Elliott wave theory

Introduction to the Elliott wave theory

The Elliott wave theory – discovered by Ralph Nelson Elliott (1871-1948), is mainly revolved around man’s mass psychology. It states that repetitive patterns and structures are an outcome of this mass psychology – interpreted mathematically as per the law of nature. Hence, Fibonacci ratios (specially the Golden ratio – 0.618) have a great influence in forming these wave patterns.

Since financial markets are seemingly influenced by news, there arises an important question about the credibility of the Elliott wave theory. Although its a fair doubt, time and time again, the markets somehow continue to form these “predictable” wave structures in multiple degrees. So its not my priority to argue the fact – what moves the markets? Instead I would like to understand the market movements or waves in a technical perspective. Elliott wave analysis is the most complete technical method to dissect any market in terms of impulse and corrective waves at multiple degrees or fractals.

WAVE TYPES

Types of waves

According to Elliott there are two types of waves – Progress and Regress. Progress waves also referred to as motive, actionary or impulse waves subdivides into 5 waves. Regress waves also referred to as corrective or reactionary waves subdivides into 3 waves.

Now it starts to get complicated, because all these motive and corrective waves operate in multiple degrees (timeframes.) There are motive waves in lower degrees, within subdivisions of a higher-degree-correction. Its because the markets are fractal. Therefore wave patterns too will be fractal in nature.

I am sure that you have seen this image multiple times all over the internet. Nevertheless, it clearly elaborates how waves are subdivided in multiple degrees. Understanding the fractal nature of financial markets and the application of Elliott waves, can provide a trader with valuable information.

In detailed examination of the above image, we can see that there are times when a 5-wave impulse is followed by another 5-wave impulse in the opposite direction at the same degree. Note that there is no rule to exclude such a count. This is usually an indication of a corrective wave starting to form in the degree higher to the one in question. This in itself is a great forecasting tool to locate higher-highs or lower-lows of waves in one degree-higher.

However – “there are often times when, despite a rigorous analysis, there is no clearly preferred interpretation. At such times, you must wait until the count resolves itself” – Elliott wave principle by Alfred John Frost, Robert Rougelot Prechter (Jr.)

IMPULSE WAVES

Characteristics of Impulse waves

The rules are simple and clear. But the actual labeling of a chart is not. Because there is no in-depth research of the time factor involved in these waves. Often the extended waves – both motive and corrective, cause confusion in labeling. Even the basic 8 wave structure ( 5-wave impulse + 3-wave correction) can look messy and difficult to read in charts. Most impulse waves comprise of 5 subwaves labeled as 12345 and adheres to the following rules.

Rules for basic 5-wave impulses:

1. Wave 2 does not completely retrace wave 1
2. Wave 2 and 4 (corrective subwaves) never overlap
3. Wave 3 is not the shortest

That’s it. So simple right? not so fast, because there are guidelines to qualify wave counts that we will discuss further.

Wave extension

Wave extension is when one and only one of the waves 1, 3 or 5 is of 5 subwaves of the same degree. This will make a counting a difficult task. Elliott also noted that wave 3 extension is a common chracteristic in “stock markets.” While wave 5 is more likely to extend in “commodities.” Although there is little to no research with regard to wave extensions in “forex” in particular, my personal observation is that extensions are not as common in forex.

• Extension within extension is also a possibility.
• With wave extension, total subwave counts of an impulse may appear as 9, 13, 17 etc.
• When wave A or C extended in a 3 wave ABC correction, the count may appear as a total of  7, 11, 15 etc.
• If its not clear to differentiate which wave extended, its sufficient to count the total number of waves to determine the formation.
• Wave 3 is mots likely to extend, simply because its the most powerful impulse.

Truncation

Truncation is a rare phenomenon that 5th wave of a motive fails to reach the end of 3rd wave. This often happens after an extended or strong 3rd wave. But still, the rules of impulse waves apply to the truncated 5th wave just the same. It must contain an impulsive 5-wave formation in the lesser degree.

Fifth wave truncation happens when there is pressure to start the next wave in the opposite direction. Hence, truncation signifies weakness and exhaustion of the current impulse.

Alternation

Alternation guideline says that in an impulsive wave, subwaves 2 and 4 alternates in variation of the correction. Means that if wave 2 is a ZigZag, wave 4 is usually a triangle or a flat and vice versa. Wave 2 usually retraces more than half of wave 1. So a ZigZag as wave 2 and a range-bound correction (either a triangle or a flat) as wave 4 is a more likely alternation.

Above image clearly displays alternation in the supercycle degree (labeled in red within brackets.) However, notice that the extension of the fifth wave does not seem to have alternating corrections.

Rich swannell in his book – Elite trader’s secrets, challenges the concept of alternation. In his 20+ year experience, this is the only guideline he found to be statistically less-impressive. He goes onto say that the probability of alternation taking place is only 61.8%. Furthermore, when wave 2 is a sideways correction (Flat, Triangle or WXY,) there is 78% probability that wave 4 is also a sideways correction. Astonishing numbers, that compel the need of some flexibility to the alternation guideline.

Diagonal

Diagonal is of a triangle or wedge shaped structure where the boundary lines tilt in one direction. Whereas in a generic corrective triangle boundary lines tilt in opposite directions. Boundary lines of a diagonal converge but an expanding diagonal is also a possibility where the boundary lines will diverge. Just that, to date, only once there was an expanding ending diagonal in the stock market, where the boundary lines diverged.

On the other hand, my personal opinion is that expanding diagonals are not so rare in forex markets. If I see a diagonal (whether expanding or contracting,) I am not in any way reluctant to label it as one. Since Elliott first introduced the wave principle; the societies, countries and economies have evolved so much. So what was rare (market events or patterns) in 1930’s, does not have to be necessarily rare in today’s markets. Especially in forex which is a highly leveraged and manipulated market.

Diagonals are considered as motive and appear as the 1st or 5th wave of an impulse, yet they have characteristics of a correction. On rare occasions C wave of an ABC correction may contain a diagonal.

Diagonals are the only type of impulse-wave where waves 2 and 4 overlap.

Diagonals never appear as the 3rd wave and comprise of 3-3-3-3-3 formation just as a generic triangle. There are two variations of diagonals with a slight difference in formation and subwave counts.

Diagonal types

Ending diagonal

Ending diagonal is of 3-3-3-3-3 subwave formation and often shows exhaustion of the overall direction. Hence, they are more likely to appear as the 5th or C wave. There is a strong thrust in the 5th subwave of a diagonal – one final push called a “throw-over”, which briefly breaks the extreme boundary lines.

Occasionally a 5th subwave truncation takes place in a diagonal, but when this happens the reversal will be much more severe.

Leading diagonal

This is presumed to be a recent discovery – one that was not documented in the original Elliott wave theory. A leading diagonal is when a diagonal appears as the 1st or A wave. However, the formation is slightly different to an ending diagonal with a formation of a 5-3-5-3-5 structure.

CORRECTIVE WAVES

Characteristics of Corrective waves

A more complex correction with ZigZag, Flat, WXY and WXYXZ wave combinations in multiple degrees.

Corrective waves are of 3 subwaves labeled as ABC. Although ABC labeling is for simple ZigZag or Flat corrections, there are other corrective structures as well – e.g. triangle.

Variations of corrective wave structures (subwave formations are noted in brackets):

1. ZigZag or a simple abc correction (5-3-5)
2. Flat (3-3-5)
3. Triangle (3-3-3-3-3)

Complex correction or a combination of above variations may occur and Elliott called them double-threes and triple-threes.

ZigZag correction

Subwave formation of ZigZag is 5-3-5 and is the simplest and the most common form of correction. Its labeled as ABC. Waves A and C are impulses within, hence the subwave-formation of 5-3-5.

Flat correction

Flat corrections subdivide into 3-3-5 and also labeled as ABC. In a regular flat correction the B wave retraces almost or more of the full length of wave A. The C wave retraces the full length or more of the wave B. If both waves B and C retraces more than the length of each preceding wave – its called an expanding flat.

On rare occasions the B wave of a flat travels too far beyond the length of waves  A, and the C wave falls short of the length of the B wave. This wave phenomenon is called a running flat.

Running flat example:

Triangle correction

Triangle is labeled as ABCDE and consists of 5 corrective waves. Boundary line of the triangle correction is very important. Because if both boundary lines tilt in the same direction it will not be a triangle anymore but a diagonal (which is a motive wave) as explained above in the diagonals section. In a triangle, price extremes of waves do not go beyond the boundary lines.

Triangles are of 3-3-3-3-3 subwave formation. There are 4 variations of the triangle.

• Ascending triangle
• Descending triangle
• Contracting triangle
• Expanding triangle

They all differ in the angle and formation of the boundary lines. In perspective of wave analysis and trading they are all the same. The only difference between them is the appearance. There is also a sub variation of triangles, where the end of A wave falls short of the boundary line. This is called a running triangle. A running triangle can be any of the types listed above.

Corrective wave combinations

This is where corrections become even more complicated. Elliott said corrective patterns may combine into two or three combos to create a larger corrective wave. He called them double-three and triple-three.

Double-three and triple-three guidelines:

• W wave is never a triangle
• Triangles appear as the last wave of a combination
• Reactionary waves that connect the patterns (X waves) can be of any pattern, but most commonly a ZigZag
• ZigZags too rarely appear more than once as a component of the combination
• In the context of combos, Elliott considered triangles as “threes”
• Prolonged combinations of corrections often appear as sideways movement
• If wave combination is not clear, total number of waves will be a valid indication – WXY as 7 waves or WXYXZ as 11 waves within a complete correction
• Flat correction is the most common W wave. But in forex, according to my experience, ZigZags are more common as the W wave.

Double-three combo

A double-three is basically a 3-wave pattern labeled with WXY. If the W and Y are ZigZags of lesser degree, then WXY may seem just as an ABC correction. But the basic difference between the two ZigZaggy patterns is that W and Y of the double-three contain 3 subwaves, while A and C of ABC contain 5 waves. Obviously they also differ in the nature as a result of the subwave-count – W and Y are predominantly corrective, while A and C are impulsive.

So in a WXY double-three combo, two corrective patterns are connected by a 3-wave correction (often a ZigZag) labeled as the X wave.

Read more about: WXY Elliott wave (double three combo)

Triple-three combo

Triple-three combos are labeled with WXYXZ. The formation is obviously a series of 3 corrective patterns connected by two 3-wave corrections – again both connective 3-wave patterns labeled as X.

Read more about: WXYXZ Elliott wave (triple three combo)

Some important notes

The idea of the Elliott wave theory is quite simple. But labeling waves or breaking down a complicated corrective structure is not. So there may be plenty of adjustments and recounts as the market moves forward. Elliott wave analysis is a highly subjective method to forecast a market. There is no objective approach for counting waves, nor there will be a definitive single count that could be deemed final. So we adjust, alternate and re-analyze in order to trade the next impulse.

One thing is certain though. Regardless of your trading strategy, Elliott wave analysis can provide a sense of direction in multiple degrees – an invaluable knowledge for profitable-trading. So combining any rule based strategy with Elliott wave analysis is definitely a winning edge in any market.

Elliott wave analysis in forex

There is an important note regarding Elliott waves in forex. Elliott wave theory is developed for non-leveraged markets. Hence there will be instances where the Elliott wave rules and guidelines are not applicable to forex in its entirety. Because forex is a highly leveraged and manipulated market.

For this reason, I personally consider the following scenarios as a valid count in forex.

When:

• an intra-day overlap of wave 2 and 4, specially in the lower degrees.
• a violation of presumed boundary lines of a triangle in addition to the wave-E throw-over.
• an apparently valid wave pattern that is considered to be of rare occurrence, is clearly visible on the chart. e.g. expanding ending diagonal.
• alternation is not vividly clear in an impulse.
• a leading diagonal appear as wave 1 or wave A.
• flat corrections appear as a ZigZag structure with the only difference being the subwave count.
• components of WXY or WXYXZ are all ZigZags.

The core principle

There is one very important principle embedded in the Elliott wave theory (or any wave strategy for that matter). It is that “there will be an impulse after every correction”. This take away point alone is enough to build a sound trading strategy. All you have to do is, practice to recognize corrective phases on charts, and anticipate possible ending scenarios for those corrections. This is a great starting point to objectively approach and create a trading strategy based on the “Elliott wave theory”