Elliott wave theory is a form of market analysis based on the theory that market patterns repeat and unfold in cycles. Ralph Nelson Elliott developed this theory in the 1930s. Elliott argued that upward and downward market price action was based on mass psychology and always showed up in the same repetitive patterns. These patterns were divided into what Elliott called “waves.” According to Elliott, crowd psychology moves from optimism to pessimism and back again and this is seen in the price movements of market trend which are identified in waves.


5-3 wave pattern
The Elliott wave theory assumes that market moves up in a series of five waves and down at a series of three waves. Elliott concluded that markets moves are not random but follow repetitive cycles driven by mass psychology. The repetitive cycles show up in waves. A wave is a movement in the market either upwards or down. Elliot discovered two basic types of wave patterns, impulse waves consisting of five waves and three smaller corrective waves. Impulse waves move in the direction of the main market trend. The corrective wave moves in the opposite direction of the main market trend.


Five wave pattern is the dominant trend stage of mass psychology
Elliott labeled five impulse wave patterns to describe various stages of mass psychology. The waves are subdivided into five smaller waves.

Wave one - trend and sentiment is overwhelmingly negative but a few buyers emerge as the market starts to move up. This wave is marked by limited public participation

Wave two - corrects wave one and does not extend beyond the starting point of wave one. The news is negative but shows signs of improving and some early buyers look to take profits not convinced of the viability of the trend. In wave two, public participation has increased.

Wave three is usually the most powerful wave. There's more positive news and prices begin to rise quickly. The public looks to get on board.

Wave four is corrective and offers opportunity to buy the market on a pullback. Early buyers look to take profits and some who missed the early move look at the pullback to get into the market.

Wave five - is the last stage of the dominant trend. Mass psychology is universally positive reaching euphoric stage and the market becomes over priced. The public are heavy buyers of the market in this stage. The market is ripe for a trend change.

Generally, waves three and five are with the trend and two and four corrections within the trend.


Elliott also concluded that markets move in a three wave corrective pattern
The corrective wave pattern is normally referred to as the ABC correction.

The A wave is hard to identify. Wave B, prices reverse higher. In wave C, prices move lower. Generally wave A and C are trend corrections and wave B a countertrend move within the correction. These waves are known as corrective.

Here is an example of what the 5-3 wave pattern and ABC correction would look like in a graph.




There also can be waves within waves
Elliott said that the waves exist at many levels, and there could be waves within waves. Here's an example of a graph with waves within the broader wave structure.




Elliott wave and Fibonacci
Elliott developed his wave theory before he realized that the waves often reflect the Fibonacci sequence numbers .The Fibonacci sequence emerges repeatedly in Elliott wave patterns. Elliott eventually came to conclusion that the Fibonacci sequence is the basis of the wave principle. More advanced technical analysis sometimes combines the Fibonacci sequence with Elliott wave. Discussing the application of the Fibonacci sequence to Elliott wave is beyond the scope of this article. For the purpose of this discussion all you need to take away is wave retracements often stop at Fibonacci retracement levels. Draft the Fibonacci retracement levels and you will have additional technical levels of support and resistance in the market to help make your trading decisions.


Why use Elliot wave?
Elliott wave is another technical tool that you may use to try to identify market trends and determine whether trends are about to change. Elliott wave can be used to generate short-term trading opportunities and analyze whether current market trends will continue.

How to use Elliot wave
To apply Elliott wave to your analysis you need to identify which wave is being formed. The major waves determine the major trend of the market. The minor waves determine the minor trends in the market. Once you identify the main wave look to buy the market in the 1, 3 and 5 waves, and sell the market in waves to 2 and 4. In the corrective phase look to buy wave A and C and look to sell wave B. The most difficult part of Elliott wave analysis to correctly label the waves.


A note of caution
Waves are usually identified by looking back at historic price action. The hard part in applying Elliott wave is try to anticipate drawing of the waves before the market action takes place. The wave patterns are actually quite simple. All you need to know is markets tend to move in waves and market direction can be identified by identifying repetitive pattern of waves. Elliott wave theory says markets will in move five waves up to three waves down. There is no absolute time for the cycle to be complete the cycle. In theory a wave could last for years. Elliott wave theory has been criticized because of the open-ended nature of the formation of waves but if you study a number of charts you will begin to see the Elliott wave patterns emerge quite often. You don't have to become a specialist in Elliott wave. There are many charting packages that will help you identify Elliott waves on a chart. With this basic understanding of Elliot wave theory its time for you to try and catch a wave.


Test your knowledge

1. Elliott wave theory is based on ____and cycles.
1. bands
2. wave patterns
3. retracements
4. trends


2. In the 5 wave pattern waves are called______ and the three waves pattern corrective.
1. Fibonacci
2. impulse
3. Arcs
4. cycles


3. Which wave is usually the strongest in a five wave pattern?
1. 1
2. 3
3. 4
4. 5


4. Elliott wave theory is generally used to try to identify___ in trend.
1. start
2. timing
3. momentum
4. Change


5. True or false
   According to Elliott wave theory there is no absolute time for a cycle to be complete.

1. b, wave patterns
2. b, impulse
3. b, wave 3
4. d, change
5. True