What is the Elliott Wave Principle?
In its simplest form, it is that most market trends unfold in 5 waves in the direction of the trend, and in 3 waves in the direction counter to the main trend. Simple! 5's and 3's.
The 5 wave patterns are impulsive waves that cause the market to trend.
The 3 wave patterns are corrective, and can be thought of as the market taking a breath so it can continue the trend. EW believes that these patterns are caused by group psychology and the interplay of fear and greed.
A complete Elliott Wave pattern has 8 waves: 5 during the “impulse” phase and 3 during the “corrective” phase.
EW is a fractal concept, so look closely at Wave (1) and Wave (2). The entire 8-wave structure that comprises the first and second wave is exactly the same as the complete 8-wave structure that completes the whole chart, which itself might be a larger Wave 1 and Wave 2 of a higher time frame. It is important to understand that Elliott Wave is fractal.
In an impulse (an uptrend, for simplicity), Waves 1, 3, and 5 will ’subdivide’ into their own smaller 5-wave affairs. Waves 2 and 4, which move against the larger trend, have a 3-wave structure.
EW principle is fractal, meaning a complete five-wave impulse up might just simply be part of Wave 1 or Wave 3 (or Wave 5) of a larger complete wave structure, which itself might be part of an even larger wave structure.This is how to understand Elliott Wave Fractal ‘waves within waves.’
Here are the ‘ideal’ correction types:
It may take few sessions to elaborate on these corrections which make up 85% of market moves. Efficient trading requires mastering of these. We will take it up later.
Keep these three "Hard rules" (Unbreakable) always in mind while assessing/ counting/ labeling the price moves to help you arrive at a correct count which can result in a unbelievable forecast & stupendous trades.
- An impulsive wave always subdivides into five waves (1-2-3-4-5).
- Wave 1 usually subdivides into an impulse or seldom into a leading diagonal.
- Wave 2 subidivides into a zigzag, flat or combination.
- Wave 2 never moves beyond the start of wave 1 (Rule-1).
- Wave 3 always moves beyond the end of wave 1 and is never the shortest (Rule-2).
- Wave 5 subidivides into an impulse or an ending diagonal.
- Wave 4 subidivides into a zigzag, flat, triangle or combination.
- Wave 4 never moves into the territory of wave 1 (Rule-3).
Below is an illustration of these rules.
These are flexible rules but quite useful in identifying/ recognising a wave and its likely type or pattern.
- Wave 1, 3 or 5 is usually extended, while wave 1 is the least commonly extended wave.
- If wave 3 is extended, it’s common for sub wave 3 of 3 to extend as well (the same applies for wave 1 and 5).
- Subwave 3 of 3 almost always has the steepest slope within the parent impulse.
- Wave 5 often ends when hitting a line drawn from the end of wave 1 or 3 that is parallel to a line drawn between the ends of waves 2 and 4.
- Wave 5 normally ends beyond the end of wave 3, if not it’s called a truncation.
- If wave 2 was a sharp correction, wave 4 will almost always be a sideways correction and vice versa (Alternation).
- Wave 2 is usually a zigzag or zigzag combination.
- Wave 4 is ususally a flat, triangle or combination thereof.
- Wave 4 usually ends within the price territory of the fourth wave of wave 3.
- Wave 4 usually breaks the trendline .
The most difficult part of Elliott Wave analysis is correctly labeling and counting the waves. A correct count can lead the analyst to amazing accuracy in forecasting the market.
Applying what is learnt:
Learning can go on for eternity but practice must start immediately to develop the "Intuitive capability" to understand and apply this knowledge for profitable trades.
EW knowledge helped us to close the shorts @ 4960 and create longs too.
A move past the "i" wave of the 1st wave and a faster retracement gave another entry point.
Expanded flat of 2nd wave hinted at underlying bullishness and thus a shallow 2nd wave to hold on for the 3rd wave.
The 5-sub waves of 3rd wave alerted us to book profits at 5300+.
Shallow 2nd wave revealed an "alternation" in 4th wave to be steeper to play "Selling".
An "abc" correction helped us to initiate a long near the lows.
1st wave is 4944 - 5197 = 253; 3rd wave is 5161 - 5310 = 149.
3rd wave cannot be shortest(Rule-2) and hence the 5th can not be more than 148.
So if 5235 is the end of 4th, then 5th can not move past 5383. If it does, then the count is wrong and we should revisit the same. If 4th continues further down, it should not enter the 1st wave territory of 5197(Rule-3), and 5th measurement should start from that new low between 5200-5235.
An alternative scenario suggests of an ending diagonal possibility in the daily time frame. In such a case, the hourly should sub divide into "ABC" as shown below.
Use Elliott Wave however you see fit and however it works for you - just like any of the hundreds of technical indicators out there.
Read the previous posts Part-1 and Part-2 here.
Get 10 Lessons on The Elliott Wave Principle that Will Change the Way You Invest Forever from Elliott wave International by registering as a member (Free).
We will discuss the impulse waves in detail including the ending diagonal in the next week. Until then keep counting the waves and money.
Get rich slowly.