Mapping The Market
Elliot Wave analysis is a form of technical analysis developed by R.N Elliot which blends traditional technical analysis with market psychology. The analysis asserts that the way in which crowd behaviour manifests itself in the markets creates clear patterns, namely waves, which reflect the ebb and flow of sentiment and can be traded.
While Elliot Wave theory is a dense and complicated subject which requires significant research, there are a few core principles and basic structures that we can focus on, which traders of all skill levels can build into their analysis and use to find trading opportunities.
Impulsive 5 Wave Sequence
At the core of Elliot Wave analysis is the idea of a basic 5 wave structure, which is an impulse move, followed by a 3 wave corrective sequence. This idea of impulsive and corrective waves sits at the core of Elliot Wave theory.
Looking at the image above you can see the classic 5 wave structure laid out. You will notice that waves 1, 3 and 5 are impulsive, where the market is expanding, whereas waves 2 and 4 are corrective, where the market is retracing.
Corrective 3 Wave Sequence
Following the initial impulsive 5 wave series, Elliot Wave Theory then suggests that the market typically corrects in a larger 3 wave structure.
The image above shows a bearish 3 wave correction (labelled A, B, C) after the initial bullish 5 wave structure has completed. The combination of a 3 wave corrective structure after an initial 5 wave impulsive structure represents a complete Elliot Wave sequence.
In the image above you can see an example of a complete Elliot Wave sequence on the charts. Price initially pushes higher, completing a 5 wave bullish impulse structure before correcting lower in the classic ABC formation.
Notably, waves 1, 3 and 5 do not have to be the same length in the 5 wave impulse sequence and typically wave three will be the largest wave. Whilst 5 wave sequences can take on different shapes and sizes, there are a few hard rules when it comes to identifying Elliot Waves.
Rules For Identifying Elliot Waves
1) Wave 2 cannot retrace more than 100% of wave 1. Essentially, wave 2 cannot complete below the low of wave 1
2) Wave 3 can never be the shortest of the three impulse waves and as mentioned, will often be the longest (though doesn’t have to be)
3) Wave 4 can never overlap wave 1. So, imagine a horizontal line drawn along the wave 1 high, wave 4 can not break down below that high.
So, if we look back at our chart example, we can tick all three criteria.
Wave 2 does not retrace more than 100% of wave 1. Wave 4 does not overlap with wave 1 and finally, wave 3 is not the shortest wave (wave 1 is!).
As well as hard criteria, which must be satisfied to successfully class the structure as an Elliot Wave, there are also some guidelines which can help you in your analysis.
Guidelines For Identifying Elliot Waves
- When wave 3 is the longest wave, waves 1 and 5 are usually the same length.
- The shape of waves 2 and 4 tends to alternate. Where wave 2 is a flat correction, wave 4 will usually be sharper and vice versa.
- After the 5 wave impulse move, the ABC correction usually completes around the low of wave 4.
So, looking at our chart example again. Wave 3 was not the longest, so this doesn’t apply. Wave 2 was a flat correction and Wave 4 was a sharper correction, and finally, the ABC correction did not complete into the low of Wave 4. Again, these are just guidelines and not rules.
Using Elliot Waves
Now you know the basic of the Elliot Wave structure you can begin to incorporate this analysis into your broader chart study. Whilst the subject, as mentioned, is incredibly deep and requires much further research – even just this basic introduction can stand you in better stead when reading the charts.
If you notice an initial 4 wave structure, it is likely that the market is going to make one final push higher to complete a 5 wave sequence before reversing lower so don’t get sucked in selling too early.
Vice versa. Where price makes an initial 4 wave bearish structure, it is likely to put in another low before reversing higher.
If you are looking to buy the dip or sell the rip in a trend, don’t get caught trying to play the first pull back if you can identify an initial 5 wave structure. Instead, wait for the ABC correction and then look to take the trade.
Ultimately, Elliot Wave analysis can be a fantastic tool for helping you frame price action and assess where the market is heading next, allowing you to make trade calls based on your study. The analysis can be used alongside all other traditional forms of technical analysis such as support and resistance, trend lines and Fibonacci as well as combined with indicators to help you identify trading opportunities.
If you have any questions about this article, please leave a comment, and we will happily answer them for you as soon as we can.