Elliott Wave Theory

Back in the old school days during the 1920-30s, there was this mad genius named Ralph Nelson Elliott. Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually, did not.They traded in repetitive cycles, which he pointed out were the emotions of investors and traders caused by outside influences (ahem, CNBC) or the predominant psychology of the masses at the time.

Elliott explained that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he called "waves". He needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.

The 5 – 3 Wave Patterns

Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern. The first 5-wave pattern is called impulse waves and the last 3-wave pattern is called corrective waves.Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
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That still looks kind of confusing. Let’s splash some color on this bad boy.Here is a short description of what happens during each wave. I am going to use stocks for my example since stocks is what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds,gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.
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Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy.This causes the price to rise.
Wave 2
At this point enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock’s price to go higher and higher.This wave usually exceeds the high created at the end of wave 1.
Wave 4
People take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to “buy on the dips”.
Wave 5
This is the point that most people get on the stock, and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. People start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.

Impulsive or Motive waves always move with the larger trend, consist of five waves, and are labelled 1-2-3-4-5.

Impulse: (IM)
An Impulse is a five-wave pattern labelled 1-2-3-4-5 moving in the direction of the larger trend.
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1) Wave 1 must itself be an Impulse or a Leading Diagonal pattern.
2) Wave 2 can be any corrective pattern except a Triangle.
3) No part of wave 2 can retrace more than 100% of wave 1.
4) Wave 3 must be an Impulse.
5) Wave 3 must be longer than wave 2 by price.
6) Wave 4 can be any corrective pattern.
7) Waves 2 and 4 cannot overlap.
8) Wave 5 must be an Impulse or an Ending Diagonal.
9) Wave 5 must be >= 70% of wave 4 by price.
10) Wave 3 must never be the shortest by price when compared to waves 1 and 5.

Diagonal – also known as a Diagonal Triangle (Leading LD and Ending ED):
A Diagonal is a common 5-wave motive pattern labelled 1-2-3-4-5 that moves with the larger trend.Diagonals move within two contracting channel lines drawn from waves 1 to 3, and from waves 2 to 4. There exist two types of Diagonals: Leading Diagonals (LD) and Ending Diagonals (ED). They have a different internal structure and are seen in different positions within the larger degree pattern. Ending Diagonals are much more common than Leading Diagonals.


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1) Diagonals must move within two contracting channel lines
2) Channel lines must converge, slope in the same direction and not be horizontal.
3) Wave 1 of a LD is either an IM or a LD
4) Wave 1 of an ED is a Zigzag, Double or Triple Zigzag.
5) Wave 2 may be any corrective pattern except a Triangle.
6) Wave 2 is never longer than Wave 1 by price.
7) Wave 3 of a LD must be an IM.
8) Wave 3 of an ED is a Zigzag, Double or Triple Zigzag.
9) Wave 3 is always greater than Wave 2 by price.
10) Wave 4 may be any corrective pattern.
11) Waves 2 and 4 must overlap.
12) Wave 5 of an ED is a Zigzag, Double or Triple Zigzag.
13) Wave 5 of a LD is either an IM or ED.
14) Wave 3 must not be shorter by price than both Waves 1 and 5
15) Wave 5 must be more than 50% of Wave 4 by price.
16) Wave 5 is never the longest by price when compared with Wave 1 and Wave 3.
17) Wave 5 is never longer than Wave 3 by price.

Corrective Waves (moving against the larger trend):

Corrective patterns are either 3 or 5 wave patterns, labelled with letters, and move against the larger trend.
ZigZag:
A Zigzag is a 3-wave structure labelled A-B-C, generally moving counter to the larger trend. It is one of the most common corrective Elliott patterns.
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1) Wave A must be an IM or a LD.
2) Wave B can only be a corrective pattern.
3) Wave B must be shorter than wave A by price distance.
4) Wave C must be an IM or an ED.
5) Wave C must be at least 70% of Wave B by price.

Double and Triple Zigzag (DZ and TZ):
Double and Triple Zigzags are similar to Zigzags, and are typically two or three Zigzag patterns strung together with a joining wave called an x wave. They are corrective in nature.Triples are uncommon. Zigzags, Double Zigzags and Triple Zigzags are also known as Zigzag family patterns, or Sharp’ patterns. Double Zigzags are labelled w-x-y, while Triple Zigzags are labelled w-x-y-xx-z. Both these patterns are included in the list of rules and guidelines below. Only a Double Zigzag is illustrated below.
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1) Wave W must be a Zigzag.
2) Wave X can be any correction except an ET.
3) Wave X must be smaller than wave W by price.
4) Wave Y must be a Zigzag.
5) Wave Y must be greater or equal to Wave X by price.
6) Wave XX can be any correction except an ET.
7) Wave XX must be smaller than wave Y by price.
8) Wave Z must be a Zigzag.
9) Wave Z must be greater than or equal to Wave XX by price.

Flat:
A Flat is a three-wave pattern labelled A-B-C that generally moves sideways. It is corrective, counter-trend and is a very common Elliott pattern.
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1) Wave A can be any corrective pattern.
2) Wave B can be any corrective pattern except a Triangle.
3) Wave B must retrace at least 50% of A by price.
4) Wave B must be less than 200% of Wave A by price.
5) Wave C must be either an IM or ED.
6) Wave C must share some common price territory with Wave A.

Double and Triple Sideways:
Double and Triple Sideways patterns (also known as Double 3’s and Triple 3’s) are similar to Flats, and are typically two or three corrective patterns strung together with a joining wave, called an x wave. They are all corrective in nature. Triples are rare. Doubles are labelled w-x-y, while Triples are labelled w-x-y-xx-z.
Both these patterns are included in the list of rules and guidelines below. Only a Double 3 is illustrated below.
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1) Wave W may be any corrective pattern except a Triangle, Double (or Triple) Zigzag or Sideways pattern.
2) Wave X may be any corrective pattern except a Triangle, Double (or Triple) Zigzag or Sideways pattern.
3) Wave X must retrace Wave W by at least 50%.
4) Wave Y may be any corrective pattern except a Double (or Triple) Zigzag or Sideways pattern.
5) Wave Y cannot be a Zigzag if W is a Zigzag.
7) Wave Y must be less than 200% of Wave W by price.
6) Wave Y must be at least as long as Wave X by price except if it is a Triangle.
7) Wave XX may be any corrective pattern except a Triangle, Double (or Triple) Zigzag or Sideways pattern.
8) The minimum XX wave retracement is 50% of Y.
9) Wave Z may be any corrective pattern except a Double (or Triple) Zigzag or Sideways pattern.
10) Wave Z cannot be a Zigzag if Wave Y is a Zigzag.
11) Wave Z must be longer than Wave XX by price.

Triangle (CT and ET):
A Triangle is a common 5-wave corrective pattern labelled A-B-C-D-E that moves counter-trend.Triangles move within two channel lines drawn from waves A to C, and from waves B to D. ATriangle is either Contracting (CT) or Expanding (ET) depending on whether the channel lines are converging or expanding. Expanding Triangles are rare. Only a Contracting Triangle is illustrated below:
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1) All waves in an ET must be ZZ, DZ, or TZ.
2) In a CT:
- Wave A is restricted to a ZZ, DZ, TZ or FL.
- Wave B is restricted to a ZZ, DZ, or TZ.
- Wave C is any corrective pattern except a Triangle
- Wave D is any corrective pattern except a Triangle
- Wave E is restricted to a CT, ZZ, DZ, or TZ.
3) The intersection of the channel lines must occur beyond the end of a CT, and before the beginning of an ET
4) The channel lines must either converge or diverge. They cannot be parallel.
5) Only one channel line in a CT may be horizontal.
6) Neither channel line of an ET can be horizontal.
7) Wave E must end in the price territory of A.

At one time I too tried to master wave analysis. If you truly learn it, it turns out that every wave consists of similar waves, only smaller)))