Technical Analysis Course online. Training, Coaching and Mentoring for Traders / Investors.

Elliott Wave Theory

The Elliott wave principle is a form of technical analysis that some traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. Ralph Nelson Elliott (1871–1948), a professional accountant, discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in 1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most comprehensively in his final major work, Nature’s Laws: The Secret of the Universe in 1946. Elliott stated that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable."


Elliott Wave Theory interprets market actions in terms of recurrent price structures. Basically, Market cycles are composed of two major types of Wave : Impulse Wave and Corrective Wave. For every impulse wave, it can be sub-divided into 5 - wave structure (1-2-3-4-5), while for corrective wave, it can be sub-divided into 3 - wave structures (a-b-c).

Waves within Wave An important feature of Elliott Wave is that they are fractal in nature. 'Fractal' means market structure are built from similar patterns on a larger or smaller scales. Therefore, we can count the wave on a long-term yearly market chart as well as short-term hourly market chart.


Rules for Wave Count

Based on the market pattern, we can identify ' where we are' in term of wave count. Nevertheless, as the market pattern is relatively simplistic, there are several rules for valid counts: 
  1. Wave 2 should not break below the beginning of Wave 1;
  2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
  3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree.
  4. Rule of Alternation : Wave 2 and 4 should unfold in two different wave forms.

Wave forms in Impulse Wave
There are three major types of wave form in Impulse Wave: 

(a) Extended Wave
Among Wave 1, 3 and 5, only one should unfolded into extended wave. 'Extension' means the wave is elongated in nature and sub-waves are conspicuous in relation to waves of higher degree.

(b) Diagonal Triangle at Wave 5
Sometimes, the momentum at Wave 5 is so weak that the 2nd and 4th sub-waves overlap with each other and evolved into diagonal triangle. 

(c) 5th Wave Failure
In some other circumstances, the Wave 5 is so weak than it even cannot surpass the top of the wave 3, causing a double top at the end of the trend.


Wave Forms in Corrective Wave

Corrective Wave forms are rather complicated, but basically we can categorize them into six major wave forms: 
 
  1. Zig-Zag : abc pattern composed of 5-3-5 sub-wave structure.
  2. Flat : abc pattern composed of 3-3-5 sub-wave structure, with b equals a.
  3. Irregular : abc pattern composed of 3-3-5 sub-wave structure, with b longer than a.
  4. Horizontal Triangle : 5-wave triangular pattern composed of 3-3-3-3-3 sub-wave structure.
  5. Double Three : abcxabc pattern composed of any two from above, linked by x wave.
  6. Triple Three : abcxabcxabc pattern composed of any three from above, linked by two x waves.


The attractiveness of Elliott Wave Analysis is : Three impulse wave forms and six corrective wave forms are conclusive. All we have to do is to identify which wave form is going to unfold in order to predict future market actions, however knowledge of market historical wave patterns and experiences in wave count are of paramount importance.