Elliott made accurate stock market predictions based on reliable characteristics he discovered in wave patterns. His theory held that prices always alternated between an impulsive and corrective phase on all trend time scales.
An impulsive sequence typically features three waves that are strong and sharp; then comes a correction, known by Elliott as the fourth wave, usually covering less than 38.2% of wave three’s progress.
Wave (C) of any corrective sequence provides traders with an ideal entry point into the market. They should search for simple corrective patterns like flat, zigzag or triangle to enter. Complex corrections may take many forms such as double combinations and triple zigzags – in these instances the x wave provides the key element by connecting two or more corrective waves of equal degree together.
An important aspect of entering the market is to recognize an extended impulsive move. Running corrections typically manifest themselves in the second wave of such moves; traders should trade according to which wave extends: in bullish moves they should BUY contracts while for bearish ones they should SELL contracts. According to the alternation rule, no second wave should ever retrace more than 100% of its predecessor – this gives traders an excellent opportunity to enter the third wave when this has completed and two corrective waves have overlapped one another.
As the market surges upward in five waves, news is positive and sentiment is high; buying starts occurring and people start buying in regardless of strong warning signals such as negative divergences from momentum indicators.
At this stage, prices may retrace up to 61.8% of gains made during Wave 1 but cannot exceed 100%, as that would breach one of Elliott’s three rules for identifying strong trends. When an impulsive advance ends, corrections abc typically end near prior Wave 4 lows.
Patterns known as fractals can repeat themselves on successive timeframes, creating an almost zoom effect. That is why Elliott wave analysis techniques should be adhered to; it allows us to detect larger patterns unfolding in the market that can help make more informed trading decisions and identify optimal entry points into new trades.
After a complex corrective wave has concluded, prices may move back in the direction of their previous dominant trend. At this stage, positive news begins to filter in, momentum indicators reach new highs, and bull markets begin gaining strength again. Unfortunately, volume often decreases and markets exhibit what Elliott Wave practitioners refer to as a “throw-over”.
Throw-over occurs when prices break through both a channel line and projected Fibonacci target simultaneously, signaling that the pattern may soon come to an end and reverse course. Divergence may also appear at this time indicating an incomplete upward push that warrants further consideration via alternative wave counts.
At the conclusion of an Elliott Wave Principle cycle, prices typically retrace over their entire prior move in an attempt to avoid deep corrections. When this retracement takes place, investors should expect a double zigzag pattern wherein it first covers part of wave 5 before going back over all of it again.
If your diagonal pattern follows a leading diagonal path, waves 2 and 4 should always subdivide into zigzags so as to ensure that wave i does not overlap with wave ii’s beginning and vice versa; this rule of alternation.
An Elliott Wave Theory rule of thumb suggests that sharp countertrend corrections in waves two should never extend past the end of wave one, or be projected between wave two’s endpoint and wave four’s startpoint, signaling deeper correction. A further dictum states that net retracements cannot exceed 61.8% of gains seen within any one wave (wave I).