The Elliott wave principle is a form of technical analysis that attempts to forecast/predict trends in the financial markets.

Elliott’s theory specifies that because humans are themselves cyclical, their activities and decisions could be predicted in cycles, too (FEAR,GREED,FIGHT,FLEE) another “Crowd Theorist” where “History repeats itself”. It is very important to understand that Elliot wave also coincides with the Fibonacci numbers on a regular basis.

Overview

The wave principle insinuates that crowd psychology, moves from optimism the buyers (BULLS) to pessimism the sellers (BEARS) and back again. These trade swings create patterns or waves, as observed in price movements of any market at each degree of trend, regardless of timescales.

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All events that result from human social & economic processes, follow laws that cause them to repeat themselves (History) in similar recurring series of waves of definite number and pattern. Elliott’s theory says, that market prices alternate between five waves and three waves at all degrees within any given trend. As waves develop, the larger price patterns develop in a similar geometry. Within the underlying dominant trend, waves 1, 3, and 5 are “motive/bullish” waves, and each motive wave itself subdivides into a further five waves. Waves 2 and 4 are “corrective/bearish” waves, and subdivide in three waves. In a bear market the underlying trend  is down, so the pattern is reversed—five waves down and three up. Motive waves move with the trend, while corrective waves move against it.

 

Degree

The patterns link to form five and three-wave structures which themselves underlie self-similar wave structures of increasing size or higher “degree.” In the first small five-wave sequences, waves 1, 3 and 5 are motive/bullish, while waves 2 and 4 are corrective/bearish. This signals that the movement of the wave one degree higher is Bullish. It also signals the beginning of the first small three-wave bearish sequences. After the initial five waves up and three waves down, the sequence begins again and the self-similar geometry begins to develop according the five and three-wave structure which it underlies one degree higher. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves. Waves of  similar degree however, may be of different size and/or duration.

Characteristics (wave signature)

Analysts maintain that it is not necessary to look at a price chart to judge where a market is in its wave pattern. Each wave has its own “signature” which often reflects the underlying sentiment of the market. Understanding how and why the waves develop is key to the application of the Wave Principle.

These wave characteristics assume a bullish market. The characteristics are opposite in a bear market.

Five wave pattern (dominant trend)

Three wave pattern (corrective trend)

Wave 1: Wave one is never obvious at its begining. When the first wave of a new bull market begins, fundamental news is generally negative. The previous trend is considered still profoundly in force. Fundamental analysts continue to monitor “Macro Data”, generally the economy probably does not look strong. Sentiment surveys are decidedly bearish, short orders will increase in volume, and implied volatility in the market is high. Volume might increase slightly as prices rise, but not significantly, to alert many technical analysts. Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental economic news is usually generally positive. Most analysts see the drop as a correction in a continuing bull market. Some technical indicators that accompany wave A include increased volume and rising volatility in other related markets.
Wave 2: Wave two corrects wave one, but cannot extend beyond the starting point of wave one. Usually, economic news is still negative. As prices retest the previous low, bearish sentiment continues building, and “the crowd” reminds everyone that the bear market is still settled. Still, some positive signs appear for those who are looking: volume is generally lower during wave two than during wave one, prices usually do not retrace more than 61.8% ( Fibonacci) of the wave one gains, and prices should fall in a three wave pattern. Wave B: Prices reverse higher, which many see as a resumption of the now diminished bull market. The peak may be represented as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, sentiment and macro data,  are probably no longer improving however, not negative.
Wave 3: Wave three is generally the largest and most powerful wave in a trend (although some argue that, in commodity markets, wave five is the largest). The news now swings to positive and fundamental analysts start to be more optimistic. Prices rise, corrections are shorter and more shallow. Anyone looking to “get in on a retracement” will have to be quick. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, “the crowd” will often join the newly established bullish trend. Wave three often extends wave one by a ratio of 1.618:1 (Fibonacci). Wave C: Prices move lower in five waves. Volume picks up, and by the third leg of wave C, most investors realize that a bear market is firmly underway. Wave C is typically at least as large as wave A and often extends to 1.618 (Fibonacci) times wave A or beyond.
Wave 4: Wave four is typically corrective. Prices may transition sideways for an extended period, and wave four typically retraces less than 38.2% (Fibonacci) of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. The most distinguishing feature of fourth waves is that they often prove very difficult to count.
Wave 5: Wave five is the final leg in the direction of the underlying trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many inexperienced investors finally buy in, just before the peak. Volume is lower in wave five than in wave three, and many momentum indicators start to show divergences (MACD, Bollinger) (prices reach a new high, the indicator does not reach a new peak).

Elliott’s market model relies heavily on studying price charts. Investors study developing price moves to distinguish the waves and their structures, and calculate the next market move, pattern recognition.

Observation

Wave identification is not simple, it is an art to which the subjective judgment of the chartists matters more than the objective, replicable verdict of the numbers. Critics say the wave principle is too vague and difficult to define the start and/or Finnish of a particular wave.

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice.