Basics of Elliott Wave Theory Explained

The Elliott Wave Theory allows traders to analyze price movements in the financial markets
It focuses on analyzing trends in the price movements
There are two movements it identifies: bullish and bearish

Elliott Wave Theory Definition

The Elliott Wave Theory is a form of technical analysis. It allows traders to analyze price movements in the financial markets. The Elliott Wave Theory is also called the Elliott Wave Principle. The basic idea behind the Elliott Wave Theory is that crowd psychology creates phases of market optimism and pessimism. The Elliott Wave Principle was discovered and formulated by Ralph Nelson Elliott. Elliott Wave traders use the Elliott Wave Theory to understand these market price cycles or phases. They use this information to forecast trends and price patterns on the chart. The market phases or waves are characterized by two factors: direction and speed. Price action can behave in the following ways:

Optimism = bullish, uptrend
Pessimism = bearish, downtrend
Quick speed = impulse, momentum, motive phase
Slow speed = correction, range, sideways, corrective phase

The market is either in a motive phase or corrective phase. The phases usually alternate but it is not a must. Sometimes motive and corrective phases can endure for a while. Or in some cases, a corrective phase can follow a corrective phase and an impulsive phase can follow a corrective phase.

Elliott Wave Theory Explained

The impulse and corrective phase can be both bullish and bearish. This means that there are four combinations possible:

Bullish impulse
Bullish correction
Bearish impulse
Bearish correction

The impulsive phase has 5 waves. The corrective phase has 3 waves.

In the 5 wave pattern: waves 1, 3, and 5 are impulsive with the trend. Waves 2 and 4 are corrective against the trend
In the 3 wave pattern: waves A and C can be impulsive against the trend. Wave B is corrected with the trend.

In waves 1, 3, and 5, there are another 5 sub-waves (15 waves in total). In waves 2 and 4, there are usually two sets of a 3 wave ABC correction (6 waves in total). So, in those 5 sub-waves, there are a total of 21 waves within those sub-waves. Once the 5 waves and 3 wave patterns are completed on the one-time frame, then the sequence begins again on a higher time frame.

Source: From R.N. Elliott's essay, "The Basis of the Wave Principle", October 1940. These wave patterns occur on all time frames, including lower and higher ones. Basically, these patterns self repeat on all degrees. The classification of a wave can vary, but Elliott Wave analysts generally agree on these degrees (with approximate duration):

Grand supercycle: multi-century
Supercycle: multi-decade (about 40–70 years)
Cycle: one year to several years (or even several decades under an Elliott Extension)
Primary: a few months to a couple of years
Intermediate: weeks to months
Minor: weeks
Minute: days
Minuette: hours
Subminuette: minutes

Elliott Wave Theory Strategy

Let’s review the main rules and characteristics per wave.

Elliott Wave Theory rules

There are dozens of guidelines but only 3 main rules. These guidelines and rules help Elliott Wave analysts make more accurate analyses, predictions, and decisions. The 3 main Elliott Wave rules are:

Wave 2 never retraces more than 100% of wave 1.
Wave 3 cannot be the shortest of the three impulse waves (waves 1, 3, and 5).
Wave 4 does not overlap with the price territory of wave 1 - with the exception of leading or ending diagonals.

Elliott Wave Theory guidelines

There are many other guidelines that help Elliott Wave analysts create an Elliott Wave strategy. Mentioning them all does not fit within the scope of this article. But this article will add a few Elliott Wave theory examples of guidelines:

Waves often alternate. If a wave 2 retracement is deep, then wave 4 is often shallow.
Waves 2 are often simple corrections while waves 4 are often complex corrections.
Wave 3 almost always has the greatest volume. If volume during the 5th wave is as high as the 3rd, expect an extended 5th wave.
If wave 1 is a leading diagonal, wave 3 is usually extended.
Expanding Flats are the most common type of flat correction. There is an ‘Expanding” Flat if Wave B retraces between 105% – 138% of wave A, and Wave C ends anywhere beyond the end of wave A.
There are dozens and dozens of more guidelines that we are not able to address here.

Wave 1 reviewed

Waves 1 are often difficult to spot because they move against the prior trend. The previous trend is usually weak(er) and showing divergence patterns. Candlesticks patterns in the opposite direction can be another signal that the trend is reversing. Price action will break above the resistance trend lines, Fractals, and moving averages. On a lower time frame, five waves develop into the new trend direction. Usually, a strong impulse occurs in wave 3, which is a clear signal of the new trend. Sometimes a leading diagonal occurs if the new trend is slow to develop.

Wave 2 reviewed

After a 5 wave pattern is completed in wave 1, a larger retracement takes place of the entire 5 waves. This is wave 2. For some traders who are not aware of Elliott Waves, this might still seem like the old trend is continuing. The correction unfolds in 3 waves: an ABC correction. Price action may not retrace the entire wave 1, otherwise, it becomes invalid. A deep retracement, however, is very common.

Wave 3 reviewed

This wave sees the most enthusiasm. Wave 2 has confirmed a higher low or lower high. Now the bulls or bears are dominating the new trend and pushing price strongly in that direction. Price action is often the most impulsive in this wave. Wave 3 also moves a far distance in relation to the first wave 4. Often there are wave extensions in wave 3, which means that a wave 1, 3, or 5 is extended. Wave 3 may never be the shortest wave, otherwise, this Elliott Wave analysis becomes invalid. A wave 3 is always an impulse.

Wave 4 reviewed

After the strong impulse in wave 3, a corrective pattern emerges. There is a retracement in the trend. A 3 wave ABC correction takes place. Often the wave 4 is shallow but complex and lengthy in time. Wave 4