Elliott Wave Theory is a technical analysis tool that helps traders understand market cycles and predict price movements. It was developed by Ralph Nelson Elliott in the 1930s and is based on the idea that market prices move in repetitive wave patterns influenced by investor psychology. These wave patterns appear across different timeframes and can be used to forecast future market trends.
1. Understanding the Wave Structure
Elliott Wave Theory consists of two main phases that describe how market prices move over time:
- Impulse Wave (Five-Wave Structure) – Moves in the direction of the main trend.
- Corrective Wave (Three-Wave Structure) – Moves against the trend as a market correction.
Each of these phases has specific rules and characteristics, which traders use to analyze price movements and predict future trends.
a) Impulse Wave (Five Waves in Trend Direction)
An impulse wave represents a strong movement in the direction of the main trend and consists of five sub-waves labeled 1, 2, 3, 4, and 5. This pattern can form in an uptrend or downtrend and is often seen during strong market trends.
Breakdown of the Five Waves:
- Wave 1 – The Start of a Trend:
- A few early investors enter the market, sensing an opportunity.
- The price moves up slightly as buying begins.
- Many traders are still unsure about the trend.
- Wave 2 – A Small Pullback:
- Some traders take profits, causing a minor price decline.
- The price does not fall below the starting point of Wave 1.
- More traders start noticing the trend but remain cautious
- Wave 3 – The Strongest and Longest Wave:
- More traders recognize the trend and buy in.
- This wave is usually the longest and most powerful because of mass participation.
- The price moves aggressively in the trend direction
- Wave 4 – A Temporary Correction:
- Some traders take profits, leading to a small decline.
- The price does not overlap Wave 1 (except in diagonal patterns).
- Traders who missed Wave 3 enter during this dip
- Wave 5 – The Final Push Upward:
- The last strong movement before a trend reversal or correction.
- Driven by market euphoria and speculation.
- Many retail traders enter at this stage, thinking the trend will continue indefinitely.
- Smart money (institutions) starts preparing to sell before the correction.
Key Concept: The Impulse Wave moves in the direction of the trend, forming the foundation of a market cycle.
b) Corrective Wave (Three Waves in Opposite Direction)
After an impulse wave, the market corrects itself through a three-wave pattern known as A-B-C correction.
Breakdown of the Three Corrective Waves:
- Wave A – The First Decline:
- Profit-taking starts, leading to a drop in price.
- Some traders think it’s just a small dip in the trend.
- Wave B – A Temporary Recovery:
- The price recovers partially, leading traders to believe the trend will continue.
- This is often a “trap” that lures buyers into believing the correction is over.
- Wave C – The Final Drop:
- The price declines sharply, completing the correction.
- Many traders panic sell, thinking the trend has reversed completely.
- Smart traders wait for this wave to end before buying back in.
Key Concept: The A-B-C correction helps reset the market, allowing for the next impulse wave to form.
2. Elliott Wave Rules and Guidelines
To correctly identify Elliott Waves, traders must adhere to three fundamental rules:
- Wave 2 can never retrace more than 100% of Wave 1.
If the price falls below the starting point of Wave 1, the pattern is invalid. - Wave 3 can never be the shortest among Waves 1, 3, and 5.
Wave 3 is usually the longest and strongest wave. - Wave 4 can never overlap the price territory of Wave 1. (Exception: Diagonal triangles)
If Wave 4 enters the price range of Wave 1, the pattern is incorrect. Additionally, traders use the following guidelines to improve accuracy: - Wave 3 is typically the strongest and longest wave.
- Wave 2 and Wave 4 alternate in their structure (one is sharp, the other is sideways).
- Fibonacci retracement levels (38.2%, 50%, 61.8%) help confirm wave structures.
3. Common Elliott Wave Patterns
Elliott Waves do not always appear in a simple 5-wave impulse and 3-wave correction structure. Variations occur based on market conditions, and recognizing these patterns helps traders make better trading decisions.
a) Extensions
An extension happens when one wave, usually Wave 3, becomes much longer than the others. This occurs when a market experiences high momentum and strong investor confidence. Extended waves are common in strong uptrends or downtrends where traders aggressively push prices in one direction.
- Typically, Wave 3 is the longest wave in the cycle.
- Shows strong market conviction – buyers or sellers dominate.
- Often contains smaller sub-waves, making it more complex to analyze.
- Found in highly volatile trends with strong buying or selling pressure.
b) Diagonal Triangles
A diagonal triangle is a wedge-shaped pattern that appears in Wave 5 (end of a trend) or Wave C (end of a correction). This pattern forms when a trend starts losing momentum, signalling a possible reversal or major correction.
- Forms in Wave 5 or Wave C when the trend is exhausted.
- Price movements become narrower, forming a wedge pattern.
- Often indicates a trend reversal after the pattern completes.
- Found in both bullish and bearish markets, signalling the end of a move.
c) Zigzag Corrections
A zigzag correction is a sharp, fast price decline that occurs against the main trend. It consists of three waves (A-B-C), where Wave C is usually equal to or longer than Wave A. This pattern is common in high volatility markets and can trick traders into believing the trend has changed.
- Consists of three waves (A-B-C).
- Wave C is often equal to or longer than Wave A.
- Creates a steep price movement against the trend.
- Can occur multiple times in a larger correction.
c) Flat Corrections
A flat correction is a sideways price movement where Wave B retraces more than 90% of Wave A. It often signals that the market is in consolidation mode, meaning the trend is taking a pause before resuming. Unlike zigzags, flat corrections do not have sharp price declines.
- Wave B retraces 90% or more of Wave A, keeping the market in a tight range.
- Indicates market consolidation before a breakout.
- More common in slow or low-volatility markets.
- Often leads to continuation of the main trend after completion.
f) Triangles
A triangle pattern is a five-wave consolidation pattern labeled A-B-C-D-E. It forms when price moves within a narrowing range, waiting for a breakout. Triangles often appear before a big price movement.
- A five-wave consolidation (A-B-C-D-E).
- Forms before major breakouts in Wave 4 or Wave B.
- Price action moves within converging trendlines.
- Indicates low volatility before a strong trend continuation.
4. Fibonacci Ratios in Elliott Waves
Elliott Wave Theory is closely tied to Fibonacci sequences, which help traders determine potential retracement and extension levels. Some key Fibonacci relationships include:
- Wave 2 retraces 50%–61.8% of Wave 1.
- Wave 3 length is often 618 times the length of Wave 1.
- Wave 4 retraces2% of Wave 3.
- Wave 5 projection is typically equal to Wave 1 or 61.8% of Wave 3.
Using Fibonacci retracement tools, traders can pinpoint high-probability entry and exit points.
5. Trading Strategies Using Elliott Wave Theory
- Identifying Entry and Exit Points
- Buy during Wave 2 or Wave 4 pullbacks in an uptrend, as these corrections provide good risk-reward ratios.
- Exit at the end of Wave 5, as a correction is expected.
- Look for Wave C completion to enter after a correction, as a new uptrend may begin.
- Combining Elliott Waves with Other Indicators
- RSI or MACD Divergence – If RSI/MACD shows divergence at Wave 5, a reversal is likely.
- Moving Averages – Use moving averages to confirm wave trends.
Trendlines – Draw trendlines to identify wave formations and potential breakouts.