A, B, C).
Waves 1, 3, and 5 are called impulsive or motive waves. Waves 2 and 4 are called corrective waves.
The following three waves (A, B, and C) form a basic trend correction. Note that the waves A and C are impulse waves. The wave B is a corrective wave.
Taken together, this 5-wave impulse sequence and a 3-wave corrective sequence form the complete Elliott Wave sequence. According to Elliott, this complete sequence is divided into two phases: the impulse phase and the corrective phase.
Elliott Wave Rules and Guidelines
According to Elliott, there are three unbreakable rules applied to a 5-wave impulse sequence:
- The wave 2 always retraces less than 100% of the wave 1.
- The wave 3 can never be the shortest of the three impulse waves.
- The wave 4 does not overlap with the price territory of the wave 1.
There are also a number of guidelines. A common guideline is that forms for the waves 2 and 4 will alternate. That is, a sharp move in the wave 2 will suggest a mild move in the wave 4.
Wave Within Wave
In Elliott Wave Theory, the principle of wave inclusion is used. That is, any wave is a part of a longer wave, and the wave itself is subdivided into shorter waves.
The basic principle of Elliott Wave Theory is that each impulse wave consists of five smaller waves, and each corrective wave (against the trend), of three waves:
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