Elliott discovered that price movements on charts exhibited predictable patterns. To predict these fluctuations with high reliability, he developed rules and guidelines.
An impulsive wave often results in three waves of correction. Wave 2 sees prices retrace deeply and pessimism remains elevated.
Wave 5 is a correction
Elliott Waves Theory distinguishes two categories of corrections – simple and complex corrections. Simple corrections may include zigzag corrections while complex ones more resemble triangles or flats. Impulsive or corrective actions may occur upon these corrections.
Wave 5 of a correction should not retrace more than the span of its previous fourth wave by one lesser degree, with its exact degree determined by its internal structure of preceding impulse waves. A W4 flat should take at least twice as long as its counterpart, or possibly three-four times longer in cases of expanded flat waves.
Once the retracement level has been calculated, you can project its target for wave 5. If the baseline from wave 2 is breached by wave 4, this indicates a possible blow-off situation in the market. Alternately, drawing a channel connecting end of wave 1 and wave 3 may provide an estimated boundary for wave 4. Additionally, trendlines connecting ends of waves 2 and 3 provide another method of projecting upward to find wave 5 targets; typically an equal relationship exists between waves 1 and 5, otherwise an approximate relationship of 0.618 would likely apply
Wave 5 is a retracement
An impulse sequence’s fifth wave may retrace all or some of its preceding waves. It is crucial that this point be understood because it signals a change in momentum that signals both an end to one trend and start of another one.
It is also possible for a fifth wave to extend beyond its preceding third wave, something often witnessed on the stock market and known as truncation.
A fourth wave typically displays less energy and momentum than its predecessors, taking longer to gain momentum before potentially retracing or zigzagging around previous trends. Furthermore, its net travel usually correlates to that of its corresponding fifth wave by being equal or 1.618x that of waves 1 through 3, providing traders with an easy way to identify corrective patterns.
Wave 5 is a rally
Wave 5 is a strong rally, carrying momentum and volume. It pushes prices higher than wave 3, exceeding projected trend lines from wave 4. This indicates a new trend has begun and gives an indication of market strength sufficient to break through resistance levels and make new highs.
The Elliott Wave theory assumes that markets move in five waves when advancing and three waves when correcting, often following a fractal pattern where smaller patterns fit into bigger ones, along with Fibonacci ratios to identify trading opportunities with favorable risk/reward ratios. Since these patterns appear on multiple time frames – 15-minute charts may only represent one part of an unfolding 60-minute sequence unfolding later – traders can identify trading opportunities that offer potential big profits.
Wave 5 is a sell-off
Elliott Wave Theory employs Fibonacci ratios to identify market trends. These patterns span various time frames – for instance, what may look like five consecutive waves could represent cycles with higher degrees on another timeframe.
The third wave of an impulse typically displays the most momentum. Market participants generally become most comfortable with the direction of the new trend at this stage; typically marked by price breakouts, continuation gaps and volume expansion; as well as strong buying pressure.
At first, 2nd waves tend to unfold as three-wave correctives that deeply retrace previous trends’ origin. At this stage, mass recognition of a new trend typically increases and economic fundamentals improve. If that trend remains in place after this final down move comes into force retracing both wave 2 and wave 4, without overlap, this type of correction (called truncated wave 5s ) becomes less frequent but sometimes occurs more frequently after strong 3rd waves have taken hold.