Like seashells or snowflakes, Elliott waves are fractals with unique properties that make them effective tools for market analysis.
Ralph Nelson Elliott proposed that stock markets move in five up and three down waves, and that their price targets reflect ratios from the Fibonacci sequence.
Wave 1 of an impulse move, is typically the strongest trend wave and often contains the greatest momentum. Because this initial step requires accurate counting, any errors could invalidate an entire pattern.
One of the main rules regarding motive waves is that wave 5 cannot retrace more than 100% of Wave 1. Additionally, it must travel beyond or cross through an imaginary line drawn parallel to Waves 3 and 5.
However, this rule can be disregarded if corrective waves take the form of zigzags or leading diagonals; such waves tend to form over longer periods and can retrace less than 100% of Wave 1’s length as well as overshoot its final point in price territory.
A fifth wave in an impulse sequence often signals a more severe correction due to traders who were late buying (or selling – in bear markets) assets during waves 1 through 4, being caught off guard by its sudden ABC correction, trading against what should have become the new trend and acting irrationally against its direction.
As this can result in an overshoot of the retracement level and invalidate the wave count, counting must start over to obtain a valid 5-wave count. Elliott Wave theory gives you a specific invalidation point that conventional market analysis doesn’t offer, helping you maintain profitable positions for as long as possible.
The Elliott Wave Theory is founded on the idea that financial markets move in predictable patterns due to mass psychology shifts triggered by greed and fear, with its patterns repeating themselves at ever smaller scales allowing market experts to make accurate predictions.
The theory divides movements into two distinct waves – motive and corrective waves. Motive waves (also called impulse waves) move with the current trend while corrective waves move against it.
Fibonacci time zones can also help traders identify possible targets for each wave; however, traders must bear in mind that certain price action may cause these rules to be violated.
Elliott Wave theory is a form of technical analysis developed by someone who noticed how financial markets move in repetitive cycles characterized by impulse and corrective waves that build upon one another.
Traders can utilize Ralph Elliott’s theory to anticipate future market movements by considering different time frames and waves. His classification system categorizes them as nine separate degrees.
Wave 2 must never retrace more than 50% of Wave 1, cannot be the shortest wave and should never overlap Wave 1. Waiting until there is an unbroken channel connecting Waves 1 and 2, will help project where to target Wave 5; generally this projected trend line will break slightly during Wave 4, showing strong price momentum.
Once an impulse wave ends, markets typically experience an ABC correction as investors and traders who missed its initial move begin buying (or selling in case of bear trends) at much higher prices than originally projected.
Rule #3 states that Wave Four cannot enter into the area of Wave 1, although this rarely happens and any slight retracements into Wave 1 can still be considered valid in a 5-wave count.
Fibonacci ratios provide a simple yet effective method to help understand market behavior. A typical impulsive move may retrace no less than 38.2% but usually more than 61.8 of Wave 1. The second wave should then extend 161.8% of Wave 1; this pattern defines Wave 2.