The Elliott wave principle asserts that market movements form an ever-evolving series of impulse and corrective waves at various time scales of trend, subdivided into five lower-degree waves alternating between motive and corrective characteristics.
Impulse sequences typically follow an impulse wave pattern wherein wave 5 tends toward equaling wave 1. If this does not happen, a relationship of approximately 0.618 between wave 1 and wave 3 may emerge as most prevalent.
Wave 5
Market performance across all time frames shows five impulse waves and three corrective waves moving in tandem, each separated by lower degree waves; these corrective sequences resemble impulse wave forms in terms of form and length; impulse waves frequently extend beyond their original limits (although these extensions may not always be visible).
If an extension occurs, its first wave of correction will likely consist of a triangle, given their unique ability to create complex combinations but remain simple at their core. Furthermore, this extension could include double or triple zigzags.
Corrective wave sequences retrace no more than the extreme of the last impulse wave of one lesser degree, often including an expanded wave five, but this is not necessary; sometimes truncated versions may occur instead; such instances tend to occur more frequently when Wave 3 was particularly strong.
Wave 4
Wave 4 occurs when participants recognize that the trend has ended and begin taking profits, causing prices to decrease and form a correction, though usually within 38.2% of its preceding wave three.
Elliott Wave Theory uses an alternation guideline, wherein each impulse wave alternates with one lesser degree corrective wave over time. Although not an inflexible rule, this system has proven its efficacy over time.
Only when waves overlap does this rule not apply – an extremely difficult situation to analyze! To detect an overlap, draw a parallel line from Wave 1’s end point all the way out to its termination point in Wave 5. In order to do this accurately. To evaluate such situations, draw another parallel line off Wave 5 from this end point and project this onto Wave 1. To check for overlaps accurately.
Wave 3
Wave 3 of an impulse wave represents the strongest impulse wave and signifies the start of a new trend. At this stage, most market participants become aware that their previous trend is over and begin purchasing assets, driving prices higher temporarily and creating an “excess” bubble in prices.
As traders who had bought in wave 1 withdraw, prices drop, creating what is known as Wave 2. Lower prices cause participants to perceive that an asset has become undervalued and start buying it back, creating Wave 3 as they think prices have undershot reality and purchase.
Corrective waves following impulse waves can take two distinct forms. A straightforward correction often resembles a zigzag pattern, rarely retracing more than 61.8% of wave one gains. Complex corrections may involve flat patterns where B and C overlap or multiple three-wave patterns such as Expanding Flat.
Wave 2
Wave 2 of an Elliott wave sequence typically is its strongest stage and this occurs due to market participants becoming aware that prevailing trends will change direction; as they begin taking profits and prices drop as part of corrective moves in wave 2.
Corrective waves typically retrace between 50% to 61.8% of an impulse move and also extend from the end of Wave 1 to the beginning of Wave 3.
Wave 5 may truncate and fail to push prices past the peak of Wave 3, or even its beginning, which indicates weakness in the market and should signal sell offs in Wave 5. Usually this retracement of Wave 4 occurs within its triangle formation as per Elliot waves’ alternation rule.
