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Lesson 5: Elliott Waves Theory

Lesson 5: Elliott Waves Theory

Elliott Wave theory is a popular way to make market forecasts, and it includes several principles and complementary hypotheses that make it a useful tool for technical analysts.

Elliott wave can be applied in any market, on any time frame, with any account size. But like anything worth learning, getting there takes patience. Through practical, easy-to-understand rules and guidelines, and step-by-step specifics, you will learn to apply what works best for you. Whether you intend to use this Elliott Wave research as your point of entry for the method, as a quick refresher, or as a handy reference guide, you will turn to its contents time and time again.

How to use this guide:

  • Learn the Elliott Wave theory step by step
  • Open a demo account and practice the Elliott Wave trading rules with virtual funds
  • When ready open a live trading account and explore a wide range of markets

Introduction to Elliott Wave

R.N. Elliott developed Elliott Wave Theory in the 1920s. Mr. Elliott discovered there is no chaos in the markets, but on the contrary, this is a natural order in the markets that manifests itself in wave patterns, which continually repeat themselves. These wave patterns continually repeat themselves over and over again in forex trading, stock trading, gold trading, and even cryptocurrency trading. The wave patterns are also fractal in nature, which means that you can subdivide these waves into smaller and smaller waves and they had the same pattern, just a different degree.

The key to the Elliott Wave Theory is to learn how to correctly detect these wave patterns that tend to occur over and over again in the markets. These wave patterns can be divided into basically two kinds, the trending wave, and the non-trending wave. Some people call them ‘impulse waves’ and ‘corrective waves’. The markets tend to trend only 20% of the time and they go into corrections 80% of the time. The impulse wave has five price movements. Three of them are in the direction of the market and two of them are in the opposite direction of the market.

Elliott Waves structure
These five waves can also be broken down into smaller waves. Each impulse wave has five waves and each correction has 3 waves.

Elliott Wave structure

The Elliott Wave corrective waves can also be broken down into a smaller degree. Waves A and C are in the direction of the reaction. This would illustrate the reaction in a bullish trend.

Elliott Wave corrective waves

It should be very easy now to distinguish between the trends of the market and the corrections.

You must remember that the possible number of wave degrees is infinite. You can only trade so many waves down. The smallest detectable wave pattern would be using a 1-minute candlestick chart. The advantage of having different degrees of waves is that you can trade the degree that you are most comfortable with. Day-traders might trade the Sub Minuette Wave Degree and intermediate investors might use the Primary Wave Degree to trade.

Elliott Wave Patterns

Recognizing the patterns of the waves as they are developing is the most important thing you can do. Many Elliott Wave technicians can correctly analyze a completed chart with the correct patterns, but what good does that do. You need to do it as it is happening. You can correctly determine where you are in the Elliott Wave pattern, as it is unfolding, it will tell you the levels the market will rise or fall to. That’s the importance of the Elliott Wave theory.

Now let’s look at the various Elliott Wave Patterns in a very strict manner according to the rules followed by Elliott Wave technicians:

Trends

a. Impulse

Pattern

Elliott Wave Patterns

Description

  • Impulse waves are composed of five waves labeled 1,2,3,4,5.
  • Waves 1, 3, 5 are themselves impulse waves.
  • Waves 1, 3, 5 are usually equal in length.
  • Waves 2 and 4 are corrective waves.

Rules and Guidelines

  • Wave 2 cannot be longer in price than wave 1.
  • It can’t go beyond the origin of wave 1.
  • Wave 3 is never the shortest when compared to waves 1 and 5.
  • Wave 4 cannot overlap wave 1. Exception, diagonal triangles.
  • The third wave usually shows the highest momentum.
  • Exception, when the fifth wave is the extended wave.

In Which Elliott Wave

  • Impulse patterns occur in waves 1, 3, 5, and waves A and C

Internal Structure

  • Composed of five waves 5-3-5-3-5

b. Extension Pattern

Pattern

Elliott Waves Extension Pattern Description

  • An extension occurs in an impulse wave.
  • It can be waves 1, 3, or 5
  • Usually, one of these waves is extended.
  • Normally the third wave is the extended wave.
  • The other two waves are normally equal in length.

Rules

  • Extended waves are composed of 5, 9, 13 or 17 waves.
  • Wave 2 can’t be longer in price distance than wave 1.
  • Wave 3 is never the shortest when compared to wave 1 and 5.
  • Wave 4 can’t overlap wave 1.
  • Wave 5 exceeds the end of wave 3.
  • The extended wave normally shows the highest acceleration.

In Which Elliott Wave

  • Extensions occur in waves 1, 3, 5, and in A and C waves.

Internal Structure

  • The minimum number of waves of an extended wave is 9, 13, or 17.
  • The minimum internal structure of 9 waves is 5-3-5-3-5-3-5-3-5.

c. Diagonal Triangle Type 1

Pattern

Elliott Wave Diagonal Triangle Type 1

Description

  • Diagonals are impulse patterns.
  • They occur in terminal waves like the fifth or a C wave.
  • Diagonals are relatively rare.
  • They occur a lot in lower wave degree charts.
  • Usually, they are followed by a violent change.

Rules and Guidelines

  • It is composed of 5 waves.
  • Waves 4 and 1 do overlap.
  • Wave 4 can’t go beyond the origin of wave 3.
  • Wave 3 can’t be the shortest wave.
  • Internally all waves of the diagonal have a corrective structure.
  • Wave 1 is the longest wave and waves 5 is the shortest.
  • The Channel lines of Diagonals must converge
  • The internal wave structure should show alternation.

In Which Elliott Wave

  • Diagonal triangles type 2 occurs in waves 1 and A.

Internal Structure

  • The five waves of the diagonal type 2 show an internal structure of 5-3-5-35.

d. Failure or Truncated 5th

Pattern

Elliott Wave Failure or Truncated 5th
Description

  • Impulse wave in which the fifth doesn’t extend beyond the third.
  • The fifth wave goes only slightly beyond the third wave.
  • Classified as a failure wave.
  • The trend is a week and will accelerate in the opposite direction.

Rules and Guidelines

  • Wave 2 can’t be longer in price than wave 1.
  • Wave 2 can’t go beyond the origin of wave1.
  • Wave 4 can’t overlap wave 1 or A.
  • Wave 5 fails to go beyond the end of wave 3.
  • Wave 3 shows the highest momentum.
  • The internal wave structure should show alternation.

Internal Structure

  • It must be composed of five waves.

Corrections

a. Zigzag

Pattern

Description

  • The most common corrective wave structure.
  • It begins with a sharp reversal.
  • It looks like an impulsive wave
  • It can extend into a double or triple zigzag. (not common)

Rules and Guidelines

  • Composed of 3 waves
  • Wave A and C are impulses, Wave B is corrective.
  • The B wave retraces no more than 61.8% of A
  • The C wave must go beyond the end of A
  • The C wave normally is at least equal to A

In Which Elliott Wave

  • Most of the time it happens in A, X or 2.
  • Also common in B waves or part of a Flat or Triangles or in 4.

Internal Structure

  • The internal structure of the 3 waves is 5-3-5 in a single Zigzag, 5-3-5-3-5-3-5 in a double.

Example of a Double Zigzag

Elliott Wave Double ZigZag example
The above is a modern representation of the Double Zigzag using the labels WXY instead of ABCXABC. This is more consistent because this way 2 zigzags of lower degrees get corrected to each other by waves of higher degree.

b. Flat

Pattern

Elliott Wave Flat Pattern
Description

  • Flats are a very common form of correction pattern.
  • Shows a sideways direction.
  • Waves A and B of the Flat are both corrective patterns.
  • Wave C is an impulse pattern.
  • Normally eave C will not go far beyond the end of wave A.

Rules and Guidelines

  • It is composed of 3 waves.
  • Wave C is an impulse, and Wave A and B are corrective.
  • Wave B retraces more than 61.8% of A
  • Wave B shows a common retracement to the end of the previous wave.
  • Wave C shouldn’t go far beyond the end of A
  • Normally wave C is at least equal to A.

In Which Elliott Wave

  • It occurs mostly in B waves, also common in 4 and 2.

Internal Structure

  • The internal structure of these waves is 3-3-5. Both waves A and B are normally Zigzags.

c. Expanded Flat or Irregular Flat

Pattern

Elliott Wave Expanded Flat or Irregular Flat

Description

  • This is a common special type of Flat.
  • B wave is extended and goes beyond the end of the previous wave.
  • The B wave has a lot of strength and shows the direction of B.
  • Strong acceleration is present which starts the 3rd or 5th wave.
  • If the C wave is much longer than A, the strength will be less.

Rules and Guidelines

  • It is composed of 3 waves.
  • Wave C is an impulse, and waves A and B are corrective.
  • Wave B retraces beyond the end of the previous impulse wave A.
  • The C wave normally is much longer than A.

In Which Elliott Wave

  • It can happen in 2, 4, B, and X. It can happen in 2 and C is relatively short, normally an acceleration in the third will take place.

Internal Structure

  • Composed of five waves, which have a structure of 3-3-5-5.

d1. Triangles (Contracting)

Pattern

Description

  • A triangle is a corrective chart pattern, which can contract or expand.
  • It can ascend or descend.
  • It is composed of five waves; each of them has a corrective nature.

Rules and Guidelines

  • It is composed of 5 waves.
  • Waves 4 and 1 do not overlap.
  • Wave 4 can’t go beyond the origin of wave 3
  • Internally all waves have a corrective wave structure.
  • Wave 1 is the longest wave and wave 5 is the shortest.

In Which Elliott Wave

  • Triangles occur in wave B, X, and 4, never in waves 2 or A.

Internal Structure

  • It is composed of five waves, internal structure 3-3-3-3-3.

d2. Expanding Triangle

Pattern

Elliott Wave Expanding Triangle

Ascending Triangle

  • This triangle slopes upwards.
  • This pattern has been implemented in Modern Rules.

Descending Triangle

  • This is a triangle, which slopes downwards.
  • This pattern has been implemented in modern rules.

Running Triangle

  • This is a triangle where the B wave exceeds the origin of wave A.

e. WXY or Combination

Pattern

Elliott Wave WXY or Combination

Description

  • Combines several types of corrections.
  • Labeled WXY and WXYXZ.

Rules and Guidelines

  • Forms small patterns to make a larger one.
  • The triangle should normally appear at the end.

In Which Elliott Wave

  • Generally, a combination occurs mostly in B, X, and 4.
  • Less common in A and rare in 2.

Internal Structure

  • A Zigzag followed by a flat, followed by a Triangle has the following internal structure. 5-3-5 (Zigzag)-5-3-3-5

f. Running Flat

Pattern

Elliott Wave running flat

Description

  • A rare form of failure.
  • Kind of a Flat with elongated B wave and very small C wave.
  • This could be an extension of an impulse wave.
  • If B is a clear three wave, then it is a running correction.
  • The market will explode in the direction of the B wave.

Rules and Guidelines

  • The B wave must be composed of three waves.
  • The C wave must be composed of five waves.
  • Wave C must be very short and not reach wave A.
  • Wave C must retrace less than 100% of wave B.
  • Wave C must retrace more than 60% of wave A.

In Which Elliott Wave

  • Most of the time it should occur in wave 2 or B.

Internal Structure

  • It is a three-wave structure 3-3-5.

Elliott Wave Targets

Targets for Elliott Wave 3 or C

To begin with, you can draw a channel as soon as waves 1 and 2 are finished. Connect the origin of wave 1, which has been labeled as zero, and the end of wave 2. then draw a parallel line from the top of wave 1.

Generally, this channel is regarded as not being very useful, but it is, First of all, the parallel line services as an absolute minimum target for the 3rd wave under development. If the 3rd wave can’t break through the upper line or fails to reach it, you are probably dealing with a C wave instead of wave 3.

Furthermore, the baseline from 0 to wave 2 serves as a stop-loss. When this baseline gets broken, there is a strong probability that wave 2 (or B) gets more complex, thus wave 3 or C has not begun yet.

Keep in mind that wave 3 is normally the strongest wave and often will go far beyond the upper trendline.

Targets for Elliott Wave 3 or C

Targets for Elliott Wave 4

As soon as wave 3 has finished you can draw a channel connecting the end of wave 1 and wave 3 with a trend line and draw a parallel line from the end of wave 2. by Doing this you can project a target for wave 4. Keep in mind that normally the baseline from wave 3 will be broken slightly by the price action of wave 4. If wave 4 doesn’t come near the baseline at all this is a sign of a very strong trend. You are probably still in wave 3 or you should get ready for a blow-off in wave 5.

Targets for Elliott Wave 4

Targets for Elliott Wave 5

Method 1

As soon as wave 4 has finished you can draw a channel connecting the end of wave 2 and wave 4 with a trend line and draw a parallel line from the end of wave 3 and project upward to wave 5. This is your target for wave 5. This would be for a normal wave 5. An extended wave 5 would push higher. If the price fails to hit the projected trend line to wave 5 then the market is weak and you should look for a sell-off.

Targets for Elliott Wave 5

Method 2

Mostly wave 3 is the strongest wave showing a very fast acceleration relative to wave 1 and 5. If wave 3 indeed shows a nearly vertical rise or decline, then draw a trend line-connecting waves 2 and 4 and draw a parallel line from wave 1. This parallel line will cut through wave 3 and will target wave 5. Experience shows this is a very valuable channel.

Targets for Elliott Wave 5

Targets for Elliott Wave D and E

As soon as wave B has finished you can draw a trend line connecting the origin of wave A and the end of wave B to get a target for wave D, provided a triangle indeed is developing, which is more certain after the completion of wave C.

As soon as wave C has finished you can draw a trend line connecting wave A and the end of wave C to get a target for wave E almost never stops at the trend line precisely, it either never reaches the trend line or it overshoots the trend line fast and temporarily.

Targets for Elliott Wave D and E

Targets in a Double Zigzag

Drawing a channel is very useful to separate Double Zigzags from impulsive waves, which is difficult since both have impulsive characteristics. Double Zigzags tend to fit a channel almost perfect, while in an impulsive wave the third wave clearly breaks out of the channel.

Targets in a Double Zigzag

Elliott Wave Fibonacci Ratios

The wave counts of the impulse and corrective patterns 5 + 3 = 8 are Fibonacci numbers.

Analyzing Fibonacci relationships between price movements is important for several reasons:

  1. You can control your wave analysis.
  2. The better the Fibonacci ratios of your wave count, the more accurate your count is because in some way or the other all waves are related to each other.
  3. You can project realistic targets once you have distinguished different scenarios, which point in the same direction.
  4. Since Fibonacci manifests itself in the proportions of one wave to another, waves are often related to each other by the ratios of 2.618, 1.618, 1, 0.618, 0.382 and 0.236. This fact can help you in estimating price targets for expected waves. If, for example, a wave 1 or A of any degree has been completed, you can project retracements of 0.382, 0.50, and .618 for wave 2 or B, which will give you your targets.
  5. Most of the time the third wave is the strongest, so often you will find that wave 3 is approximately 1.618 times wave 1.
  6. Wave 4 normally shows a retracement, which is less than wave 2, like 0.236 or 0.382. If wave three is the longest wave, the relationship between waves 5 and three often is 0.618.
  7. Also wave 5 equals wave 1 most of the time.
  8. The same relationship can be found between the A and C waves. Normally C equals A or is 1.618 times the length of A.
  9. You can even combine waves to find support and resistance lines or zones. For example, the next price movement of wave 1 and 3 times 0.618 creates another interesting target for wave 5.
  10. It is worthwhile to experiment a lot with your wave count, Elliott Wave Fibonacci ratios will help you to solve the rhythm of the markets.

Targets

Wave 1

The first wave of a new impulsive price movement tends to stop at the base of the previous correction, which is the B wave. The often coincides with a 38.2% or a 61.8% Fibonacci retracement of the previous correction.

Wave 2

Wave 2 minimally retraces 38.2% and mostly 61.8% or more of wave 1. It often stops at subwave 4 and more often at subwave 2 of previous wave 1. A retrace of more than 76% is highly suspicious, although it doesn’t break any rules yet.

Wave 3

Wave 3 minimally is equal to wave 1, except for a Triangle. If wave 3 is the longest wave it will tend to be 161% of wave 1 or even 26l%.

Wave 4

Wave 4 minimally retraces 23% of wave 3 and more often reaches a 38.2% retracement. It normally reaches the territory of subwave 4 of the previous 3rd wave. In very strong markets wave 4 could only retrace 14% of wave 3.

Wave 5

Wave 5 normally is equal to wave 1 or travels a distance of 61.8% of the length of wave 1. It could also have the same relationships to wave 3 or it could travel 61.8% of the net length of wave 1 and 3 together. If wave 5 is the extended wave it mostly will be 161.8% of wave 3 or 161.8% of the net length of wave 1 and 3 together.

Wave A

After a Triangle in a fifth wave, wave A retraces to wave 2 of the Triangle of previous wave 5. When wave A is part of a Triangle, B or 4 it often retraces 38.2% of the complete previous 5 wave (so not only the fifth of the fifth) into the territory of the previous 4th wave. In a Zigzag it often retraces 61.8% of the fifth wave.

Wave B

In a Zigzag wave B mostly retraces 38.2% or 61.8% of wave A. In a Flat, it is approximately equal to wave A. In an Expanded Flat, it usually will travel a distance of 138.2% of wave A.

Wave C

Wave C minimally has a length of 61.8% of wave A. It could be shorter in which case it normally is a failure, which foretells an acceleration in the opposite direction. Generally wave C is equal to wave A or travels a distance of 161.8% of wave A. Wave C often reaches 161.8% of the length of wave A in an Expanded Flat. In a contracting Triangle wave C often is 61.8% of wave A.

Wave D

In a contracting Triangle wave D often travels 61.8% of wave B.

Wave E

In a contracting Triangle wave, E often travels 61.8% of wave C. It cannot be longer than wave C!

Wave X

Wave X minimally retraces 38.2% of the previous A-B-C correction; a retracement of 61.8% is also common.

Elliott Wave Glossary

Alternation (guideline of) - If wave two is a sharp correction, wave four will usually be a sideways correction, and vice versa.

Apex - Intersection of the two boundary lines of a contracting triangle.

Corrective wave - A three-wave pattern, or combination of three wave patterns, that moves in the opposite direction of the trend of one larger degree.

Diagonal Triangle (Ending) - A wedge-shaped pattern containing overlap that occurs only in fifth or C waves. Subdivides 3-3-3-3-3.

Diagonal Triangle (Leading) - A wedge shaped pattern containing overlap that occurs only in first or A waves. Subdivides 5-3-5-3-5.

Double Three - Combination of two simple sideways corrective patterns, labeled W and Y, separated by a corrective wave labeled X.

Double Zigzag - Combination of two zigzags, labeled W and Y, separated by a corrective wave labeled X.

Equality (guideline of) - In a five-wave sequence, when wave three is the longest, waves five and one tend to be equal in price length.

Expanded Flat - Flat correction in which wave B enters new price territory relative to the preceding impulse wave.

Failure - See Truncated Fifth.

Flat - Sideways correction labeled A-B-C. Subdivides 3-3-5.

Impulse Wave - A five-wave pattern that subdivides 5-3-5-3-5 and contains no overlap.

Impulsive Wave - A five-wave pattern that makes progress, i.e., any impulse or diagonal triangle.

Irregular Flat - See Expanded Flat.

One-two, one-two - The initial development in a five wave pattern, just prior to acceleration

at the center of wave three.

Overlap - The entrance by wave four into the price territory of wave one. Not permitted in impulse waves.

Previous Fourth Wave - The fourth wave within the preceding impulse wave of the same degree. Corrective patterns typically terminate in this area.

Sharp Correction - Any corrective pattern that does not contain a price extreme meeting or exceeding that of the ending level of the prior impulse wave; alternates with sideways correction.

Sideways Correction - Any corrective pattern that contains a price extreme meeting or exceeding that of the prior impulse wave; alternates with sharp correction.

Third of a Third - Powerful middle section within an impulse wave.

Thrust - Impulsive wave following completion of a triangle.

Triangle (contracting, ascending or descending) - Corrective pattern, subdividing 3-3-3-3-3 and labeled a-b-c-d-e. Occurs as a fourth, B, X (in sharp correction only) or Y wave. Trendlines converge as pattern progresses.

Triangle (expanding) - Same as other triangles but trendlines diverge as the pattern progresses.
Triple Three - Combination of three simple sideways corrective patterns labeled W, Y, and Z, each separated by a corrective wave labeled X.

Triple Zigzag - Combination of three zigzags, labeled W, Y and Z, each separated by a corrective wave labeled X.

Truncated Fifth - The fifth wave in an impulsive pattern that fails to exceed the price extreme of the third wave.

Zigzag - Sharp correction, labeled A-B-C. Subdivides 5-3-5.

Conclusion

Elliott Wave theory is something that continues to provide a sense of structure to markets for a lot of people worldwide. The ability to constantly shift the theory when a rule is broken can hinder the use of the theory as a means to place trades. However, it also adds a significant degree of clarity to the art of trend recognition. How much complexity a trader wishes to add to R.N. Elliott’s initial rules is up to them, yet it is certainly a method that many choose to place front and centre in their market strategies.

Before trading online, you should be aware that the market is susceptible to prominent levels of volatility and as a result, an asset might experience a breakout or breakdown in a short space of time.

As a result, you should carry out both technical and fundamental analyses on the asset you want to trade before you open a position. We also offer educational resources like CAPEX Academy to help you understand trading and get to know the risks.

Informațiile prezentate în acest document sunt pregătite de CAPEX.com și nu au intentia de a constitui consultanță pentru investiții. Informațiile din acest document sunt furnizate drept o comunicare generală de marketing cu scop informativ și, ca atare, nu au fost pregătite în conformitate cu cerințele legale concepute pentru a promova independența cercetării în domeniul investițiilor și nu sunt supuse niciunei interdicții de abordare înainte de diseminarea cercetărilor legate de investiții.

Utilizatorii/cititorii nu ar trebui să se bazeze exclusiv pe informațiile prezentate aici și ar trebui să facă propriile lor cercetări/analize, prin citirea cercetărilor de bază. Conținutul acestui document este generic și nu ia în considerare circumstanțele personale ale fiecărui individ, experiența de investiții sau situația financiară actuală.

Prin urmare, Key Way Investments Ltd nu va accepta nicio responsabilitate pentru eventualele pierderi ale traderilor datorate utilizării conținutului sau a conținutului informațiilor prezentate în acest document. Performanțele trecute și previziunile nu sunt indicatori fiabili ai rezultatelor viitoare.
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