Elliott Waves Theory: Introduction

How does it works ?

Elliott’s theory of waves is a theory of the functioning of financial market fluctuations proposed by Ralph Nelson Elliott. It is directly inspired by Dow’s theory.

The starting point of this theory is that the evolution of the markets is by a series of successive waves, and this, whatever the scale of observation of this market for the very short term or the very long term. This is called a fractal process.

Long or very short term wave

To understand how Elliott’s theory of waves works, we need to know and learn the rules and elements that govern this theory.

Two main phases

The driving phase of an Elliott wave cycle consists of five waves. You can see the waves in green on our diagram above, numbered from 1 to 5. The driving phase must be considered as a detailed view of a phase 2 uptrend described by Stan Weinstein.

The correction phase is shown in red on our diagram above by the letters A, B and C. It is the phase that “corrects” the uptrend. We are not really concerned with this phase with our pullback strategy, but it is good to keep the basic cycle in mind to be ready when a new motor phase begins.

Elements you need:

  • 1st indication: the complete movement is composed of 5 waves. 3 of these waves are in the direction of movement, and two waves are in the opposite direction. The first, third, and fifth waves represent the impulsive form, the second and fourth wave the corrective form.

  • 2nd indication: The five waves of a dimension become a single wave of a dimension of a higher degree. In contrast, a single wave of one dimension is composed of 5 sub-waves of a dimension of a lower degree.

  • 3rd indication: Each impulsive wave (1-3-5) is composed of 5 sub-waves, while each corrective wave (2-4) is composed of 3 sub-waves.

Let’s talk about serious things

After these few very important indications we need to learn how the next waves should be.

To start, there are three first rules.

  • First rule: Wave 2 can correct wave 1 up to 100% but can not go below it. It is then necessary to make a new count.

  • Second rule: Wave 3 is never the shortest wave (amplitude and not duration). If it is smaller than Wave 1 then Wave 5 will be even smaller than 3. There is no exception.

  • Third rule: Wave 4 can never go lower than the top of Wave 1.

Each wave has his personality, let’s discover each one !

Wave 1
The waves 1 are difficult to recognize since they can be interpreted as simple corrections forming part of the previous market. They are usually very short and fast. It often happens that wave 1 can only be broken down into three waves and not five. This wave is the wave of “clever” according to Dow’s theory that they had access to information before others . We can also say that it is the wave of contrarians who buy when the market goes down and sell when it goes up.

Wave 2
It generally corrects the first wave in a considerable way and often leads one to think that the previous movement is not yet finished (end of wave C). 2 waves that completely correct the waves 1 are not rare: we then observe a double bottom configuration if it is a bullish movement or double top in the case of a bearish movement.

Wave 3
This is the wave of “followers”. She is the main wave of the movement. A basic rule to remember about this type of wave is that it is never the shortest among the pulse waves that are waves 1, 3 and 5. These are waves that usually experience extensions and are accompanied very high volumes.

Wave 4
It is a wave much less violent than the wave 2. It comes to consolidate the market. According to the principle of alternation (see below), this wave is often complex: structure in several waves and often in a triangle. A rule to remember: a wave 4 will never break the level reached by the market at the end of wave 1.

Wave 5
This is the wave of small carriers. It is generally not very dynamic but it lasts quite a long time. This is the last phase of a movement: the end of euphoria for bullish movements and despair for bearish movements. At the end of Wave 5, there is a drop in volumes and sometimes a wave 5 that does not exceed the top or the bottom (depending on whether the market is bullish or bearish) Wave 3.

Wave A
They are sometimes considered as technical corrections and not as the beginning of the end of the movement.

Wave B
They sometimes find the top (case of a bullish movement) of wave 5 to form a double-top.

Wave C
They come to close the sequence of eight waves of Elliott’s theory. These are waves that look like waves in size. Their similarities lead to frequent confusion: are we in a market really bearish or in a simple phase of correction?

If you want to learn more about this theory you should take a look to the Fibonacci article before learning the whole Elliott’s waves theory.

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