Elliott
Waves theory
Basic
Theory
According
to physical law: "Every action creates an equal and
opposite reaction". The same goes for the financial
markets. A price movement up or down must be followed by a
contrary movement, as the saying goes: "What goes up must
come down"( and vice versa).
Price
movements can be divided into trends on the one hand and
corrections or sideways movements on the other hand. Trends show
the main direction of prices, while corrections move against the
trend. In Elliott terminology these are called Impulsive waves
and Corrective waves.
The
Impulse wave formation has five distinct price movements, three
in the direction of the trend (I, III, and V) and two against
the trend ( II and IV).
Obviously
the three waves in the direction of the trend are impulses and
therefore these waves also have five waves. The waves against
the trend are corrections and are composed of three waves.
The
corrective wave formation normally has three, in some cases five
or more distinct price movements, two in the direction of the
main correction ( A and C) and one against it (B). Wave 2 and 4
in the above picture are corrections. These waves have the
following structure:
Note
that these waves A and C go in the direction of the shorter term
trend, and therefore are impulsive and composed of five waves,
which is shown in the picture above.
An
impulse wave formation followed by a corrective wave, form an
Elliott wave degree, consisting of trend and counter trend.
Although the patterns pictured above are bullish, the same
applies for bear markets, where the main trend is down.
The
following example shows the difference between a trend (impulse
wave) and a correction (sideways price movement with overlapping
waves). It also shows that larger trends consists of (a lot of )
smaller trends and corrections, but the result is always the
same.
Very
important in understanding the Elliott Wave Principle is the
basic concept that wave structures of the largest degree are
composed of smaller sub waves, which are in turn composed of
even smaller sub waves, and so on, which all have more or less
the same structure ( impulsive or corrective) like the larger
wave they belong to.
Elliott distinguished nine wave degrees ranging from two
centuries to hourly.
|
Wave
degree
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Trend
|
Correction
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Grand
Supercycle
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|
Supercycle
|
|
|
|
Cycle
|
|
|
|
Primary
|
|
|
|
Intermediate
|
|
|
|
Minor
|
|
|
|
Minute
|
|
|
|
Minuette
|
|
|
|
Sub
minuette
|
|
|
In
theory the number of wave degrees are infinite, in practice you
can spot about four more wave degrees if you examine at tick
charts.
This
indicates that you can trade the investment horizon, which is
most suited for you, from very aggressive intra day trading to
longer term investing. The same rules and patterns apply over
and over again. Now we will take a look at the patterns...
Classic
Elliott Wave patterns
Below
we have depicted all Elliott Wave patterns that are allowed
under a very strict interpretation of the Elliott Wave
Principle. Elliott detected most of these patterns, except for
the Diagonal 2 pattern. The WXY and WXYXZ pattern have not been
defined as such by Elliott, but he already had discovered these
sort of combinations.
In
our Automatic analysis engine we use the WXY and WXYXZ also for
Double and Triple Zigzags. This is a much more consistent way of
labeling these patterns, since now the ABC waves in waves W and
Y are sub waves and an unfitting Wave X has been eliminated.
Because
of this the Automatic analysis no longer has to search for more
than five waves. Using the old definition of for example a
Triple Zigzag, the search was for eleven waves, apart from
inconsistencies this would have slowed down the analysis
considerably.
I.
Trends
a.
Impulse
Pattern
Description
Impulses
are always composed of five waves, labeled 1,2,3,4,5. Waves 1, 3
and 5 are themselves each impulsive patterns and are
approximately equal in length. Waves 2 and 4 on the contrary are
always corrective patterns.
Rules
and guidelines
The
most important rules and guidelines are:
- Wave
2 cannot be longer in price than wave 1, and it must not
go beyond the origin of wave 1.
- Wave
3 is never the shortest when compared to waves 1 and 5.
- Wave
4 cannot overlap wave 1, except in diagonal triangles and
sometimes in wave 1 or A waves, but never in a third wave.
In most cases there should not be an overlap between wave
1 and A.
- As
a guideline the third wave shows the greatest momentum,
except when the fifth is the extended wave.
- Wave
5 must exceed the end of wave 3.
- As
a guideline the internal wave structure should show
alternation, which means different kind of corrective
structures in wave 2 and 4.
In
which wave
Impulse
patterns occur in waves 1, 3, 5 and in waves A and C of a
correction( this correction could be a wave 2, 4 or a wave B, D,
E or wave X).
Internal
structure
It
is composed of five waves. The internal structure of these waves
is 5-3-5-3-5. Note that the mentioned 3s are corrective waves,
which should be composed of 5 waves in a corrective triangle.
b.
Extension
Pattern
Description
By
definition an extension occurs in an impulsive wave, where waves
1, 3 or 5 can be extended, being much longer than the other
waves. It is quite common that one of these waves will extend,
which is normally the third wave. The two other waves then tend
to equal each other.
In
our pattern definitions we call it an Extension1 if the first
wave extends, an Extension3 if the 3rd wave extends
and an Extension5 if the 5th wave extends.
Rules
and guidelines
The
most important rules and guidelines concerning an extended wave
are:
- It
is composed of 5, 9, 13 or 17 waves.
- Wave
2 cannot be longer in price length than wave 1, so it
should not go beyond the origin of wave 1.
- Wave
3 is never the shortest when compared to waves 1 and 5.
- Wave
4 cannot overlap wave 1.
- Wave
5 exceeds the end of wave 3.
- The
extended wave normally shows the highest acceleration.
In
which wave
Extensions
occur in waves 1, 3, 5, and in A and C waves, when compared to
each other.
Internal
structure
As
a minimum it is composed of 9 waves, though 13 or 17 waves could
occur. So the minimal internal structure of the 9 waves is
5-3-5-3-5-3-5-3-5. Note that the 3s mentioned are corrective
waves, which could be composed of 5 waves in the case of a
corrective triangle.
c.
Diagonal triangle type 1
Pattern
Description
Diagonals
are sort of impulsive patterns, which normally occur in terminal
waves like a fifth or a C wave. Don’t confuse them with
corrective triangles.
Diagonals
are relatively rare phenomena for large wave degrees, but they
do occur often in lower wave degrees on intra-day charts.
Usually Diagonal triangles are followed by a violent change in
market direction.
Rules
and guidelines
The
most important rules and guidelines are:
- It
is composed of 5 waves.
- Waves
4 and 1 do overlap.
- Wave
4 can’t go beyond the origin of wave 3.
- Wave
3) cannot be the shortest wave.
- Internally
all waves of the diagonal have a corrective wave
structure.
- Wave
1 is the longest wave and wave 5 the shortest.
- The
channel lines of Diagonals must converge.
- As
a guideline the internal wave structure should show
alternation, which means different kind of corrective
structures.
In
which wave
Diagonal
triangles type 1 occur in waves 5, C and sometimes in wave 1.
Internal
structure
The
internal structure of the five waves is 3-3-3-3-3.
d.
Diagonal triangle type 2
Pattern
Description
Diagonal
type 2 is a sort of impulsive pattern, which normally occurs in
the first or A wave. The main difference with the Diagonal
Triangle type 1 is the fact that waves 1, 3 and 5 have an
internal structure of five waves instead of three.
Experience shows it can also occur in a wave 5 or C, though the
Elliott Wave Principle does not allow this. Don’t confuse this
with corrective triangles.
Diagonals
are relatively rare phenomena for large wave degrees, but they
do occur often in lower wave degrees in intra day charts. These
Diagonal triangles are not followed by a violent change in
market direction, because it is not the end of a trend, except
when it occurs in a fifth or a C wave.
Rules
and guidelines
The
most important rules and guidelines are:
- It
is composed of 5 waves.
- Wave
4 and 1 do overlap.
- Wave
4 can’t go beyond the origin of wave 3.
- Wave
3) cannot be the shortest wave.
- Internally
waves 1, 3 and 5 have an impulsive wave structure.
- Wave
1 is the longest wave and wave 5 the shortest.
- As
a guideline the internal wave structure should show
alternation, which means that wave 2 and 4 show a
different kind of corrective structure.
In
which wave
Diagonal
triangles type 2 occur in waves 1 and A.
Internal
structure
The
five waves of the diagonal type 2 show an internal structure of
5-3-5-3-5.
e.
Failure or Truncated 5th
Pattern
Description
A
failure is an impulsive pattern in which the fifth wave does not
exceed the third wave. Fifth waves, which travel only slightly
beyond the top of wave 3, can also be classified as a kind of
failure. It indicates that the trend is weak and that the market
will show acceleration in the opposite direction.
Rules
and guidelines
The
most important rules and guidelines are:
- Wave
2 cannot be longer in price distance than wave 1, so it
should not go beyond the origin of wave 1.
- Wave
3 is never the shortest when compared to waves 1 and 5.
- Wave
4 cannot overlap wave 1, except for diagonal triangles and
sometimes in waves 1 or A, but never in a third wave.
There should not be overlap between wave 1 and A.
- Wave
5 fails to go beyond the end of wave 3.
- As
a guideline the third wave shows the greatest momentum.
- As
a guideline the internal wave structure should show
alternation, which means different kinds of corrective
structures.
In
which wave
A
failure can only occur in a fifth wave or a C wave, but normally
not in the fifth wave of wave 3.
Internal
structure
It
must be composed of five waves.
II.
Corrections
a.
Zigzag
Pattern
Description
A
Zigzag is the most common corrective structure, which starts a
sharp reversal. Often it looks like an impulsive wave, because
of the acceleration it shows. A zigzag can extend itself into a
double or triple zigzag, although this is not very common,
because it lacks alternation (the same two patterns follow each
other). Notice that the zigzag can only be the first part of a
corrective structure.
Rules
and guidelines
- It
is composed of 3 waves.
- Waves
A and C are impulses, wave B is corrective.
- The
B wave retraces no more then 61.8% of A.
- The
C wave must go beyond the end of A.
- The
C wave normally is at least equal to A.
In
which wave
Most
of the time it happens in A, X or 2. Also quite common in B
waves as a part of a Flat, (part of) Triangles and sometimes in
4.
Internal
structure
A
single Zigzag is composed of 3 waves, a double of 7 waves
separated by an X wave in the middle, a triple of 11 waves
separated by two X waves (see pictures below). The internal
structure of the 3 waves is 5-3-5 in a single Zigzag,
5-3-5-3-5-3-5 in a double.
Example
of a Double Zigzag
As you
have noticed we have a more modern representation of the Double
Zigzag using the labels WXY instead of ABCXABC. This is more
consistent, since this way 2 zigzags of lower degree get
connected to each other by waves of higher degree. On top if
that, our automatic analysis needed such a consistent method of
labeling to reach maximum performance. Instead of labeling 7
waves (ABCXABC), the Automatic analysis needs to label only 3
waves (WXY). According to the same method a Triple Zigzag is
represented by WXYXZ instead of ABCXABCXABC. This way the number
of waves was reduced to five instead of eleven.
b.
Flat
Pattern
Description
Flats
are very common forms of corrective patterns, which generally
show a sideways direction. Waves A and B of the Flat are both
corrective patterns. Wave C on the contrary is an impulsive
pattern. Normally wave C will not go beyond the end of wave A.
Rules
and guidelines
- It
is composed of 3 waves.
- Wave
C is an impulse, wave A and B are corrective.
- Wave
B retraces more then 61.8% of A.
- Wave
B often shows a complete retracement to the end of the
previous impulse wave.
- Wave
C shouldn’t go beyond the end of A.
- Normally
wave C is at least equal to A.
In
which wave
It
occurs mostly in B waves, though also quite common in 4 and 2.
Internal
structure
As
mentioned before a Flat consists of 3 waves. The internal
structure of these waves is 3-3-5. Both waves A and B normally
are Zigzags.
c.
Expanded Flat or Irregular Flat
Pattern
Description
This
is a common special type of Flat. Here the B wave is extended
and goes beyond the (orthodox) end of the previous impulsive
wave. The strength of the B wave shows that the market wants to
go in the direction of B. Often a strong acceleration will take
place, which starts a third wave or an extended fifth. If the C
wave is much longer then A, the strength will be less.
Rules
and guidelines
- It
is composed of 3 waves.
- Wave
C is an impulse, waves A and B are corrective.
- Wave
B retraces beyond the end of the previous impulse, which
is the start of wave A. The C wave normally is much longer
then A.
In
which wave
This
corrective pattern can happen in 2, 4, B and X. If it happens in
2 and C is relatively short, normally an acceleration in the
third will take place.
Internal
structure
It
is composed of five waves, which have an internal structure of
3-3-5.
d.
Triangles
Contracting
Triangle:
Pattern
Description
A
triangle is a corrective pattern, which can contract or expand.
Furthermore it can ascend or descend. It is composed of five
waves, each of them has a corrective nature.
Rules
and guidelines
- It
is composed of 5 waves.
- Wave
4 and 1 do overlap.
- Wave
4 can’t go beyond the origin of wave 3.
- Wave
3 cannot be the shortest wave.
- Internally
all waves of the diagonal have a corrective wave
structure.
- In
a contracting Triangle, wave 1 is the longest wave and
wave 5 the shortest. In an expanding Triangle, wave 1 is
the shortest and wave 5 the longest.
- Triangles
normally have a wedged shape, which follows from the
previous.
- As
a guideline the internal wave structure should show
alternation.
In
which wave
Triangles
occur only in waves B, X and 4. Never in wave 2 or A.
Internal
structure
It
is composed of five waves, of which the internal structure is
3-3-3-3-3.
Expanding
Triangle:
Ascending
Triangle:
This
is a triangle, which slopes upwards. This pattern has been
implemented in the Modern Rules.
Descending
Triangle:
This
is a triangle, which slopes downwards. This pattern has been
implemented in the Modern Rules.
Running
Triangle:
This
is a triangle where the B wave exceeds the origin of wave A.
e.
WXY or Combination
Many
kinds of combinations are possible. Below a rather complex
example has been depicted.
Pattern
Description
A
Combination combines several types of corrections. These
corrections are labeled as WXY and WXYXZ if it is even more
complex. It starts for example with a Zigzag (wave W), then an
intermediate X wave, then a Flat (wave Y) and so on. A so-called
double or triple three is also a Combination, but this pattern
combines Flats separated by X waves.
Rules
and guidelines
- All
types of corrective patterns can combine to form a bigger
corrective pattern.
- The
rules and guidelines, as mentioned for other corrective
patterns apply.
- A
triangle in a Combination should normally occur at the
end.
- Corrective
patterns in a Combination normally show alternation.
In
which wave
Generally
a Combination occurs mostly in B, X and 4, it is less common in
A and rare in 2.
Internal
structure
For
example a Zigzag, followed by a Flat, followed by a Triangle has
the following internal structure:
5-3-5(Zigzag)-5-3-5(X)-3-3-5(Flat)-3-3-3-3-3(Triangle).
f.
Running Flat
Pattern
