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Elliot Wave Theory

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Elliot Wave Theory Trading System

The Elliott Wave principle was discovered in the late 1920s by Ralph Nelson Elliott. He discovered that stock markets do not behave in a chaotic manner, but that markets move in repetitive cycles, which reflect the actions and emotions of humans caused by exterior influences or mass psychology. Elliott contended, that the ebb and flow of mass psychology always revealed itself in the same repetitive patterns, which subdivide in so called waves.

In part Elliott based his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Thus Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns he had identified.

Fractals are mathematical structures, which on an ever smaller scale infinitely repeat themselves. The patterns that Elliott discovered are built in the same way. An impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves of the before mentioned impulse, again five waves will be found. In this smaller pattern, the same pattern repeats itself ad infinitum (these ever smaller patterns are labeled as different wave degrees in the Elliott Wave Principle).

Only much later were fractals recognized by scientists. In the 1980s the scientist Mandelbrot proved the existence of fractals in his book "the Fractal Geometry of Nature". He recognized the fractal structure in numerous objects and life forms, a phenomena Elliott already understood in the 1930s.

In the 70s, the Elliot Wave Principle gained popularity through the work of Frost and Prechter. They published a legendary book (a must for every Elliot Wave Trading student) on the Elliott Wave (Elliott Wave Principle key to stock market profits, 1978), wherein they predicted, in the middle of the crisis of the 70s, the great bull market of the 1980s. Not only did they correctly forecast the bull market but Robert R. Prechter also predicted the crash of 1987 in time and pinpointed the high exactly.

Only after years of study, did Elliott learn to detect these recurring patterns in the stock market. Apart from these patterns Elliott also based his market forecasts on Fibonacci numbers. Everything he knew has been published in several books, which laid the foundation for people like Bolton, Frost and Prechter, to make profitable forecasts, not only for stock markets, but for all financial markets.

According to physical law: "Every action creates an equal and opposite reaction". The same goes for the financial markets. A price movement up or down must be followed by a contrary movement, as the saying goes: "What goes up must come down" (and vice versa).

Elliott Wave Principle is based on 2 main assumptions:

1. The market is not efficient. It is an inefficient market place that is controlled by the whims of the masses. The masses consistently overreact and will make things over and under priced consistently.

2. If the above is true, then you should be able to do a "sociological" survey of stock prices independent of other news that effects stock prices. The general explanation for this behavior is that the masses tend to listen for the news they are ready to hear, and that the movement that actually happens depends on other effects.

The interpretation of the Elliott Wave Theory is as follows:

Every action is followed by a reaction.
There are five waves in the direction of the main trend followed by three corrective waves (a "5-3" move).
A 5-3 move completes a cycle.
This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.
The underlying 5-3 pattern remains constant, though the time span of each may vary.

The 3 waves that you see on the picture above are in the trend direction and called impulsive. These 3 waves also have 5 waves within them. The waves that are against the trend (2 and 4) are called corrective and have 3 waves within them.

The corrective wave formation normally has three, in some cases five or more, distinct price movements, two in the direction of the main correction (A and C) and one against it (B).

An important feature of the principle is that it is "Fractal" in nature. "Fractal" means market structure is built from similar patterns on 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.

The Elliott Wave Theory has assigned a series of categories to the waves in order of the largest to the smallest. They are: Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, Sub-Minuette.

To use the theory in everyday trading, the trader determines the main wave, or supercycle, goes long and then sells or shorts the position as the pattern runs out of steam and a reversal is eminent.

Now let us take a look at some wave patterns and try to learn recognizing them on real charts.

Here are some patterns for impulsive waves:

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.

Diagonal triangle at wave 5

5^th wave fails to develop correctly

Here are some patterns for Corrective waves:

Zigzag pattern. Consists of 5-3-5 sub-wave structure

Flat pattern. Consists of 3-3-5 sub-wave structure and where a equals b

Irregular pattern. Consists of 3-3-5 sub-wave structure and where b is longer than a

Horizontal triangle pattern. Consists of 5 wave triangle with 3-3-3-3-3 sub-wave structure

Double three pattern. abcxabc pattern composed of any two from above, linked by x wave.

Triple three pattern. abcxabcxabc pattern composed of any three from above, linked by two x waves.

Here are some rules and hints for trading using Elliott Wave Theory...

Learn to recognize as many wave categories and patterns as possible.

- Know the rules and guidelines.

- Learn the internal structure of the patterns, which will enable you to recognize a pattern within a pattern.

- Remember that only waves 1,3,5, A and C can be impulsive waves.

- All other waves are corrective, against the trend, and show overlap in their internal structure.

Design alternative scenarios by labeling a chart

1. Start labeling a chart by taking into account the following rules and guidelines:

- Separate impulses from corrections, an impulse normally shows acceleration and no overlap, a correction shows a sideways pattern.

- Waves of the same degree should have the same proportions, which is especially important for waves 2 and 4. A minuscule 4th wave cannot belong to a big wave 2 and so on.

- Wave 2 can never retrace more than 100% nor go beyond the origin of wave 1.

- Wave 3 normally is the longest wave and shows the most powerful acceleration.

- In wave 3 there is never an overlap between wave 4 and 1, as occurs in fifth waves (and first or A waves.

- Label the big picture, understand which pattern it belongs to (3 or 5 wave pattern)

- Label more in detail, by labeling the smaller wave degrees initially, then go back to the large wave degrees, changing your labels if necessary.

- Check if the required internal structure of your waves, comply with the rules and guidelines.

- Check if the internal structure of the internal structure is correct.

- Check your wave count for alternation, especially with waves 2 and 4. If wave 2 showed a simple Zigzag, wave 4 should show a complex pattern.

- A corrective pattern mostly minimally carries into the territory of the 4th wave of the previous impulse wave.

- Within a 5-wave impulse, two waves will tend to equality. If wave three is the longest, wave 5 will tend to equality with wave 1.

- Use momentum indicators and volume to support your wave labeling. Wave 3 should have the highest momentum and volume (if it is the longest wave).

- Draw channels and determine if your wave count more or less fits these channels. The better the fit, the better the count.

2. Design as many scenarios as the Wave Principle allows, with regard to the wave degree or time frame you are analyzing.

3. Do the same for shorter and longer time frames (or lower and higher wave degrees) and try to narrow down alternatives by fitting them to a multiple of wave degrees.

4. Assess the probabilities of these scenarios by studying their compliance with the permitted internal wave structure, the outcome of the Fibonacci ratios and the fit of the channels.

5. Draw the expected price action and pattern of each scenario you have designed, mark price levels where you get signals to enter or exit the market.

Using Elliott Wave Principle in your trading is and art and a very hard thing to learn and master. Nevertheless, if you will spend enough time and put effort into studying this theory, you will certainly benefit greatly. In knowledgeable professional hands Elliott Waves could be very powerful technical analysis tool.

Topics Related to Elliot Wave Theory:

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Part 3: Forex Charts

Part 4: Forex Fundamental Analysis & Economic News Releases

Part 5: Technical Analysis

Part 6: Technical Indicators

Part 7: Fibonacci Analysis

Part 8: Elliot Wave Theory

Part 9: Candlestick Chart Analysis

Part 10: Money Management

Part 11: Trading Psychology

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