Wednesday, January 02, 2019

Basics Of Elliott Wave Theory

Elliott Wave Theory has been at the forefront of technical analysis tools. And I too have used it for a long long time in the past. I may have moved on to different tool since then, but I still can't resist marking the waves every now and then.

This theory was proposed by one of the greats in the world of technical analysis, Ralph Nelson Elliott. He observed a wave-like pattern in the market movements and then subsequently moved on to provide us traders with a detailed structure and set of rules to follow to make sense of the ever-changing markets.

It's a fascinating tool and if you apply yourself the results could be nothing short of amazing. Here I am attempting to answer a few common questions regarding this theory...

What is Elliott Wave theory?

As said earlier RN Elliott observed this wave-like pattern in the movements of the markets. He found out that some of the waves were longer than the others and stayed in force longer than the rest. The retracement after completing each wave also had a distinct pattern, some went deeper and retraced more of the preceding wave, some remained shallow and did not retrace much of the directional progress made in the prior wave.

While the concept behind this theory is pretty easy to fathom, the actual application to the real market situations is not that easy. In fact, it takes years of experience to be able to mark the waves correctly and then anticipate the subsequent market movements.

How does Elliott Wave analysis work?

Ok, so before we dive deeper into the nitty-gritty of this stuff, let me briefly describe to you, how and why this theory works. I delved pretty deep into this stuff when I was using it a few years back, it is amazing, but I found a better match. Anyways, the question to be answered is why this theory works, so here goes...

The reason this works is the concept of self-similarity. Due credit must be given to another one of the great minds (he actually got a Nobel Prize for this work), Benoit Mandelbrot. This guy discovered the property of self-similarity in many things in nature, his proposition was that the parts do look like the whole in many cases. Ed: A stone roughly has the same shape as the mountain, not all but most of them do...

Since this is observed so widely in nature, it also applies to human nature and consequently to things where human beings are involved. Nowhere is it truer than in markets. There is an old adage in the markets...
History repeats itself. - Old Adage
So does market moves. Also, the bigger market moves are comprised of smaller ones and they too have this property of self-similarity. It often happens that if you look at the market moves without the time frame they all basically look the same.

This particular property gives us an opportunity to find some great reward to risk ratios in the markets. But first, let's take a look at how waves are structured...

How many waves are there in Elliott Wave Theory?

There are basically two types of waves in the markets...

  1. One that goes in the direction of the main trend called Impulse Waves
  2. One that goes against the direction of the main trend called Corrective Waves
Now, to be with the trend and having the highest odds of success in your favour you need to trade the impulse waves and bide your time during corrective waves.

What is an impulse wave?

An impulse wave is simply a directional price movement in the direction of the main trend. They usually have 5 component waves as shown in the figure below...

3 waves moving in the direction of the trend and 2 waves in between providing the pause for the trend to catch its breath and continue. An impulse wave is responsible for the directional progress in the markets. They are more dynamic, quick and give the opportunity to capture the greatest price differential.

One interesting thing you may have noticed is that the wave 3 is the bigger or the waves 1,3 and 5. That is often the case and also is one of the rules of EWT.
Wave 3 cannot be the shortest. - EWT
Sometimes wave 5 can become the largest wave but in that case, also wave 3 will be the second largest. This pattern is called as wave 5 extension.

What is a corrective wave? What is an ABC correction?

Let us now turn our attention to corrective waves. These are the waves that provide the pause in between two impulsive waves. These offer the trend to catch its breath and then resume with renewed force. Look at its construction in the chart below...

Usually, the corrective waves consist of 3 waves A-B-C but in case the corrective wave takes the shape of a triangle it may have 5 waves.

In a more in-depth discussion, we may also explore the complex corrections, where 2 or more corrective patterns attach to each other and form prolonged corrections. But that one is for later...

What is an ending diagonal?

This is one of the typical EWT patterns. They are seen in waves 5 or C in the majority of cases. the interpretation is the same as a normal ending diagonal, where the market momentum gradually diminishes until the opposing party takes over.

the structure is as shown in the chart below...

Sometimes this kind of development is seen in wave 1 or A in that case we call it a leading diagonal.

What are the rules of Elliott Wave Theory?

To be a correct Elliott wave we need to observe the following rules while marking the waves...

  1. Wave 2 never retraces all of that is 100% wave 1.
  2. wave 3 is never the shortest.
  3. Wave 4 cannot enter the territory of wave 1, except in case of ending and leading diagonals and a triangle pattern.
If you stick by these rules your wave counts will be valid and will be reliable. Markets won't always play by the book, actually they never play by the book, but still, these rules will stand you in good stead.


Now EWT is a huge topic and cannot be crammed in a single blog post. While I don't have any plans to start using it in my analysis, I may share more on this topic in the future. but if you have more queries regarding this amazing tool or want to know more, hit me up in the comments window so that I can respond to your queries.

And yes your friends and colleagues may find this one useful, so don't hesitate to share it with your friends and colleagues on various social media channels, because...

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