Elliott Wave Theory was developed by its namesake R.N. Elliot. The wave concept is based on the emotion of market participants which generates a natural ebb and flow what forms waves. The theory is based on how emotion handles fear and greed when markets move. Elliot described price changes in the financial markets. He described five basic wave sequences and three corrective sequences.
The conventions used in the labeling of waves describes the size of the uptrend along with the length and depth of the wave. Upper case roman numerals identifies large degrees of waves in an uptrend. An uptrend will begin with the largest and most pronounced degree of wave which is known as the Grand Super cycle and works its way down to waves of smaller degree. For example a primary wave is one notch down from a super cycle.
Elliot waves are referred to as either impulse waves or correction waves. An impulse wave moves in the direction of the general trend while the corrective wave moves in the opposite direction of the impulse wave. When the general trend is up, the impulse wave is the up wave, and the corrective wave is the down wave.
The impulse wave in an upward trend has 5-waves that incorporate the trend. These impulse waves are labeled with capital roman numerals from 1 to 5. The basic corrective wave forms with three waves, typically labeled using a, b and c. The complete Elliot wave sequence is 5-waves up and 3-waves down. According to Elliot the complete sequence of the waves is separated into 5-waves up which is the impulsive wave, and 3-waves down which is the corrective wave.
Elliot waves are fractal in nature. This means that the structure of the wave sequence that applies to the larger wave structure also applies to mini-phases within the larger wave structure. No matter how large the wave structure is, impulse waves are 5-wave sequences and corrective waves are 3-wave corrections.
There are only a few main rules that govern the Elliot wave principal, and a number of guidelines. While the rules are hard and fast, the guidelines are left up to the trader’s interpretation. The rules only apply to the impulse waves and not the corrective waves.
The first rule is that wave 2 cannot retrace 100 percent of wave 1. The second rule is that wave 3 can never be the shortest of the three impulse waves. And rule 3 is that wave 4 can never overlap wave 1. Wave 2 cannot move below the low of Wave 1. A break below this low would call for a re-count.
Although wave 3 is generally the longest of the 3 impulse waves, there is no rule that states that it cannot be the shortest. Elliot wave says that wave 3 must exceed the high of wave 1, and if this is not the case, you would have to start your wave count from the beginning, known as a recount. Impulse waves surge forward and are a reflecting of trend progress. The third, and final rule, is that Wave 4 cannot overlap Wave 1, which means the low of Wave 4 cannot exceed the high of Wave 1. Such a violation would call for a re-count.
The first guideline is that wave 3 is the longest of the impulse waves within the Elliot wave structure. Wave 5 is generally the same length as wave 1. The second guideline is that wave 2 and wave 4 will alternate in terms of their corrective nature. For example, if wave 2 is a sharp correction, wave 4 will be a flat correction. The third guideline is that following a surge in wave 5, the correction ABC usually ends in the prior wave 4 low point.
The guidelines are very useful in targeting the end of specific waves. In a large uptrend you can use percentages to target the end or beginnings of each wave. For example, the percentage decline in wave 1 could be applied to the high or wave 4 or wave 5. Each guideline is helpful. The third guideline is helpful in estimating the end of the wave 2 correction.
In closing, this article covers the very basics of the Elliot wave principal. Traders may improve their counting by applying the 3-rules and 3-guidelines to their wave counting. If you apply the rules for the first count and guidelines for the second you are likely to evaluate the waves in the proper manner. By eliminating false waves you may be able to target specific areas of a trend and improve levels to initiate a trade or take profit.