What is Elliott wave theory?
The theory was developed by R.N. Elliott in the 1930s and was popularized by Robert Prechter in the 1970s. Elliott studied several years of stock market data across various indices and discovered that market forms the same types of patterns on a smaller timeframe (lesser degree) that it does on a longer timeframe (higher degree). These patterns provide clues as to what might happen next in the market. According to the theory, it does not depend on what timeframe you are analyzing; market movements follow the same types of patterns. The Elliott Wave Theory suggests that the stock prices move continuously up and down in the same pattern known as waves that are formed by the traders’ psychology. Elliott call these waves Motives and Corrective Waves as shown in figure (1)
Elliot Wave Cycle
According to the theory, the stock market unfolds according to basic pattern of five waves up and three waves down to form one complete cycle of eight waves as shown in figure (2)
What are Motives and Corrective Waves?
1. Motive Waves
2. Correction Waves
1- Motive Waves
• Motive waves move in the direction of the main trend and has internal structure of 5 waves.
• Wave 1, 3 and 5 are motive waves.
There are two types of motive waves
A- Impulsive Wave
1- Wave 2 cannot retrace more than 100% of Wave 1.
2- Wave 3 can never be the shortest of waves 1, 3, and 5.
3- Wave 4 can never overlap Wave 1.
If one of these rules is violated, the structure is not an impulse wave. As shown in figure (3)
B- Diagonal Wave
The diagonal wave looks like a wedge that may be either expanding or contracting. The diagonal rules are the same as the impulse wave rules except wave 4 could overlap with wave 1 as shown in figure (4)
Diagonals can be further divided into the ending and leading diagonals. The ending diagonal usually occurs in Wave 5 of an impulse wave or the last wave of corrective waves whereas the leading diagonal is found in either the Wave 1 of an impulse wave or the Wave A position of a zigzag correction.
2- Correction Waves
There are four types of corrective waves:
The Zig-Zag is a corrective wave that is made up of 3 waves labelled as A, B and C that move strongly up or down. The A and C waves are motive waves whereas the B wave is corrective (often with 3 sub-waves) as shown in figure (5).
The flat is another three-wave correction in which the sub-waves are formed in a 3-3-5 structure which is labelled as an A-B-C structure. In the flat structure, both Waves A and B are corrective and Wave C is motive having 5 sub-waves.as shown in figure (6)
The triangle is a pattern consisting of five sub-waves in the form of a 3-3-3-3-3 structure, that is labelled as A-B-C-D-E. this corrective pattern shows a balance of forces and it travels sideways. The triangles can also be categorized as symmetrical, descending or ascending, based on whether they are pointing sideways, up with a flat top or down with a flat bottom.as shown in figure (7)
D- Combinations Correction
The combination could include two variations of corrective patterns such as zigzag followed by a flat as shown in figure (8)
How the Wave Principle Improves Trading?
Here are five ways the Wave Principle can benefit you and improve your trading:
- The Wave Principle identifies the trend.
- It identifies countertrend price moves within the larger trend.
- It determines the maturity of the trend.
- It provides high-confidence price targets.
- It provides specific points of invalidation.
How to trade using Elliot wave theory?
My best advice to you as you look for a trading opportunity is to start your search by asking the question, “Do I see a wave pattern I recognize?” You should look for one of the five core Elliott wave patterns: impulse wave, ending diagonal, zigzag, flat, or triangle.
Trading using Impulsive wave
Whenever an impulse wave is complete the trading technique is to enter on a break below the extreme of wave (iv) of 5 as shown in figure (9). Set the initial protective stop at the extreme of the price move.
Trading using Ending Diagonal
Wait for a break of the extreme of wave 4 before taking a position, and place the initial protective stop at the extreme of the price move as shown in figure (10)
Trading using Zigzag
Entering a trade during a zigzag is on a break of the extreme of wave [iv] of C, provided this level is beyond the termination of wave A as shown in figure (11)
Trading using Flat
The recommended entry technique is similar to that of an impulse wave: Wait until prices exceed the extreme of wave (iv) of C to enter a trade as shown in figure (12)
Trading using Triangle
A triangle is a sideways price move—typically bounded by converging trendlines—that subdivides into waves A, B, C, D, and E. The entry guideline is to wait for prices to break the extreme of wave D and place an initial protective stop where wave E terminates. As shown in figure (13)
As we have discussed above Elliott wave theory is open to interpretations in different ways by different traders, so are their patterns. Thus, traders should ensure that when they identify the patterns.