#### Elliott wave theory - Wave analysis

Elliott made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern. A corrective wave, on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found.

This nexted pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically.

In the financial markets, we know that “what goes up, must come down,” as a price movement up or down is always followed by a contrary movement. Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.

The Elliott Wave Theory is interpreted as follows:

Five waves move in the direction of the main trend, followed by three waves in a correction (totaling a 5-3 move). This 5-3 move then becomes two subdivisions of the next higher wave move.

The underlying 5-3 pattern remains constant, though the time span of each wave may vary.

Let’s have a look at the following chart made up of eight waves (five net up and three net down) labeled 1, 2, 3, 4, 5, A, B and C.

Waves 1, 2, 3, 4 and 5 form an impulse, and waves A, B and C form a correction. The five-wave impulse in turn forms wave 1 at the next-largest degree, and the three-wave correction forms wave 2 at the next-largest degree.

The corrective wave normally has three distinct price movements – two in the direction of the main correction (A and C) and one against it (B). Waves 2 and 4 in the above picture are corrections. These waves typically have the following structure:

Note that in this picture, waves A and C move in the direction of the trend at one-larger degree and, therefore, are impulsive and composed of five waves. Wave B, in contrast, is counter-trend and therefore corrective and composed of three waves.

An impulse-wave formation, followed by a corrective wave, forms an Elliott wave degree consisting of trends and countertrends.

As your can see from the patterns pictured above, five waves do not always travel net upward, and three waves do not always travel net downward. When the larger-degree trend is down, for instance, so is the five-wave sequence.

Markets move against the trend of one greater degree only with a seeming struggle. Resistance from the larger trend appears to prevent a correction from developing a full motive structure. The struggle between the two oppositely trending degrees generally makes corrective waves less clearly identifiable than motive waves, which always flow with comparative ease in the direction of the one larger trend. As another result of the conflict between trends, corrective waves are quite a bit more varied than motive waves.

Corrective patterns fall into four main categories:

1. Zigzag (5-3-5; includes three types: single, double, and triple)

2. Flat (3-3-5; includes three types: regular, expanded, and running

3. Triangle (3-3-3-3-3; four types:

three of the contracting variety

(ascending, descending, and symmetrical)

and one of the expanding variety

(reverse symmetrical)

4. Combination (two types: double three and triple three)

1. ZIGZAGS (5-3-5 includes three types: single, double, and triple)

A single zigzag in a bull market is a simple three-wave declining pattern labeled A-B-C and subdividing 5-3-5. The top of wave B is noticeably lower than the start of wave A, as illustrated in Figures 9 and 10.

Occasionally zigzags will occur twice, or at most, three times in succession, particularly when the first zigzag falls short of a normal target. In these cases, each zigzag is separated by an intervening “three” (labeled X), producing what is called a double zigzag (see Figure 11) or triple zigzag. The zigzags are labeled W and Y (and Z, if a triple).

Flat (3-3-5; includes three types: regular, expanded, and running

A flat correction differs from a zigzag in that the subwave sequence is 3-3-5, as shown in Figures 12 and 13. Since wave A lacks sufficient downward force to unfold into a full five waves as it does in a zigzag, the B wave reaction seems to inherit this lack of countertrend pressure and terminates near the start of wave A. Wave C, in turn, generally terminates just slightly beyond the end of wave A rather than significantly beyond as in zigzags.

Flat corrections usually retrace less of preceding impulse waves than do zigzags. They participate in periods involving a strong larger trend and thus virtually always

precede or follow extensions. The more powerful the underlying trend, the briefer the flat tends to be. Within impulses, fourth waves frequently sport flats, while second waves rarely do.

Three types of 3-3-5 corrections have been identified by differences in their overall shape. In a regular flat correction, wave B terminates about at the level of the beginning of wave A, and wave C terminates a slight bit past the end of wave A, as we have shown in Figures 12 and 13. Far more common, however, is the variety called an expanded flat, which contains a price extreme beyond that of the preceding impulse wave. In expanded flats, wave B of the 3-3-5 pattern terminates beyond the starting level of wave A, and wave C ends more substantially beyond the ending level of wave A, as shown in Figures 14 and 15.

In a rare variation on the 3-3-5 pattern, which we call a running flat, wave B terminates well beyond the beginning of wave A as in an expanded flat, but wave C fails to travel its full distance, falling short of the level at which wave A ended. There are hardly any examples of this type of correction in the price record.

3. Triangle (3-3-3-3-3; four types)

Triangles are overlapping five wave affairs that subdivide 3-3-3-3-3. They appear to reflect a balance of forces, causing a sideways movement that is usually associated with decreasing volume and volatility. Triangles fall into four main categories as illustrated in Figure 16. These illustrations depict the first three types as taking place within the area of preceding price action, in what may be termed regular triangles. However, it is quite common, particularly in contracting triangles, for wave b to exceed the start of wave a in what may be termed a running triangle, as shown in Figure 17.

4. Combination (two types: double three and triple three)

COMBINATIONS (DOUBLE AND TRIPLE THREES)

Elliott called sideways combinations of corrective patterns “double threes” and “triple threes.” While a single three is any zigzag or flat, a triangle is an allowable final component of such combinations and in this context is called a “three.” A double or triple three, then, is a combination of simpler types of corrections, including the various types of zigzags, flats and triangles. Their occurrence appears to be the flat correction’s way of extending sideways action. As with double and triple zigzags, each simple corrective pattern is labeled W, Y and Z. The reactionary waves, labeled X, can take the shape of any corrective pattern but are most commonly zigzags. Figures 18 and 19 show two examples of double threes.

For the most part, double threes and triple threes are horizontal in character. One reason for this trait is that

there is never more than one zigzag in a combination. Neither is there more than one triangle. Recall that triangles occurring alone precede the final movement of a larger trend. Combinations appear to recognize this character and sport triangles only as the final wave in a double or triple three.

All the patterns illustrated in this booklet take the same form whether within a larger rising or falling trend. In a falling trend, they are simply inverted.

**Leading Diagonal**

Guidelines

• Special type of motive wave which appears as subdivision of wave 1 in an impulse or subdivision of wave A in a zigzag

• In Figure 4A, the leading diagonal is a subdivision of wave 1 in an impulse. In Figure 4B, the leading diagonal is a subdivision of wave A in a zigzag

• Leading diagonal is usually characterized by overlapping wave 1 and 4 and also by the wedge shape but overlap between wave 1 and 4 is not a condition, it may or may not happen

• The subdivision of a leading diagonal can be 5-3-5-3-5 or 3-3-3-3-3. The examples above show a leading diagonal with 5-3-5-3-5 subdivision

Guidelines

• Special type of motive wave which appears as subdivision of wave 5 in an impulse or subdivision of wave C in a zigzag

• In Figure 5A, the ending diagonal is a subdivision of wave 5 in an impulse. In Figure 5B, the ending diagonal is a subdivision of wave C in a zigzag

• Ending diagonal is usually characterized by overlapping wave 1 and 4 and also by the wedge shape. However, overlap between wave 1 and 4 is not a condition and it may or may not happen

• The subdivision of an ending diagonal is 3-3-3-3-3

Guidelines

• Zigzag is a corrective 3 waves structure labelled as ABC

• Subdivision of wave A and C is 5 waves, either impulse or diagonal

• Wave B can be any corrective structure

• Zigzag is a 5-3-5 structure

Fibonacci Ratio Relationship

• Wave B = 50%, 61.8%, 76.4% or 85.4% of wave A

• Wave C = 61.8%, 100%, or 123.6% of wave A

• If wave C = 161.8% of wave A, wave C can be a wave 3 of a 5 waves impulse. Thus, one way to label between ABC and impulse is whether the third swing has extension or not

A flat correction is a 3 waves corrective move labelled as ABC. Although the labelling is the same, flat differs from zigzag in the subdivision of the wave A. Whereas Zigzag is a 5-3-5 structure, Flat is a 3-3-5 structure. There are three different types of Flats: Regular, Irregular / Expanded, and Running Flats.

**Regular Flats**

Guidelines

• A corrective 3 waves move labelled as ABC

• Subdivision of wave A and B is in 3 waves

• Subdivision of wave C is in 5 waves impulse / diagonal

• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three

• Wave B terminates near the start of wave A

• Wave C generally terminates slightly beyond the end of wave A

• Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

• Wave B = 90% of wave A

• Wave C = 61.8%, 100%, or 123.6% of wave AB

**Expanded Flats**

Guidelines

• A corrective 3 waves move labelled as ABC

• Subdivision of wave A and B is in 3 waves

• Subdivision of wave C is in 5 waves impulse / diagonal

• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three

• Wave B of the 3-3-5 pattern terminates beyond the starting level of wave A

• Wave C ends substantially beyond the endng level of wave A

• Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

• Wave B = 123.6% of wave A

• Wave C = 123.6% – 161.8% of wave AB

**Running Flats**

Guidelines

• A corrective 3 waves move labelled as ABC

• Subdivision of wave A and B is in 3 waves

• Subdivision of wave C is in 5 waves impulse / diagonal

• Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three

• Wave B of the 3-3-5 pattern terminates substantially beyond the starting level of wave A as in an expanded flat

• Wave C fails travel the full distance, falling short of the level where wave A ended

• Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

• Wave B = 123.6% of wave A

• Wave C = 61.8% – 100% of wave AB

A triangle is a sideways movement that is associated with decreasing volume and volatility. Triangles have 5 sides and each side is subdivided in 3 waves hence forming 3-3-3-3-3 structure. There are 4 types of triangles in Elliott Wave Theory: Ascending, descending, contracting, and expanding. They are illustrated in the graphic below

Guidelines

• Corrective structure labelled as ABCDE

• Usually happens in wave B or wave 4

• Subdivided into three (3-3-3-3-3)

• RSI also needs to support the triangle in every time frame

• Subdivision of ABCDE can be either abc, wxy, or flat

Double three is a sideways combination of two corrective patterns. We’ve already looked at several corrective patterns including zigzag, flat, and triangle. When two of these corrective patterns are combined together, we get a double three. In addition,

Guidelines

• A combination of two corrective structures labelled as WXY

• Wave W and wave Y subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree

• Wave X can be any corrective structure

• WXY is a 7 swing structure

Fibonacci Ratio Relationship

• Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W

• Wave Y = 61.8%, 100%, or 123.6% of wave W

• Wave Y can not pass 161.8% of wave W

Below are examples of different combinations of two corrective structures which form the double threes:

Above figure is a combination of a flat and a zigzag

Above figure is a combination of a flat and a triangle

Above figure is a combination of two double threes of lesser degree

Triple three is a sideways combination of three corrective patterns in Elliott Wave Theory

Guidelines

• A combination of three corrective structures labelled as WXYXZ

• Wave W, wave Y, and wave Z subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree

• Wave X can be any corrective structure

• WXYZ is an 11 swing structure

Fibonacci Ratio Relationship in Elliott Wave Theory

• Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W

• Wave Z = 61.8%, 100%, or 123.6% of wave W

• Wave Y can not pass 161.8% of wave W or it can become an impulsive wave 3

Below are examples of different combinations of three corrective structures which form the triple threes:

Above figure is a combination of a flat, double three, and zigzag

Above figure is a combination of three double threes

Wave 1 and wave 2

Elliott Wave Theory Wave 1 and wave 2

Wave 1: In Elliott Wave Theory, wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts

Wave 2: In Elliott Wave Theory, wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and “the crowd” haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern

Wave 3

Elliott Wave Theory Wave 3

Wave 3: In Elliott Wave Theory, wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to “get in on a pullback” will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, “the crowd” will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1

Wave 3 rally picks up steam and takes the top of Wave 1. As soon as the Wave 1 high is exceeded, the stops are taken out. Depending on the number of stops, gaps are left open. Gaps are a good indication of a Wave 3 in progress. After taking the stops out, the Wave 3 rally has caught the attention of traders

Wave 4

Elliott Wave Theory Wave 4

At the end of wave 4, more buying sets in and prices start to rally again. Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.

Wave 5

Wave 5: In Elliott Wave Theory, wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received)

The wave 5 lacks huge enthusiasm and strength found in the wave 3 rally. Wave 5 advance is caused by a small group of traders.Although the prices make a new high above the top of wave 3, the rate of power or strength inside wave 5 advance is very small when compared to wave 3 advance

4.5 Wave A, B, and C

Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond