Elliot Wave Theory and How Groups Behave

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Introduction

The Elliott Wave Principle is used to analyze financial market cycles and forecast trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.  Ralph Nelson Elliott discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns - Elliott Waves.  There is a mountain of info out there on The Elliott Principle and we'll only touch on the basics of Elliott theory below.  It should provide a good platform if you want to learn more.

The Basic Structure of The Elliott Wave

The Elliot Wave Principle states that collective investor psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns in the price movements of markets at every degree of trend or time scale.  In Elliott's model, market prices alternate between an impulsive phase, and a corrective phase on all time scales of trend, as the illustration shows.  At the top of the below chart we can see a basic wave cycle made up of an up trend and a down trend.  The up trend is made of 3 impulse phases (1, 3 & 5) and 2 corrective phases (2 & 4) and the down trend is made up of 2 impulse phases (A & C) and 1 corrective phase (B).  You'll see that impulse phases move with the larger trend and corrective phases move against the main trend - no matter the direction of the trend.     

Elliott waves are fractal in nature and each impulse phase is subdivided into 3 impulse phases and 2 corrections and each correction is subdivided into 2 impulse phases and 1 corrective phase.  For instance, wave 1 in the top wave cycle is subdivided into 3 impulse and 2 corrective phases, as is wave A.  This is shown by the middle wave cycle in the chart.  However, wave 4, a corrective phase, is subdivided into 2 impulse and 1 corrective phase.  Why? Because wave 4 is the main trend when viewed in a smaller time frame.  Again, shown in the middle wave cycle.

No matter how big or small the wave degree, impulse waves take on a 5-wave sequence (3 impulse & 2 corrective) and corrective waves take on a 3-wave sequence (2 impulse & 1 corrective). In other words, any impulse wave subdivides into 5 smaller waves and any corrective wave subdivides into three smaller waves.  This progression can be seen below.

Elliott Wave Structure showing Fractals

Interpreting Elliott Waves

There are only three rules when it comes to interpreting Elliott Waves. There are many guidelines, but only three HARD rules, which are unbreakable.  Guidelines, on the other hand, are bendable and subject to interpretation. Furthermore, these rules only apply to a 5-wave impulse sequence. Corrections, which are much more complicated, are given more leeway when it comes to interpretation.
  • Rule 1: Wave 2 cannot retrace more than 100% of Wave 1.  
  • Rule 2: Wave 3 can never be the shortest of the three impulse waves.
  • Rule 3: Wave 4 can never overlap Wave 1.
The chart below shows these rules.  Any failure in these rules, means traders need to restart counting Elliott waves.

Elliott Wave Rules and Guidelines


There are also guidelines to follow.  These aren't as hard as the rules
  • Guideline 1: When wave 3 is the longest impulse wave, wave 5 will approximately equal wave 1.
  • Guideline 2: The forms for Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, wave 4 will be a flat correction and vice-versa.
  • Guideline 3: After a 5-wave impulse advance, corrections (abc) usually end in the area of wave 4's low.
This is just a brief outline, but chartists can greatly improve their Elliott Wave counting by applying the three rules and three guidelines. Elliott Wave counts start with a process of elimination - start by going through the rules then the guidelines. Eliminating bogus counts paves the way to a more accurate count. Even with accurate counts, chartists will still need to re-evaluate and adjust counts as new price information emerges. Once chartists think they've got the hang of identifying Elliot waves they can think about predicting where the market may go in the future.  Be aware that waves are subjective and not all Elliott practitioners agree on what they see.  Some charting software will count Elliott waves for you and are worth exploring.  

Fibonacci and Elliot

The Fibonacci series is the basis of Elliott Theory.  Numbers from the Fibonacci sequence surface repeatedly in Elliott Wave structures and both are related to the "golden ratio" 1.618. Practitioners commonly use this ratio and related ratios to establish support and resistance levels for market waves, namely the price points which help define the parameters of a trend (See Module 4 Fibonacci retracement).

The Trouble with Elliott Theory in Practice

The Elliott Wave Principle is highly subjective and for most traders can be very problematic. Take 5 Elliott Wave practitioners and all 5 will see different shapes within a trend. Elliott is considered too vague to be useful, since it cannot consistently identify when a wave begins or ends and Elliott Wave forecasts are prone to subjective revision. Some who advocate technical analysis of markets have questioned the value of Elliott Wave analysis. However, Elliot Wave Theory is a compelling account of market behaviour and as such surely has some merit.

More...

Elliot Wave Theory is also placed under Module 4 - Charting Tools, as it has a lot to do with Fibonacci.  

Further Reading

Book:  The Elliot Wave Principle By Robert Pritchard

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Introduction

The Elliott Wave Principle is used to analyze financial market cycles and forecast trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.  Ralph Nelson Elliott discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns - Elliott Waves.  There is a mountain of info out there on The Elliott Principle and we'll only touch on the basics of Elliott theory below.  It should provide a good platform if you want to learn more.

The Basic Structure of The Elliott Wave

The Elliot Wave Principle states that collective investor psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns in the price movements of markets at every degree of trend or time scale.  In Elliott's model, market prices alternate between an impulsive phase, and a corrective phase on all time scales of trend, as the illustration shows.  At the top of the below chart we can see a basic wave cycle made up of an up trend and a down trend.  The up trend is made of 3 impulse phases (1, 3 & 5) and 2 corrective phases (2 & 4) and the down trend is made up of 2 impulse phases (A & C) and 1 corrective phase (B).  You'll see that impulse phases move with the larger trend and corrective phases move against the main trend - no matter the direction of the trend.     

Elliott waves are fractal in nature and each impulse phase is subdivided into 3 impulse phases and 2 corrections and each correction is subdivided into 2 impulse phases and 1 corrective phase.  For instance, wave 1 in the top wave cycle is subdivided into 3 impulse and 2 corrective phases, as is wave A.  This is shown by the middle wave cycle in the chart.  However, wave 4, a corrective phase, is subdivided into 2 impulse and 1 corrective phase.  Why? Because wave 4 is the main trend when viewed in a smaller time frame.  Again, shown in the middle wave cycle.

No matter how big or small the wave degree, impulse waves take on a 5-wave sequence (3 impulse & 2 corrective) and corrective waves take on a 3-wave sequence (2 impulse & 1 corrective). In other words, any impulse wave subdivides into 5 smaller waves and any corrective wave subdivides into three smaller waves.  This progression can be seen below.

Elliott Wave Structure showing Fractals

Interpreting Elliott Waves

There are only three rules when it comes to interpreting Elliott Waves. There are many guidelines, but only three HARD rules, which are unbreakable.  Guidelines, on the other hand, are bendable and subject to interpretation. Furthermore, these rules only apply to a 5-wave impulse sequence. Corrections, which are much more complicated, are given more leeway when it comes to interpretation.
  • Rule 1: Wave 2 cannot retrace more than 100% of Wave 1.  
  • Rule 2: Wave 3 can never be the shortest of the three impulse waves.
  • Rule 3: Wave 4 can never overlap Wave 1.
The chart below shows these rules.  Any failure in these rules, means traders need to restart counting Elliott waves.

Elliott Wave Rules and Guidelines


There are also guidelines to follow.  These aren't as hard as the rules
  • Guideline 1: When wave 3 is the longest impulse wave, wave 5 will approximately equal wave 1.
  • Guideline 2: The forms for Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, wave 4 will be a flat correction and vice-versa.
  • Guideline 3: After a 5-wave impulse advance, corrections (abc) usually end in the area of wave 4's low.
This is just a brief outline, but chartists can greatly improve their Elliott Wave counting by applying the three rules and three guidelines. Elliott Wave counts start with a process of elimination - start by going through the rules then the guidelines. Eliminating bogus counts paves the way to a more accurate count. Even with accurate counts, chartists will still need to re-evaluate and adjust counts as new price information emerges. Once chartists think they've got the hang of identifying Elliot waves they can think about predicting where the market may go in the future.  Be aware that waves are subjective and not all Elliott practitioners agree on what they see.  Some charting software will count Elliott waves for you and are worth exploring.  

Fibonacci and Elliot

The Fibonacci series is the basis of Elliott Theory.  Numbers from the Fibonacci sequence surface repeatedly in Elliott Wave structures and both are related to the "golden ratio" 1.618. Practitioners commonly use this ratio and related ratios to establish support and resistance levels for market waves, namely the price points which help define the parameters of a trend (See Module 4 Fibonacci retracement).

The Trouble with Elliott Theory in Practice

The Elliott Wave Principle is highly subjective and for most traders can be very problematic. Take 5 Elliott Wave practitioners and all 5 will see different shapes within a trend. Elliott is considered too vague to be useful, since it cannot consistently identify when a wave begins or ends and Elliott Wave forecasts are prone to subjective revision. Some who advocate technical analysis of markets have questioned the value of Elliott Wave analysis. However, Elliot Wave Theory is a compelling account of market behaviour and as such surely has some merit.

More...

Elliot Wave Theory is also placed under Module 4 - Charting Tools, as it has a lot to do with Fibonacci.  

Further Reading

Book:  The Elliot Wave Principle By Robert Pritchard

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