In this article we’ll cover the fundamentals of Elliott Wave Theory. As a starting point we’ll explain a basic 5-wave impulse sequence followed by a 3-wave corrective sequence. This creates a complete Elliott Wave sequence, with a total of 8 waves. We’ll also discuss the fractal nature of Elliott Waves and rules for correctly identifying the sequence.
Ralph Nelson Elliott
Ralph Nelson Elliott (1871 –1948), originally from Kansas, was an accountant by trade before becoming an analyst of the stock market.
His research of market data led him to develop the Wave Principle, a theory that prices unfold in specific patterns called Elliott Waves.
His ideas were popularized later by Robert Prechter. In 1979 Prechter left Merrill Lynch where he had been working as a market technician and published the first subscription issue of the Elliott Wave Theorist.
The Wave Principle
Elliott’s research led him to believe that while market movements appear random, they actually follow predictable, natural laws.
In the early 1930’s, he systematically studied 75 years of historical market data. He arrived at the conclusion that markets do not move in a random manner and that prices move in repetitive cycles, which reflect the emotions of investors.
In 1938 at age 66, he shared the results of his studies in a book titled The Wave Principle. Elliott did his analysis on the stock market but his theory can be applied to any market including commodities and forex.
His theory holds that collective psychology drives the movement of markets and that if you can correctly identify these repetitive wave patterns you can predict where price will move next.
Basic 5-3 Wave Sequence
Elliott held that a trending market moves in what he described as a 5-3 wave pattern.
The chart above shows a rising 5 wave sequence. Waves 1,3 and 5 are called impulse waves because they move with the dominant trend. Waves 2 and 4 are corrective waves because they move counter to the trend. This 5-wave sequence represents a basic impulse advance.
Following the impulse advance the basic 5-3 pattern has a corrective phase formed by three waves, typically marked a, b and c.
According to Elliott, there are 21 corrective ABC patterns. These corrective patterns can be categorized in three groups; zig-zags, flats, and triangles.
The 5 wave impulse phase followed by a 3 wave corrective phase yields a complete Elliott Wave sequence, with a total of 8 waves. representing a complete cycle.
Among the three impulse waves (1, 3, or 5) will always be “extended” – longer than the other two.
Fractal Nature of Elliott Waves
Fractals are structures that can be split into parts each of which is a very similar copy of the whole. They are often found in nature, for example in snowflakes, sea shells and Romanesco broccoli to name a few.
Elliott Waves are also fractal. Each wave can be split into parts, each of which is a very similar copy of the whole. Mathematicians like to call this property “self-similarity”. Any impulse wave subdivides into 5 smaller waves. Any corrective wave subdivides into three smaller waves.
Elliott assigned a series of categories to the waves in order of the largest to the smallest. They are named as follows:
Grand Supercycle (multi-century)
Supercycle (about 40–70 years)
Cycle (one year to several years)
Primary (a few months to a couple of years)
Intermediate (weeks to months)
According to Elliott Wave Theory financial markets play out the 5-3 moves on all time frames, from Grand Supercycles to Sub-Minuettes.
Three Cardinal Rules of the Elliott Wave Theory
Rule Number #1: Wave 3 can never be the shortest among the three impulse waves.
Rule Number #2: Wave 2 can never retrace beyond the low of Wave 1.
Rule Number #3: Wave 4 can never retrace into the price area covered by Wave 1
Fibonacci and Elliott Wave Theory
Fibonacci Ratios can be used in forecasting an individual wave’s move within an Elliott Wave pattern.
Wave 2 often retraces to 50%, 61.8%, 76.4%, or 85.4% of wave 1
Wave 3 often extends to 161.8% of wave 1
Wave 4 often retraces to 14.6%, 23.6%, or 38.2% of wave 3
Wave C often extends 61.8% lower than Wave A
In the Fibonacci sequence of numbers, after 0 and 1, each number is the sum of the two prior numbers. (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144)
The basis of the ‘golden’ Fibonacci ratio of 61.8% comes from dividing a number in the Fibonacci series by the number that follows it. For example, 89/144 = 0.6180.
The 38.2% ratio is derived from dividing a number in the Fibonacci series by the number two places to the right and the 23.6% ratio comes from dividing a number in the Fibonacci series by the number three places to the right.
The key in using the Elliott Wave Theory in trading is being able to correctly identify waves. Using the rules and guidelines will allow you to begin to correctly identify the sequences. Once you begin to recognize patterns you can use these to aid you in your trading strategy.