Elliott Wave Theory, is one important method of technical analysis that finance traders use to analyze financial market cycles. In The Elliott Wave Principle — A Critical Appraisal, Hamilton Bolton made this opening statement:

As we have advanced through some of the most unpredictable economic climate imaginable, covering depression, major war, and postwar reconstruction and boom, I have noted how well Elliott’s Wave Principle has fitted into the facts of life as they have developed, and have accordingly gained more confidence that this Principle has a good quotient of basic value.

What is the Elliott Wave Theory?

Elliott Wave Theory is named after Ralph Nelson Elliott (28 July 1871 – 15 January 1948). He was an American accountant and author. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves.

Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns. Elliott based part his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Elliott first published his theory of the market patterns in the book titled The Wave Principle in 1938.

Basic Principle of the 1930’s Elliott Wave Theory

Simply put, movement in the direction of the trend is unfolding in 5 waves (called motive wave) while any correction against the trend is in three waves (called corrective wave). The movement in the direction of the trend is labelled as 1, 2, 3, 4, and 5. The three wave correction is labelled as a, b, and c. These patterns can be seen in long term as well as short term charts.

Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. This information (about smaller patterns fitting into bigger patterns), coupled with the Fibonacci relationships between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid reward/risk ratios.

The Five Wave Pattern

In markets, progress ultimately takes the form of five waves of a specific structure. Three of these waves, which are labeled 1, 3 and 5, actually effect the directional movement. They are separated by two countertrend interruptions, which are labeled 2 and 4, as shown in Figure. The two interruptions are apparently a requisite for overall directional movement to occur.

R.N. Elliott did not specifically state that there is only one overriding form, the “five wave” pattern, but that is undeniably the case. At any time, the market may be identified as being somewhere in the basic five wave pattern at the largest degree of trend. Because the five wave pattern is the overriding form of market progress, all other patterns are subsumed by it.

Wave Mode

There are two modes of wave development: motive and corrective. Motive waves have a five wave structure, while corrective waves have a three wave structure or a variation thereof. Motive mode is employed by both the five wave pattern of Figure and its same-directional components, i.e., waves 1, 3 and 5. Their structures are called “motive” because they powerfully impel the market.

Corrective mode is employed by all countertrend interruptions, which include waves 2 and 4 in Figure 1-1. Their structures are called “corrective” because they can accomplish only a partial retracement, or “correction,” of the progress achieved by any preceding motive wave. Thus, the two modes are fundamentally different, both in their roles and in their construction, as will be detailed throughout this course.

Details of the Complete Cycle

In his 1938 book, The Wave Principle, and again in a series of articles published in 1939 by Financial World magazine, R.N. Elliott pointed out that the stock market unfolds according to a basic rhythm or pattern of five waves up and three waves down to form a complete cycle of eight waves. The pattern of five waves up followed by three waves down is depicted in Figure.

In Elliott’s model, market prices alternate between an impulsive, or motive phase, and a corrective phase on all time scales of trend. Impulses are always subdivided into a set of 5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3.

In Figure, wave 1, 3 and 5 are motive waves and they are subdivided into 5 smaller degree impulses labelled as ((i)), ((ii)), ((iii)), ((iv)), and ((v)). Wave 2 and 4 are corrective waves and they are subdivided into 3 smaller degree waves labelled as ((a)), ((b)), and ((c)). The 5 waves move in wave 1, 2, 3, 4, and 5 make up a larger degree motive wave (1)

Corrective waves subdivide into 3 smaller-degree waves, denoted as ABC. Corrective waves start with a five-wave counter-trend impulse (wave A), a retrace (wave B), and another impulse (wave C). The 3 waves A, B, and C make up a larger degree corrective wave (2)

In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up

Wave Degree

Grand Supercycle	[I] [II] [III] [IV] [V]	[A] [B] [C]
Supercycle	(I) (II) (III) (IV) (V)	(A) (B) (C)
Cycle	I II III IV V	A B C
Primary	I II III IV V	A B C
Intermediate	[1] [2] [3] [4] [5]	[a] [b] [c]
Minor	(1) (2) (3) (4) (5)	(a) (b) (c)
Minute	1 2 3 4 5	a b c
Minuette	1 2 3 4 5	a b c

Elliott Wave degree is an Elliott Wave language to identify cycles so that analyst can identify position of a wave within overall progress of the market. Elliott acknowledged 9 degrees of waves from the Grand Super Cycle degree which is usually found in weekly and monthly time frame to Subminuette degree which is found in the hourly time frame. The scheme above is used in all of EWF’s charts.

Waves Personality (Motive and Corrective)

The idea of wave personality is a substantial expansion of the Wave Principle. It has the advantages of bringing human behavior more personally into the equation and even more important, of enhancing the utility of standard technical analysis.

Motive ( Five Wave Patterns) of Elliott Wave Theory

The New Elliott Wave Principle – What is Changing in Today’s Market
There are five wave patterns for Elliot Wave Theory. They have named waves one to five. Look at the below graph to see how the waves look.

Wave 1

Wave 1 begins the accumulation phase and the formation of the five-wave pattern. Wave 1 can be difficult to identify as it often looks as a short pullback against the previous trend. Compared to other waves, Wave 1 is highly uncertain. This is why traders confirm the establishment of Wave1 after the formation of Wave 2.

Wave 2

Wave 2 marks the bottom of a five-wave structure. Wave 2 is comparatively shorter than Wave 1 as it must not go below the bottom of it. The pattern is considered as flawed if Wave 2 breaks below Wave 1. Wave 2 is a retracement of Wave 1. It goes against the direction of Wave 1.

Wave 3

Wave 3 is the longest and strongest wave in a five-wave structure. Wave 3 is an extension of Wave 1. Traders often try to catch this wave as it offers an explosive price move. This wave represents the confidence of market participants in the newly established trend. Compared to other waves, Wave 3 is easy to spot because of its length.

Wave 4

Wave 4 is the final retracement of a five-way structure. Wave 4 is comparatively weaker than Wave 2. This is why, Wave 3 and Wave 4 together often look like a wage or a flag and pole chart pattern. On the other hand, if Wave 4 goes below the bottom of Wave 3, then the five-wave pattern is considered as flawed.

Wave 5

Wave 5 is the final wave of a five-wave structure. Wave 5 marks the end of the newly established trend and indicates that a correction is pending in the market. This wave is typically the weakest wave in a five-wave structure. Generally, traders and investors start booking their profits as the Wave 5 is the final impulse move of the existing trend.

Corrective ( Three Wave Patterns) of Elliott Wave Theory

Three-wave patterns or Elliott Wave corrective patterns usually occur after the completion of the five-wave pattern. The three-wave pattern is a move that is against the established trend. The three waves in the three-wave pattern are –

Wave A

Wave A is the first corrective wave. Wave A is a sharp retracement of Wave 5 as it moves against the established trend and confirms a price correction. As the move is strong and sharp, traders can identify Wave A with ease.

Wave B

Wave B is the second corrective wave. Wave B forms in the direction of the previously established trend as the market participants try in resuming the trend. It must not go above the high of Wave A. The corrective wave pattern is flawed and the price can continue to go in the direction of the existing trend, if it breaks the high of Wave A.

Wave C

Wave C is the third corrective wave. Wave C resumes the correction and breaks below the low of Wave B. The length of this wave is generally higher than the length of Wave B. Wave C officially marks the correction of the previous five-wave structure.

How to Calculate Elliot Wave Theory?

Calculating Elliot waves can get tricky as the reading of these waves is largely subjective. Elliott wave theory is also largely criticized due to this factor. But as you practice with these waves, your eyes get used to identifying these waves. Here are 3 tips that will help you in identifying Elliot waves –

Trend identification

The first and foremost step in calculating the waves is to first identify the main trend. This step will be much easier for you if you are used to reading charts. On the other hand, try reading the chart and understand the uptrend and downtrend structure in the chart if you are a beginner.

Mark the Elliot waves

Now that you have successfully identified the trend, it is time for you to mark the waves with the help of the rules and guidelines of Elliott wave theory. Remember, the more you practice, the better you will get at accurately identifying the motive waves.

Use another technical indicator

Using another technical indicator will enhance your edge. Traders often use technical indicators such as, MA (Moving Average), MACD (Moving Average Convergence Divergence), RSI (Relative Strength Index) and Fibonacci retracement to further predict the top and bottom of a pattern.

Use of Fibonacci Ratios in Elliott Wave Theory

Elliot waves and Fibonacci tools are used by traders to identify the potential support and resistance of a price chart. Elliott wave theory and Fibonacci tools are often used together.

Fibonacci retracement is used in the Elliot wave theory to identify the potential retracement levels of the waves. Fibonacci ratios like 0.38%, 0.50% and 0.618% are given much significance. Whereas, Fibonacci extension is used to further predict the extent to which a wave can go. Ratios like 1.27%, 1.414% and 1.618% are given much importance.

Different waves in an Elliott Wave structure relates to one another with Fibonacci Ratio. For example, in Motive/ Impulse (Five Wave Pattern) wave:

Wave 2 is typically 50%, 61.8%, 76.4%, or 85.4% of wave 1
Wave 3 is typically 161.8% of wave 1
Wave 4 is typically 14.6%, 23.6%, or 38.2% of wave 3
Wave 5 is typically inverse 1.236 – 1.618% of wave 4, equal to wave 1 or 61.8% of wave 1+3

Traders can thus use the information above to determine the point of entry and profit target when entering into a trade.

Guidelines & Fibonacci Ratio Relationship in All Motive and Corrective Waves of Elliott Wave Theory

The rules and guidelines governing specific waves are described below, and along with the specific Fibonacci Ratio to which they apply. You should note that rules are, in fact, requirements. If you find a rule has been violated, even by a little, you should proceed to an alternate wave count. On the other hand, Guidelines don’t have to be true, but they are so frequently true (somewhere along the order of 80 to 90% of the time) that they can be assumed to be true and relied upon. 80% reliability is a huge statistical advantage in the stock market. It is these guidelines that provide the real predictive power behind the Elliott Wave theory.

We break down the guidelines applicable to Elliott Wave Theory into two categories, major and observational. The observational guidelines are covered in the sections for each of the particular waves and wave structures.

All wave structures we can see at a glance in the below

Motive Waves in Elliott Wave Theory

In Elliott Wave Theory, the traditional definition of motive wave is a 5 wave move in the same direction as the trend of one larger degree. There are three different variations of a 5 wave move which is considered a motive wave: Impulse wave, Impulse with extension, and diagonal.

EWF prefers to define motive wave in a different way. We agree that motive waves move in the same direction as the trend and we also agree that 5 waves move is a motive wave. However, we think that motive waves do not have to be in 5 waves. In today’s market, motive waves can unfold in 3 waves. For this reason, we prefer to call it motive sequence instead.

Impulse

Guidelines

• Impulse wave subdivide into 5 waves.
• Wave 2 cannot retrace more than 100% of Wave 1.
• Wave 3 can never be the shortest of waves 1, 3, and 5.
• Wave 4 can never overlap Wave 1.
• Wave 5 can cross the high of wave 3
• But, if wave 3 is longest , then wave 5 will be approx of = wave 1

Fibonacci Ratio Relationship

• Wave 2 is 50%, 61.8%, 76.4%, or 85.4% of wave 1
• Wave 3 is 161.8%, 200%, 261.8%, or 323.6% of wave 1-2
• Wave 4 is 14.6%, 23.6%, or 38.2% of wave 3 but no more than 50%
• There are three different ways to measure wave 5. First, wave 5 is inverse 123.6 – 161.8% retracement of wave 4. Second, wave 5 is equal to wave 1. Third, wave 5 is 61.8% of wave 1-3

Impulse with Extension

Most impulses contain what Elliott called an extension. Extensions are elongated impulses with exaggerated subdivisions. The vast majority of impulse waves do contain an extension in one and only one of their three actionary subwaves.

At times, the subdivisions of an extended wave are nearly the same amplitude and duration as the other four waves of the larger impulse, giving a total count of nine waves of similar size rather than the normal count of “five” for the sequence.

Guidelines

• Impulses usually have an extension in one of the motive waves (either wave 1, 3, or 5)
• Extensions are elongated impulses with exaggerated subdivisions
• Extensions frequently occur in the third wave in the stock market and forex market. Commodities market commonly develop extensions in the fifth wave

In a nine-wave sequence, it is occasionally difficult to say which wave extended. However, it is usually irrelevant anyway, since under the Elliott system, a count of nine and a count of five have the same technical significance. The diagrams, illustrating extensions, will clarify this point.

Wave Truncation

Generally, the subordinate impulse waves in a motive wave (waves 1, 3, and 5) will all be higher than the previous subordinate impulse wave with Wave 3 usually being the strongest wave. However, Wave 5 will sometimes fail to exceed the end of Wave 3. This is called truncation, and is another guideline. The truncated fifth wave must contain five subordinate waves or the wave count will not be valid. Truncation usually occurs after a particularly strong Wave 3 and indicates weakness in the preceding trend. It is also more common in highly leveraged markets, such as Forex markets and Commodity Futures.

Leading Diagonal

Guidelines

• Special type of motive wave which appears as subdivision of wave 1 in an impulse or subdivision of wave A in a zigzag
• In Figure 4A, the leading diagonal is a subdivision of wave 1 in an impulse. In Figure 4B, the leading diagonal is a subdivision of wave A in a zigzag
• Leading diagonal is usually characterized by overlapping wave 1 and 4 and also by the wedge shape but overlap between wave 1 and 4 is not a condition, it may or may not happen
• The subdivision of a leading diagonal can be 5-3-5-3-5 or 3-3-3-3-3. The examples above show a leading diagonal with 5-3-5-3-5 subdivision

Ending Diagonal

Guidelines

• Special type of motive wave which appears as subdivision of wave 5 in an impulse or subdivision of wave C in a zigzag
• In Figure 01, the ending diagonal is a subdivision of wave 5 in an impulse. In Figure 02, the ending diagonal is a subdivision of wave C in a zigzag
• Ending diagonal is usually characterized by overlapping wave 1 and 4 and also by the wedge shape. However, overlap between wave 1 and 4 is not a condition and it may or may not happen
• The subdivision of an ending diagonal is either 3-3-3-3-3 or 5-3-5-3-5

Corrective Waves

The classic definition of corrective waves is waves that move against the trend of one greater degree. Corrective waves have a lot more variety and less clearly identifiable compared to impulse waves. Sometimes it can be rather difficult to identify corrective patterns until they are completed. However, as we have explained above, both trend and counter-trend can unfold in corrective pattern in today’s market, especially in forex market. Corrective waves are probably better defined as waves that move in three, but never in five. Only motive waves are fives.

There are five types of corrective patterns:

• Zigzag (5-3-5)
• Flat (3-3-5)
• Triangle (3-3-3-3-3)
• Double three: A combination of two corrective patterns above
• Triple three: A combination of three corrective patterns above

Zigzag

Guidelines

• Zigzag is a corrective 3 waves structure labelled as ABC
• Subdivision of wave A and C is 5 waves, either impulse or diagonal
• Wave B can be any corrective structure
• Zigzag is a 5-3-5 structure

Fibonacci Ratio Relationship

• Wave B = 50%, 61.8%, 76.4% or 85.4% of wave A
• Wave C = 61.8%, 100%, or 123.6% of wave A
• If wave C = 161.8% of wave A, wave C can be a wave 3 of a 5 waves impulse. Thus, one way to label between ABC and impulse is whether the third swing has an extension or not

Flat

A flat correction is a 3 waves corrective move labelled as ABC. Although the labelling is the same, flat differs from zigzag in the subdivision of the wave A. Whereas Zigzag is a 5-3-5 structure, Flat is a 3-3-5 structure. There are three different types of Flats: Regular, Irregular / Expanded, and Running Flats.

Regular Flats

Guidelines

• A corrective 3 waves move labelled as ABC
• Subdivision of wave A and B is in 3 waves
• Subdivision of wave C is in 5 waves impulse / diagonal
• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
• Wave B terminates near the start of wave A
• Wave C generally terminates slightly beyond the end of wave A

Fibonacci Ratio Relationship

• Wave B = 90% of wave A
• Wave C = 61.8%, 100%, or 123.6% of wave AB

Expanded Flats

Guidelines

• A corrective 3 waves move labelled as ABC
• Subdivision of wave A and B is in 3 waves
• Subdivision of wave C is in 5 waves impulse / diagonal
• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
• Wave B of the 3-3-5 pattern terminates beyond the starting level of wave A
• Wave C ends substantially beyond the ending level of wave A

Fibonacci Ratio Relationship

• Wave B = 123.6% of wave A
• Wave C = 123.6% – 161.8% of wave AB

Running Flats

Guidelines

• A corrective 3 waves move labelled as ABC
• Subdivision of wave A and B is in 3 waves
• Subdivision of wave C is in 5 waves impulse / diagonal
• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
• Wave B of the 3-3-5 pattern terminates substantially beyond the starting level of wave A as in an expanded flat
• Wave C fails travel the full distance, falling short of the level where wave A ended

Fibonacci Ratio Relationship

• Wave B = 123.6% of wave A
• Wave C = 61.8% – 100% of wave AB

Triangles

A triangle is a sideways movement that is associated with decreasing volume and volatility. Triangles have 5 sides and each side is subdivided in 3 waves hence forming 3-3-3-3-3 structure. There are 4 types of triangles in Elliott Wave Theory: Ascending, descending, contracting, and expanding. They are illustrated in the graphic below

Guidelines

• Corrective structure labelled as ABCDE
• Usually happens in wave B or wave 4
• Subdivided into three (3-3-3-3-3)
• RSI also needs to support the triangle in every time frame
• Subdivision of ABCDE can be either abc, wxy, or flat

Double Three

Double three is a sideways combination of two corrective patterns. We’ve already looked at several corrective patterns including zigzag, flat, and triangle. When two of these corrective patterns are combined together, we get a double three. In addition,

Guidelines

• A combination of two corrective structures labelled as WXY
• Wave W and wave Y subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree
• Wave X can be any corrective structure
• WXY is a 7 swing structure

Fibonacci Ratio Relationship

• Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W
• Wave Y = 61.8%, 100%, or 123.6% of wave W
• Wave Y can not pass 161.8% of wave W

Below are examples of different combinations of two corrective structures which form the double threes:

The above figure is a combination of a Regular flat and a zigzag and “X” is the number 3

The above figure is a combination of 2 Regular flat corrections and “X” is the number 3

The above figure is a combination of a flat and a triangle

Triple Three

Triple Three is a sideways combination of three corrective patterns in Elliott Wave Theory

Guidelines

• A combination of three corrective structures labeled as WXYXZ
• Wave W, wave Y, and wave Z subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree
• Wave X can be any corrective structure
• WXYZ is an 11-swing structure

Fibonacci Ratio Relationship in Elliott Wave Theory

• Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W
• Wave Z = 61.8%, 100%, or 123.6% of wave W
• Wave Y can not pass 161.8% of wave W or it can become an impulsive wave 3

Below are examples of different combinations of three corrective structures which form the triple threes:

Above figure is a combination of a flat, double three, and zigzag

Above figure is a combination of three double threes

Limitation of Elliot Wave Theory

The limitations of Elliott wave theory are the main reason why it faces much criticism. Following are the 3 limitations of the Elliot wave theory – 

1. Elliott wave theory is highly subjective

Elliott wave theory requires a trader to mark the waves according to his own individual perception of the current market data. This can result in confusion as other traders can interpret the same data differently and mark the waves in a completely different way.

2. Elliott wave theory is difficult to understand

As a beginner trader, identifying and marking Elliot waves correctly can get very difficult. This results in the faulty analysis of the price chart. 

3. Elliott wave theory believes that market moves can be predicted  

The stock market is constantly changing and is affected by various other factors constantly. Sometimes, prices can move drastically because of the latest news in the market and it may not move according to its past market data. 

FAQ

Is the Elliot Wave Theory accurate?

No, Elliott wave theory cannot be accurate at all times. The accuracy of the Elliot wave theory depends on factors like liquidity, market situation, the ability of a trader to mark Elliot waves correctly, etc. 

At the same time, it is also important for traders to understand that no technical tool can be accurate 100% of the time. There is no holy grail strategy when it comes to the stock market. 

Can wave 4 can retrace dip into the area of wave (1) slightly?

Yes, Elliott Wave (4) can retrace into the area of Wave (1) (slightly).

Rule number 3 states that Wave (4) cannot retrace into the area of Wave (1). However, in practice, particularly in the commodity markets, a small retracement into the area of Wave (1) often happens.

Here Wave (4) has retraced back just below the high of Wave (1), which normally would invalidate this as a potential 5-wave count. However, in practice you can allow Wave (4) to dip into the area of wave (1) slightly.

Actually, if the market in question immediately reverses and then moves out of the area of Wave (1), then this should be allowed as a valid 5 wave count. As you will see later, although this minor breach of the Wave (1) extreme can be allowed it should not normally happen in a perfect 5-wave count.

As such, when this happens you should treat the wave count as valid but not perfect.

Is Elliot Wave bullish or bearish?

Elliot waves can be both bullish or bearish. Elliott wave theory can help a trader predict the market’s potential top as well as the bottom. During an uptrend, a trader can mark the five-wave pattern in a downward to upward fashion. Similarly, during a downtrend, a trader can mark the five-wave pattern in an upward to downward fashion. 

Is Elliot Wave good for trading?

Yes, Elliot waves can prove to be good for trading. Elliot waves are beneficial as it helps a trader in identifying a potential entry and exit point. Elliott wave theory is also used to identify major trends and potential corrections in the market. 

But it should also be noted that like all other technical indicators, Analysis based on Elliot wave theory will not work every time. 

Is it hard to learn Elliot Wave theory?

Yes, Elliott wave theory can get hard to learn. Learning Elliot wave theory gets difficult due to the fact that it involves identifying and marking complex market patterns. It takes time for a trader’s eyes to get used to identifying Elliot waves. 

It should also be noted that as you spend time practicing on a chart, you will be able to identify and mark Elliot waves successfully. 

Can you also use Elliot Wave Theory in Fundamental Analysis?

No, you cannot use Elliot wave theory in fundamental analysis. Elliot wave is a technical analysis tool which predicts the future price movement based on the previous market data