Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1920s. Elliott found that financial markets have characteristic movements that repeat in perpetuity. He called these movements "waves," due to the troughs and peaks that present themselves in a cyclical up-and-down fashion.
Elliott Wave trading is a broad and intricate topic, taking practitioners years to master. Despite its complexity, some basic elements of Elliott wave trading can be incorporated immediately and may help improve analytical skills and trade timing.
Impulsive and Corrective Waves
In Elliott Wave Theory, the two types of waves in price movement are called "trend" or "impulse" waves and "consolidation" or "corrective" waves. Looking at a chart, a trader may attempt to define which wave cycle is underway, what recent waves have occurred, and—if the waves have been identified correctly—what wave is likely to occur next.
These chart patterns are fractals, and that means you can zoom into or out of a chart to find smaller or larger occurrences of Elliott waves. An impulse wave, for instance, will be made up of many smaller waves trending in the same general direction. These patterns can span decades, or they can show up on one-minute charts.
Corrective waves are the smaller waves because they occur within and against a broader trend. Traders usually try to play in the direction of the impulse waves because prices are making the largest moves in that direction. In other words, impulse waves provide a better chance of making a large profit than corrective waves, because a trade that rides an impulse wave will likely be held longer.
Corrective waves are used to enter into a trend trade, in an attempt to capture the next bigger impulse wave. For example, a trader who goes long (hoping the stock price rises) should try to time their buys just as the corrective wave is ending, and then they'll be able to ride the impulse wave as it takes the price higher.
Short sellers simply reverse the strategy during a downtrend—they will short the stock during a corrective wave up so that they can ride the next impulsive wave down.
Spotting Trend Changes
Impulsive and corrective waves are also used to determine when a trend is changing direction. If a stock is in an uptrend, and then the price moves down more than the last impulse up, that means the uptrend may be over. The biggest movement always occurs in the direction of the trend, so when corrective waves start looking more like impulse waves, that means the trend may have changed.
Trend and Consolidation Price Structures
Elliott found that, when a trend is underway, it typically has three large price moves in the direction of the trend, interspersed with two corrections. This creates a five-wave pattern: impulse, correction, impulse, correction, and another impulse. Traders often refer to these five waves by the number in which they occur. Therefore, if you hear a trader refer to "wave four" of a stock, they're talking about the second correction (the one that comes after the second impulse).
A similar count of three movements can be measured within each correction. There will be a sharp move against the trend (the impulse of the correction), followed by a small movement back in the direction of the trend (the correction of the correction), and finally, there's one last sharp movement against the trend (a second impulse of the correction) before the correction is over and the trend resumes. To prevent confusion with the numbered waves of the overall trend, corrective waves are labeled A, B, and C.
Remember, these movements are fractal, so the patterns occur on small and large time frames. For example, the first impulse wave higher within an uptrend on a daily chart may be composed of five waves on an hourly chart. Each corrective wave (waves two and four) is composed of three smaller waves (A, B, C), and there will also be larger A, B, C waves on a longer time frame as the broader trend ends (after wave five).
Typical Correction Size
When buying on corrections during an uptrend or selling on corrections in a downtrend, it is helpful to know how large the typical correction is. Unfortunately, there isn't a set calculation, but there are some guidelines that can help you learn where to look for an impulse or correction to end.
In general, wave three is the largest wave of the cycle. Waves two and four cannot be larger than waves one, three, or five (or else it isn't an Elliott wave cycle).
As he was developing his wave theory, Elliott made extensive use of the Fibonacci ratios. Traders may be familiar with these ratios from the Fibonacci retracement tool, which your brokerage will likely offer with its charting software. This means, when you're measuring Elliott waves, you should keep an eye out for key Fibonacci percentages, such as 38%, 50%, and 62%.
For example, if you're watching a correction after an impulse, you might use the Fibonacci retracement tool to draw lines on your chart at 38%, 50%, and 62%. As the price action approaches those lines, look for signs of weakness—they could indicate that the correction is ending.
Some traders have set percentages that they look for with certain waves, such as watching for a 60% correction on the second wave. Their experience with many trades and trends over many years will lead them to use these numbers consistently. However, corrections may be larger or smaller than average on any given trade, and it's best to study many different charts on your own before forming such a rigid rule for wave sizes.
Combine the 3 Concepts
You can utilize the three concepts discussed here—impulse and corrective waves, trend structures, and correction sizes—by only taking trades in the direction of the impulse waves. Take trades during the corrective waves and look for trade entry signals once the price has corrected the average amount. The correction isn't likely to stop exactly at the percentage levels discussed above, so it's better to use those as reference points and wait for the chart to confirm your suspicions before jumping into a trade.
These three Elliott wave concepts may improve trader's analysis skills or improve their trade timing, but it is not without its own issues. The theory can be complex to apply, as it isn't always easy isolating the five-wave and three-wave patterns.
Consider keeping track of each wave in the overall price structure. For example, after a five-wave pattern to the upside, a bigger three-wave decline usually follows. Watching the direction of the impulse waves will signal potential trend changes, and that signal is stronger if combined by a five-wave impulse pattern or three-wave correction pattern ending.
Frequently Asked Questions (FAQs)
What time frame should you use with the Elliott wave theory?
In theory, Elliott wave patterns are fractal and should apply to any time frame. Therefore, the "best" time frame to use is the one you're most comfortable trading. If you're a day trader, you may use one-minute, five-minute, or one-hour candles. If you're a swing trader, you may use four-hour, daily, or weekly candles. If you don't know what your strength is, then try multiple time frames in a demo account to see which one works best for you.
Where do you start counting Elliott waves?
One issue with this and any other chart pattern is that you won't know for certain where a pattern starts and stops until it has already happened. You can use technical analysis, indicators, and broad market clues to guess when a wave is about to start, but you won't know whether you're right or wrong until you've missed the best entry point for a trade. If you're looking back at historical charts, then you can start counting waves at a point of trend reversal—when an uptrend stops and a downtrend starts, or vice versa.
What does it mean to "recount" Elliott waves?
If a wave breaks a rule, such as wave three failing to break the high of wave one, then that means your initial assessment of the waves was wrong, and you need to "recount." You may need to zoom out or look at another time frame to recalibrate your theory about where the stock is within the Elliott wave count.