Summary on Elliot wave theory

Elliot wave theory was founded and developed by a business expert accountant by trade Mr. Ralph Nelson Elliot.

From his analysis while studying stock market charts covering almost 75 years, Elliot concluded that the market is not rational.

The continuous change in stock market prices is due to the basic harmony found in nature. He discovered that the crowd behavior trends and reverse patterns occurred in a repetitive form on the charts relating to people’s behavior.

He simply explained these happenings that people rarely change their behavior. He went further, illustrated these patterns and named them waves. Elliot’s belief was that since the same things always happen in the market, traders can be able to identify these patterns in the trending market price charts and be able to tell where price will be going next.

So he came up with the Elliot wave theory. Under his theory, Elliot noted that the power struggles in the market caused by the market participants as the market progresses sometimes make it divert from its direction.

He then finally concluded that this kind of behavior appears into two different forms on a market chart; the impulsive move and the corrective move.

The impulsive waves can occur both in an uptrend and down trend taking a form of 5-3 wave patterns.  It has the three waves 1, 3, 5 moving in the direction of the trend known as the motive waves and two waves 2 and 4 which move against the trend.

Waves 1, 3, 5 can further be divided into five smaller waves each while 2 and 4 into 3’s. Wave 2 can never go beyond wave one and wave 4 can never retrace into wave 1.

The corrective wave is composed of 3 waves moving in the opposite direction of the initial trend but never move beyond the origin of the previous impulse wave. The letters a, b, c are used to label these waves respectively.

The corrective waves can be zigzag, flat, triangles or a combination.

The zigzag correction is a 3 wave correction labeled A-B-C and is divided into a sequence of 5-3-5. A and C are motive waves with 5 sub waves while b is corrective with 3 sub waves.

The flat correction is a sideways 3 wave correction where the sub waves appear inform of 3-3-5. It is labeled A-B-C where by A and B is corrective with 3 sub waves and C is a motive wave with 5 sub waves. The fourth wave in an impulse waves often has it.

The triangles are overlapping five wave patterns labeled A-B-C-D-E subdivided into 3-3-3-3-3. Moves in a sideways movement and is associated with decreasing volumes and volatility.

Combinations (double and triple). This is the sideways combinations of the corrective pattern; double threes and triple threes. It is combination of the zigzag, flat and triangles making a flat correction extending sideways. Double threes and triple three are horizontal in character.  

The three main Elliot wave rules and the guidelines for trading Elliot wave.

  • Wave 2 never retraces 100% of wave 1
  • Wave 3 cannot be the shortest wave in a completed 5 wave sequence.
  • Wave 4 cannot retrace into wave 1

Guidelines

  • The impulse wave is composed of 5 waves.
  • Wave 3 is usually the strongest wave
  • Wave 5 and wave 1 are very often equal in price
  • Wave 2 usually unfolds as simple a-b-c correction
  • Once a 5-wave sequence is complete the whole sequence is corrected.
  • The first leg off the move from a completed 5 wave sequence often finds support and resistance at the prior minor wave 4.
  • Once a correction is completed the main trend resumes
  • Wave 4 can’t retrace into the area of Wave 1.

The violation of any of the above rules implies that the Elliot wave count is incorrect.

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