Elliott Wave Theory Basics

Ralph Nelson Elliott believed markets had well-defined waves that could be used to predict market direction. In 1939, Elliott detailed the Elliott Wave Theory, which states that securities traded in repetitive cycles, which he discovered were the emotions of investors, also known as investor sentiment. Elliott stated that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which he termed "waves". In this section, we provide a primer to Elliott Wave Theory. We will cover a lot of basic information but if you want more detailed information to become an Elliott Wave expert, we recommend you do additional research. One of the leading websites for Elliot Wave Theory is Elliot Wave International.

 

The Five Wave Pattern

According to the Elliott Wave Theory, prices tend to move in a predetermined number of waves consistent with the Fibonacci sequence. Specifically, Elliott believed the market moved in five distinct waves with a trend and three distinct waves against a trend.

The progress of a security in a market ultimately forms waves of a specific structure and pattern. This structure is usually a 5-3 structure, where there are normally 5 waves to the impulse force and 3 waves to the correction force.

Within the 5 waves of the impulse force, there are 3 motive components that move in the direction of the trend labeled waves 1, 3 and 5. There are 2 corrective components that counter the current trend labeled waves 2 and 4. Same thing applies in the 3 waves of the correction force, where waves 1 and 3 move in the direction of the correction and wave 2 moves counter to the direction of the correction.

Lets use an up trend Bull move as an example:

Wave Description:

The following description applies to a market moving upwards. In a down market you will generally see the same types of behavior in reverse that you saw watching the security go up. The description of the wave is shown in the chart above.

Wave 1

The security makes its initial move up. Generally due to it being undervalued and traders believe its time to buy.

Wave 2

After a rise, some people now start taking profits. This causes the price to go down. As more people start to see the security still being undervalued, the price does not drop to its prior low.

Wave 3

This is generally the longest wave. It has become a "popular" security, and more people want in and they buy it for a higher and higher price. This wave exceeds the peaks created at the end of wave 1.

Wave 4

At this point people again take profits and some people may start seeing the security overvalued. This wave tends to be weak because their are usually more people that are still bullish on the security and after some profit taking comes wave 5.

Wave 5

This is where most people jump on the bandwagon, and is mostly driven by emotion. People will carelessly purchase the security trying to catch the wave. This is where the security becomes the most overpriced. As more people jump in trying to ride the wave, the price drives up and gets even more overpriced. Then the security will move into either one of two patterns; an ABC correction, or starting again with wave 1. 

An ABC correction is when the security is overpriced, in the mindset of current investors. Some people will take their profits now, thinking a reversal is overdue. This drops the price. Yet, some people will still buy, driving the price back up, especially if they still consider the stock a good value or undervalued. During this time frame volatility is usually much less then the previous 5 wave cycle, and what is generally happening is the market is taking a pause while fundamentals catch up.

You may have more than one ABC correction or if the security is overvalued it could revers and start a 5 wave down cycle. In general, an odd number of ABC corrections indicate a continuance to the uptrend while an even number of corrections indicate a reversal and a downtrend starting.

Impulse or Correction?

Waves one, three and five are the impulse waves, or minor up-waves. Waves two and four are the corrective waves, or minor down-waves in the major bull move. The waves lettered a and c are the minor down-waves in a major bear move, while b is the one up-wave in a minor bear wave. Sounds simple enough, right? Lets start using a real world example:

 

 

The Elliott Wave isn't always pretty and perfect as we see above, but the theory is intact. This long term wave is actually graphed over a period of almost three years. There are a few variations from the perfect wave, but that is quite normal. Elliott proposed that the waves exist at many levels, meaning there could be waves within waves. An important feature of Elliott Wave Theory is that they are 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 charts as well as short-term hourly market charts.  The graph below shows how primary waves could be broken down into smaller waves. It shows the graph above from the beginning through point 1 toward point 2:

 

The major waves determine the major trend of the market, and minor waves determine minor trends. Elliott provided many variations on the main wave, and placed particular importance on the golden mean, 0.618, as a significant percentage for retracement.

Trading using Elliott Wave patterns is quite simple, on the surface. Identify the main wave or Supercycle, enter long, and then sell or short, as the reversal is determined. This continues in progressively shorter cycles until the cycle completes and the main wave resurfaces. However, care must be taken since much of the wave identification is taken in hindsight and determining which cycle the market is in is not always obvious.

An impulse-wave formation followed by a corrective wave, form an Elliott wave degree, consisting of trends and countertrends. Although the patterns pictured above are bullish, the same applies for bear markets, where the main trend is down.

 

Assumptions of Elliot Wave Theory:

• The market is not efficient
• It is a true free market (i.e., prices are set by the consumer's beliefs).
• It provides consistent and standard metrics that can be measured.
• It is manipulated by a statistically significantly large group of people.
  

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.

 

Elliott Wave Theory Cycles

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

Whereas a Grand Supercycle might be the chart of a security since 1932, spanning decades, a Sub-Minuette might be the price of that security on a 5-minute chart. The catagories are all based on identifyable degrees of waves, and waves within waves. Since this is a basic primer about Elliott Wave Theory, we won't get into details about the wave catagories.

Recent News (links open in new tab)

NZ Dollar Down on Rates Dovish Comments

Thu, 11 Mar 2010 02:43:44 +0000
After gaining for two consecutive days versus important currencies like the euro and the U.S. dollar, the kiwi currency didn’t manage to sustain its trend after central bankers in the country affirmed that lack of economic improvements in the South Pacific nation will delay interest rate hikes.(...)Read the rest of NZ Dollar Down on Rates Dovish Comments (126 words) Posted on Forex News.

Yen Reverts Losing Trend on Domestic Speculations

Thu, 11 Mar 2010 02:12:16 +0000
The yen started this Thursday’s session in Asia gaining versus currencies regionally and globally, on speculations that local investors are repatriating capital before the Japanese fiscal year ends in the following weeks.(...)Read the rest of Yen Reverts Losing Trend on Domestic Speculations (133 words) Posted on Forex News.

Canadian Dollar Keeps Uptrend on Growth

Wed, 10 Mar 2010 03:37:27 +0000
The Canadian dollar had an amazing eighth day of consecutive gains versus its southern counterpart as currencies tied to growth profited from another session of optimism in commodities and equities markets, allowing the loonie to remain bullish.(...)Read the rest of Canadian Dollar Keeps Uptrend on Growth (110 words) Posted on Forex News.