Elliott Waves Basics

Back in the thirties, Ralph Nelson Elliott demonstrated that markets evolve in cycles and that these cycles follow wave-like states and are controlled by Fibonacci numbers. Elliott’s Wave theory is an exciting proposition because it includes all moves, on all time frames. According to this theory, the evolution of the markets is made by a series of successive waves, and it does this independently of the time frame of observation of the particular market (from one minute to very long-term scales).

Fibonacci Numbers are: 0-1-1-2-3-5-8-13-21-34-55-89-144, etc... (the sequence is constructed by adding the two previous numbers to form the following figure). The Golden Ratio is the ratio between two of those successive numbers, which tends to 1,6180339887.

Basic principles of the Elliott Wave Theory

- Markets are formed by cycles and evolve by waves.

- Every wave decomposes into sub-waves of a lower time frame.

- A full cycle is composed of an impulsive wave of impulsion and a corrective wave. The impulsive wave is itself broken down into five sub-waves, and the corrective wave breaks down into three sub-waves.

- Subsequent cycles (Short, Medium and Long Term) are continuous and chained to one another. A cycle never acts in a independent manner, but is directly influenced by its upper rank and previous cycle.

Impulsive waves are waves 1, 3, 5, A, C, and are in the direction of the trend.

Corrective waves are waves 2, 4, B, and are counter-trend.

The wave 1 of the Medium Term cycle breaks down into into 5 waves of the Short Term cycle.

Description of Waves

WAVE 1

Waves 1 are difficult to identify since they can be interpreted as simple corrections being part of the previous move. They are in general very short and fast. It often happens that we can only break down wave 1 into three waves and not into 5. This wave is the wave of the "clever" according to the theory of Dow which considered that these had access to information before the others. They can however also say it is the wave of the "contrarians", who buy when the market goes down and sell when it goes up.

WAVE 2

This wave generally makes a considerable correction on the first wave and often makes us think that the previous movement has not ended (end of wave C). Waves 2 which correct waves 1 completely are not rare things: we can then notice a double bottom pattern if the movement is bullish, or a double top in the case of a bearish movement.

WAVE 3

It is the wave of the "followers". It is the main wave of the whole move. A basic rule to be kept concerning this type of wave is that it is never the shortest among the impulsive waves 1, 3 and 5. Those are waves that generally bear extensions and are accompanied by very strong volumes.

WAVE 4

It is a much less violent wave than wave 2. It comes to consolidate the market. According to the principle of alternation, this wave is therefore often complex: structured in several waves and often in a triangle shape. A rule to be kept: a wave 4 will never break the level attained by the market at the end of wave 1.

WAVE 5

It is the wave of the small bearers. It is in general not very dynamic but lasts for quite a while. It is the last stage of a move: the end of the euphoria in the case of bullish movements and of despair on bearish movements. At the end of wave 5, we can appreciate a fall of volumes and sometimes a wave 5 which does not exceed the top or bottom (depending on whether the market is bullish or bearish) of wave 3.

WAVE A

They are sometimes considered to be technical corrections and not viewed as the beginning of the end of the move.

WAVE B

They sometimes find the top (in case of a bullish move) of wave 5 to form a double top. The inverse occurs on a bearish move, forming double bottoms.

WAVE C

They come to close the eight wave sequence of Elliott’s theory. These are waves which are similar to waves 3 in amplitude. Besides, their similarities lead to frequent confusions: are we in a really bearish market or is this only a simple stage of correction?

Elliott Waves Rules

- Rule 1: Wave 4 must never break at close the top of wave 1.

- Rule 2: Wave 3 must be the wave with most amplitude.

- Rule 3: One of the three impulsive waves must be in extension.

- Rule 4: A corrective wave of correction cannot be made of five sub-waves (only three are always required to confirm the pattern).

WARNING: The Elliott Wave Theory is not a decision-making tool. You should not base your entries or exits on Elliott waves or either on Fibonacci numbers. This theory serves solely as a reference mark to spot the trend.