Chapter 1: Elliott Wave Theory

Elliott Wave

Elliott Wave theory is one of the most acknowledged and widely used forms of technical analysis. RN Elliott developed the theory after analyzing nearly 75 years of stock data, and Robert Prechter later popularized it.

According to the Wave theory, the market trades in repetitive cycles, which Elliot primarily attributed to the emotions of investors (or the psychology of the masses at the time) as well as outside influences.

Why it is appealing?

The Elliot Wave theory proves that the upward and downward price swings caused by the collective psychology always reflect the same repetitive patterns.

Elliot observed that all financial markets move in a zigzag formation, which he termed Wave cycles. With this theory, Elliot was able to analyze markets in greater depth by identifying the specific characteristics of wave patterns and was able to make detailed market predictions based on these patterns.

This is what makes the Elliott Wave theory so appealing to traders as it provides them with a method to spot precise price points where the market is likely to reverse.

In simpler words, Elliott came up with a system that enables traders to catch tops and bottoms.

Basic Principals of the Theory

The Elliott Wave theory states that the market is fractal in nature i.e. it forms the same patterns that are observed on larger degree charts on smaller timeframe as well, and that it can be used to predict future price movement. The theory states that it does not depend on the timeframe one analyzes as a similar price pattern is observed across all time frames.

The theory claims that that market action among the participants produces wave patterns and trends, defined by Elliott as the physical sign of mass psychology.

The complete cycle of the Elliot Wave development consists of eight waves that make up two phases:

1. An impulse wave sub-divided into five waves and,
2. A corrective wave sub-divided into three waves

Price movement

According to the theory, price movement in the direction of the main trend is defined as the impulse or motive phase, which unfolds in five waves. Three of those waves (1, 3, and 5) move in the direction of the underlying trend, while the two intervening waves (2 and 4) act as counter-trends or minor retracements within the phase.

Wave 5’s up move is followed by a correction 3, which traders usually label as A, B, and C. The 5-3 wave pattern can be seen across all timeframes.

The corrective phase consists of two waves (A and C) that move in the opposite direction of the motive phase, and an intervening retracement wave (B) that moves in the same direction of the motive phase.

The 5-3 wave pattern establishes a complete Elliot wave cycle. The theory tends to get more complicated as more degrees of waves get added. The key to using the Elliot wave successfully lies in counting the waves correctly and identifying the wave in which the market is currently trading in.

Wave Degrees

Elliott identified nine degrees of waves that could range from a multi-century timeframe to short-term intraday movements.

A labeling convention is used to identify the degree of each wave. The largest degree wave is labeled as Grand Supercycle, followed by Supercycle, while the smallest degree wave is labeled as ‘sub-minuette’.

hierarchy of the nine degrees of waves

Here is the hierarchy of the nine degrees of waves:

• A Grand Supercycle is made up of Supercycle waves
• Supercycle waves are made up of Cycle waves
• Cycle waves are made up of Primary waves
• Primary waves are made up of Intermediate waves
• Intermediate waves are made up of Minor waves
• Minor waves are made up of Minute waves
• Minute waves are made up of Minuette waves, and
• Minuette waves are made up of Subminuette waves

Timeframe for each of these nine degrees of waves

Here is the timeframe for each of these nine degrees of waves:

• Grand Supercycle (multi-century)
• Supercycle (about 40–70 years)
• Cycle (one year to several years)
• Primary (a few months to a couple of years)
• Intermediate (weeks to months)
• Minor (weeks)
• Minute (days)
• Minuette (hours)
• Sub-Minuette (minutes)

An example

Most chartists use only 1-4 wave degrees, as applying all nine degrees of waves while trading tends to get quite complicated. The labeling convention is shown in the table below.

An example of how Roman characters are used to represent the different waves.

 

 

Basic 5-Wave Sequence

As we saw earlier, there are two types of waves: impulse and corrective. An impulse wave’s movement is seen in the direction of the larger degree wave. In a rising market, where the direction of the larger degree wave is upwards, the advancing waves are impulsive, while the declining waves are corrective.

Waves 1, 3, 5 are impulse, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.

*Do not confuse Waves 2 and 4 with the ABC corrective pattern though*

Likewise, in a bear market, where the larger degree wave is down, the impulsive waves are also down and vice versa for corrective waves.

 

 

We can see a rising 5-wave sequence in the chart above. Waves 1-3-5 (marked in green) tend to move in the direction of the main trend, while 2-4 (marked in red) are minor corrections within the main trend. The entire 5-wave sequence forms the impulse advance phase.

Basic 3-Wave Sequence

The 5-wave trends are then corrected and reversed by 3-wave countertrends and letters are used instead of numbers to track the correction.

 

 

The above chart shows a simple corrective wave labeled a, b, and c. Notice that a-c waves (marked in green) act as a correction to the main impulse phase, while wave b (marked in red) tends to act as a minor up move within the correction phase.

Complete 5-3 Elliot Wave Sequence

 

The above chart depicts a complete Elliot Wave sequence with the initial 5-wave impulse phase followed by the 3-wave corrective phase. The ‘a-b-c’ corrective phase represents a correction in the larger impulse phase.

 

 

In the above chart, we witness the inverse. The impulse phase, which is the main trend, is downwards, while the correction phase, comprising of waves a-b-c, trends upwards.

Rules of Elliot Wave Theory

Rules of Elliot Wave Theory

There are three main rules to the Elliot Wave theory that analysts must know. These rules apply only to the impulse phase

• First rule: Wave 2 cannot retrace more than 100% of Wave 1
• Second rule: Wave 3 cannot be the shortest among waves 1, 3, and 5
• Third rule: Waves 1 and Wave 4 must not overlap

 

The above image clearly explains the three rules in a simple manner.

• Wave 2 cannot move below the low of Wave 1. A break below this low would invalidate the theory.
• Wave 3 is usually the longest of the three impulse waves; the theory states that it cannot be shorter than wave 1 and 5. Wave 3 should also exceed the height of wave 1.
• Wave 4 cannot overlap Wave 1, which means the low of Wave 4 cannot exceed the high of Wave 1.

Guidelines

There are numerous guidelines to this theory, but we will take a look at the most prominent ones. Unlike the three cardinal rules, these guidelines can be broken.

They are:

• 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, then Wave 4 will be a flat correction. If Wave 2 is flat, then Wave 4 will be sharp.
• Guideline 3: Sometimes, Wave 5 does not move beyond the end of Wave 3. This is known as truncation.
• Guideline 4: After a 5-wave impulse advance, corrections (a-b-c) usually end in the area of prior Wave 4 low.
• Guideline 5: Wave 3 tends to be very long, sharp, and extended.
• Guideline 6: Waves 2 and 4 frequently bounce off Fibonacci retracement levels.

Practical Example

 

 

In the above example of Time Technoplast, we observe the complete Elliot Wave plotted in the graph. As we can see, the waves are not shaped perfectly in real life, however, all the technical rules can be perfectly observed.

An analyst who is successfully able to identify the wave in which the stock is currently trading would be in a position to preempt future movement in the stock and profit from it.