Elliott Wave Theory is founded upon the observation that freely traded markets exhibit trends and countertrends, which can be categorised into impulse waves and corrective waves.
Traders use this theory to identify market trends, increase accuracy in predicting market movements, and enhance trading results. There are specific guidelines and rules traders must abide by when applying this theory to charts.
Wave 1
Wave 1 marks the initial sign that an existing trend has ended and a new one has begun. Thus, market participants should pay careful attention to it.
Ralph Nelson Elliott first introduced the Elliott Wave Theory, which proposes that market prices move in predictable patterns dependent on investor psychology and sentiment analysis, known as impulse waves and corrective waves.
Impulse waves can always be divided into five lower-degree impulse waves that alternate between motive and corrective characteristics, as seen with Wave 1 through Wave 5. Impulsive Waves 1 and 2 correspond to impulses while Waves 4-5 act as corrections (often known as zigzags). An exception occurs when leading or ending diagonals occur: Waves 2 and 4 subdivide into zigzags while Wave 3 cannot overlap its beginning with the beginning of Wave 1, as well as Wave 5 must not extend beyond its boundaries in such instances.
Wave 2
An impulse or ending diagonal is almost always comprised of three waves; usually the third wave extends further, yet does not overlap wave 1. Wave 3 may take the form of either zigzagging or flattening; never triangle-like; and it cannot serve as leading diagonal.
The fourth wave usually retraces at least 38.2% but more commonly 61.8% of wave 1. It rarely reaches sub wave 4 of any previous three-wave impulse.
An effective channel can be created by connecting the end of wave 1 and the start of wave 3. This serves as a minimum target for Wave 4, yet more often than not it exceeds this channel and leads to what is known as “throw-overs.”
Wave 3
Once wave 2 concludes, wave 3 usually follows with an aggressive correction that could retrace up to 61.8% of wave 2. These waves typically display lower volumes than wave 3, as well as having an extremely low put/call ratio; at this stage sentiment tends to become pessimistic while economic fundamentals become weak.
Wave 3 must not be the shortest of the five waves and must not overlap with either its origin or start point for Wave 1. Neither should it exceed Wave 2, nor move beyond its beginning. Correction may take many forms including zigzags, flats triangles or contracting or expanding diagonals – sometimes called leading diagonals which may extend further than expected.
Wave 4
Corrective waves occur following impulse waves. They typically retrace 38-78% of their length but it may retrace even further.
As a rule, this wave will not overlap with wave 1. Furthermore, it should be remembered that correction waves in impulse sequences cannot ever be the shortest ones.
When the market makes a sideways correction in wave 4, its extent often extends. Usually limited by a trend line drawn off the start of Wave 3, double and triple Zigzags are unlikely to occur; rather, extended W4s could signal longer corrective sequences ahead.
Wave 5
An impulse sequence’s fifth wave may be extended. When extended, its subwaves resemble those of waves one and three – this type of wave is known as a leading diagonal or an expanded triangle.
This pattern appears as either an impulse wave one position or wave A position of a zigzag wave, though it may also occur as an ending diagonal with its internal structure consisting of contracting or expanding diagonals.
Elliott Wave Theory traders should confirm their decisions using other technical and fundamental analysis tools in order to reduce false signals and avoid trading against the trend, which may cause prices to suddenly reverse and lead to large losses over short periods of time.