Elliott wave theory was developed by Ralph Nelson Elliott in the 1920s.Elliott found that financial markets have characteristic movements that repeat themselves forever. He called these movements 'waves' because of the troughs and peaks that occur in an up-and-down circular fashion.
Elliott Wave trading is a broad and complex subject that takes years for professionals to master. Despite its complexity, some basic elements of Elliott wave trading can be assimilated immediately and can help improve analytical skills and trade timing.
Impulsive and corrective waves
In Elliott wave theory, the two types of waves in price movements are called "trend" or "impulse" waves and "consolidation" or "corrective" waves.By looking at a chart, a trader can try to determine which wave cycle is in progress, which recent waves have occurred, and - if the waves have been spotted correctly - which wave is likely to occur next.
These chart patterns are fractal, meaning you can zoom in or out on a chart to find smaller or larger Elliott wave patterns.A pulse wave, for example, will consist of many smaller waves tending in the same general direction. These patterns can span decades or appear on minute charts.
Corrective waves are the smallest waves because they occur within and against a broader trend. Traders usually try to play in the direction of impulse waves because prices make the biggest moves in that direction. In other words, push waves offer a better chance of a large profit than corrective waves because a trade that leads to a push wave is likely to be held longer.
Corrective waves are used to enter a trend trade in an attempt to catch the next major impulse wave. For example, a trader going long (hoping the stock price will rise) should try to time his purchases just as the corrective wave ends and then be able to ride the push wave as it increases the price.
DealersThey simply reverse the strategy during a downtrend – they will short the stock during an upward corrective wave so they can ride the next downward momentum wave.
Spotting trend changes
Impulsive and corrective waves are also used to determine when a trend is presentchange of direction. If a stock is in an uptrend and then the price moves down more than the last push up, it means that the uptrend may be over. The biggest movement always happens in the direction of the trend, so when corrective waves start to look like push waves, it means that the trend may have changed.
Trend and Consolidation Price Structures
Elliott found that when a trend is underway, it usually has three large price moves in the direction of the trend, interspersed with two corrections.This creates a five wave pattern: push, correction, push, correction and another push. Traders often refer to these five waves by the number they occur in. So if you hear a trader refer to a stock's "wave four," he's talking about the second correction (the one that comes after the second push).
A corresponding number of three moves can be counted in each correction. There will be a sharp move against the trend (push of the correction), followed by a small pull back in the direction of the trend (the correction of the correction), and finally there will be a final sharp move against the trend ( another push of the correction ), before the correction is complete and the trend continues. To avoid confusion with the total voltage numbered waves, the corrective waves are labeled A, B and C.
This pattern tends to occur in highly traded markets with high volumes, such as the SPDR S&P 500 ETF(SPION). The pattern is harder to spot - or doesn't appear - insideindividual shareswhich are more sensitive to only a few individual stocks being traded.
Remember that these movements are fractals, so patterns occur in small and largetimeframes. For example, the first impulse wave higher in an uptrend on a daily chart may consist of five waves on an hourly chart. Each corrective wave (waves two and four) consists of three smaller waves (A, B, C) and there will also be larger waves A, B, C over a longer period as the broader trend ends (after wave five) .
Standard correction size
When you buy on corrections during an uptrend or sell on corrections in adownward trend, it is useful to know how large the standard deviation is. Unfortunately, there is no set calculation, but there are some guidelines that can help you know where to look for an urge or fix to quit.
Generally, wave three is the longest wave in the cycle. Waves two and four cannot be larger than waves one, three or five (or it is not an Elliott wave cycle).
While developing his wave theory, Elliott made extensive use of Fibonacci ratios.Traders may know these ratios from the Fibonacci retracement tool that your brokerage will likely provide with their charting software. This means that when counting Elliott waves, pay attention to important Fibonacci percentages such as 38%, 50% and 62%.
For example, if you are watching for a correction after a push, you can use the Fibonacci retracement tool to draw lines on your chart at 38%, 50% and 62%. When price action approaches these lines, look for signs of weakness - they may indicate that the correction is about to end.
Some traders have set percentages they look for with certain waves, such as looking for a 60% correction in the second wave. Their experience with many trades and trends over many years will lead them to use these numbers consistently. However, corrections can be larger or smaller than the average in a given trade, and it is best to study several different charts yourself before forming such a rigid rule for wave sizes.
Combine the 3 concepts
You can use the three concepts discussed here - impulse and corrective waves, trend structures and correction magnitudes - by only taking trades in the direction of impulse waves. Take trades during corrective waves and look for trade entry signals when the price corrects the average amount. The correction probably won't stop exactly at the percentage levels discussed above, so it's better to use them as reference points and wait for the chart to confirm your suspicions before making a trade.
These three Elliott wave concepts can improve a trader's analytical skills or improve their trading time, but they are not without their own problems. The theory can be complex to apply, as it is not always easy to isolate the five and three wave patterns.
Consider viewing each wave in the overall price structure. For example, a five-wave up pattern is usually followed by a larger three-wave downtrend. Following the direction of the impulse waves will signal potential trend changes, and this signal is stronger if combined with a five-wave impulse pattern or a three-wave correction pattern.
Frequently Asked Questions (FAQ)
What Time Frame Should You Use With Elliott Wave Theory?
In theory, Elliott wave patterns are fractals and should apply on any time frame. So the "best" time frame to use is the one you feel most comfortable with. If you are a day trader, you can use one minute, five minute or one hour candles. If you are oneswing trader, you can use four-hour, daily or weekly candles. If you don't know what your strength is, try several time frames on a demo account to see which one works best for you.
Where do you start counting Elliott waves?
One problem with this and any other chart pattern is that you don't know for sure where a pattern starts and stops until it has already happened. You can use technical analysis,indicators, and broad market signals to guess when a wave is about to start, but you won't know if you're right or wrong until you miss the best entry point for a trade. If you look back at historical charts, you can start counting waves at a trend reversal point – when an uptrend stops and a downtrend begins, or vice versa.
What does it mean to "explain" Elliott waves?
If a wave breaks a rule, such as wave three not breaking the high of wave 1 means your initial assessment of the waves was wrong and you need to "recalculate". You may need to zoom out or look at a different time frame to recalibrate your theory of where the stock is within the Elliott wave volume.