About Elliott Waves Theory Basics
The Elliott Wave Theory is named
after Ralph Nelson Elliott. Inspired by
the Dow Theory and by observations found
throughout nature, Elliott concluded
that the movement of the stock market
could be predicted by observing and
identifying a repetitive pattern of
waves. In fact, Elliott believed that
all of man's activities, not just the
stock market, were influenced by these
identifiable series of waves.
Elliott based part his work on the
Dow Theory, which also defines price
movement in terms of waves, but Elliott
discovered the fractal nature of market
action. Thus Elliott was able to analyze
markets in greater depth, identifying
the specific characteristics of wave
patterns and making detailed market
predictions based on the patterns he had
Definition of Elliott Waves
In the 1930s, Ralph Nelson Elliott
found that the markets exhibited certain
repeated patterns. His primary research
was with stock market data for the Dow
Jones Industrial Average. This research
identified patterns or waves that recur
in the markets. Very simply, in the
direction of the trend, expect five
waves. Any corrections against the trend
are in three waves. Three wave
corrections are lettered as "a, b, c."
These patterns can be seen in long-term
as well as in short-term charts.
Ideally, smaller patterns can be
identified within bigger patterns. In
this sense, Elliott Waves are like a
piece of broccoli, where the smaller
piece, if broken off from the bigger
piece, does, in fact, look like the big
piece. This information (about smaller
patterns fitting into bigger patterns),
coupled with the Fibonacci relationships
between the waves, offers the trader a
level of anticipation and/or prediction
when searching for and identifying
trading opportunities with solid
There have been many theories about
the origin and the meaning of the
patterns that Elliott discovered,
including human behavior and harmony in
nature. These rules, though, as applied
to technical analysis of the markets
(stocks, commodities, futures, etc.),
can be very useful regardless of their
meaning and origin.
Simplifying Elliott Wave Analysis
Elliott Wave analysis is a
collection of complex techniques.
Approximately 60 percent of these
techniques are clear and easy to use.
The other 40 are difficult to identify,
especially for the beginner. The
practical and conservative approach is
to use the 60 percent that are clear.
When the analysis is not clear, why
not find another market conforming to an
Elliott Wave pattern that is easier to
From years of fighting this battle,
we have come up with the following
practical approach to using Elliott Wave
principles in trading.
The whole theory of Elliott Wave can
be classified into two parts:
Elliott Wave Basics — Impulse
The impulse pattern consists of five
waves. The five waves can be in either
direction, up or down. Some examples are
shown to the right and below.The
first wave is usually a weak rally with
only a small percentage of the traders
participating. Once Wave 1 is over, they
sell the market on Wave 2. The sell-off
in Wave 2 is very vicious. Wave 2 will
finally end without making new lows and
the market will start to turn around for
The initial stages of the Wave 3
rally are slow, and it finally makes it
to the top of the previous rally (the
top of Wave 1).
At this time, there are a lot of
stops above the top of Wave 1.
Traders are not convinced of the
upward trend and are using this rally to
add more shorts. For their analysis to
be correct, the market should not take
the top of the previous rally.
Therefore, many stops
are placed above the top of Wave 1.
Wave 3 rally picks up steam and takes
the top of Wave 1. As soon as the Wave 1
high is exceeded, the stops are taken
out. Depending on the number of stops,
gaps are left open. Gaps are a good
indication of a Wave 3 in progress.
After taking the stops out, the Wave 3
rally has caught the attention of
The next sequence of events are as
follows: Traders who were initially long
from the bottom finally have something
to cheer about. They might even decide
to add positions.
traders who were stopped out (after
being upset for a while) decide the
trend is up, and they decide to buy into
the rally. All this sudden interest
fuels the Wave 3 rally.
This is the time when
the majority of the traders have decided
that the trend is up.
Finally, all the buying
frenzy dies down; Wave 3 comes to a
Profit taking now begins to set in.
Traders who were long from the lows
decide to take profits. They have a good
trade and start to protect profits.This
causes a pullback in the prices that is
called Wave 4.
Wave 2 was a vicious sell-off; Wave 4
is an orderly profit-taking decline.
While profit-taking is
in progress, the majority of traders are
still convinced the trend is up. They
were either late in getting in on this
rally, or they have been on the
They consider this profit-taking
decline an excellent place to buy in and
On the end of Wave 4, more buying
sets in and the prices start to rally
The Wave 5 rally lacks the huge
enthusiasm and strength found in the
Wave 3 rally. The Wave 5 advance is
caused by a small group of traders.
Although the prices make a new high
above the top of Wave 3, the rate of
power, or strength, inside the Wave 5
advance is very small when compared to
the Wave 3 advance.
Finally, when this lackluster buying
interest dies out, the market tops out
and enters a new phase.
Elliott Wave Basics — Corrective
Corrections are very hard to master.
Most Elliott traders make money during
an impulse pattern and then lose it back
during the corrective phase.
An impulse pattern consists of five
waves. With the exception of the
triangle, corrective patterns consist of
3 waves. An impulse pattern is always
followed by a corrective pattern.
Corrective patterns can be grouped into
two different categories:
Simple Correction (Zig-Zag)
is only one pattern in a simple
correction. This pattern is called a
Zig-Zag correction. A Zig-Zag correction
is a three-wave pattern where the Wave B
does not retrace more than 75 percent of
Wave A. Wave C will make new lows below
the end of Wave A. The Wave A of a
Zig-Zag correction always has a
five-wave pattern. In the other two
types of corrections (Flat and
Irregular), Wave A has a three-wave
pattern. Thus, if you can identify a
five-wave pattern inside Wave A of any
correction, you can then expect the
correction to turn out as a Zig-Zag
inside a Zig-Zag Correction
Usually 50% of Wave A
Should not exceed 75% of
either 1 x Wave A
or 1.62 x Wave A
or 2.62 x Wave A
A simple correction is
commonly called a Zig-Zag correction.
Complex Corrections (Flat,
The complex correction group consists of
In a Flat correction, the length of each
wave is identical. After a five-wave
impulse pattern, the market drops in
Wave A. It then rallies in a Wave B to
the previous high. Finally, the market
drops one last time in Wave C to the
previous Wave A low.
In this type of correction, Wave B makes
a new high. The final Wave C may drop to
the beginning of Wave A, or below it.
Fibonacci Ratios in
an Irregular Wave
Wave B = either 1.15 x
Wave A or 1.25 x Wave A
Wave C = either 1.62 x
Wave A or 2.62 x Wave A
In addition to the three-wave correction
patterns, there is another pattern that
appears time and time again. It is
called the Triangle pattern. Unlike
other triangle studies, the Elliott Wave
Triangle approach designates five
sub-waves of a triangle as A, B, C, D
and E in sequence.
by far, most commonly occur as fourth
waves. One can sometimes see a triangle
as the Wave B of a three-wave
correction. Triangles are very tricky
and confusing. One must study the
pattern very carefully prior to taking
action. Prices tend to shoot out of the
triangle formation in a swift thrust.
triangles occur in the fourth wave, the
market thrusts out of the triangle in
the same direction as Wave 3. When
triangles occur in Wave Bs, the market
thrusts out of the triangle in the same
direction as the Wave A.
If Wave Two is a simple correction,
Wave Four to be a complex correction.
If Wave Two is a complex correction,
expect Wave Four to be a simple