Elliott wave theory

Elliott observed that crowd behaviour moves prices in recognisable sequences. A move in the direction of the larger trend is called a motive wave and has five parts. A move against it is called a corrective wave and has three.

The pattern is fractal. Each wave is built of smaller waves of the same form, and the whole five-three sequence is itself one part of a larger wave. This is why the count can be applied to a 5-minute chart and to a monthly one.

Waves 1, 3 and 5 are themselves five-wave moves. Waves 2 and 4 are three-wave corrections. In a downtrend the whole picture is mirrored.

• Wave 1 – the first move in the new direction. It often looks like one more bounce inside the old trend.
• Wave 2 – a pullback that retraces part of wave 1 but does not pass its start.
• Wave 3 – usually the longest and strongest wave, as more traders recognise the trend.
• Wave 4 – a sideways or shallow correction.
• Wave 5 – the last push in the trend direction, often on weaker momentum.
• Waves A, B and C – the correction of the whole five-wave move: A against the trend, B a partial recovery, C a second leg against the trend.

An impulse count must satisfy three rules. If one is broken, the count is wrong and must be redone.

• Wave 2 never retraces more than 100% of wave 1. In an uptrend it cannot fall below the start of wave 1.
• Wave 3 is never the shortest of waves 1, 3 and 5.
• Wave 4 does not enter the price territory of wave 1. In an uptrend its low stays above the high of wave 1.

Wave lengths are often compared through Fibonacci ratios. These are guidelines, not rules – they describe what is common, and markets depart from them all the time.

• Wave 2 often retraces 50% to 61.8% of wave 1.
• Wave 3 is often about 161.8% of the length of wave 1.
• Wave 4 often retraces about 38.2% of wave 3.
• Wave 5 is often equal to wave 1, or 61.8% of the distance from the start of wave 1 to the end of wave 3.
• Wave C is often equal to wave A.

A guideline called alternation says that if wave 2 is sharp, wave 4 tends to be sideways, and the reverse.

• Zigzag – a sharp A-B-C move in which wave B retraces only part of wave A and wave C goes beyond the end of A.
• Flat – a sideways A-B-C in which wave B returns to about the start of wave A.
• Triangle – five overlapping legs, labelled A to E, that contract between two converging lines. It usually appears in wave 4 or wave B.

Most traders combine the count with market structure, support and resistance and momentum tools such as RSI or MACD. A weaker momentum reading on wave 5 than on wave 3 is a common check. On Charts, the Fibonacci retracement and trend line tools are enough to mark and measure the waves by hand.

• Direction – trade with the motive waves. The usual targets are wave 3 and wave 5.
• Entry – near the end of wave 2 or wave 4, measured with a Fibonacci retracement of the previous wave.
• Stop – at the level that breaks a rule: the start of wave 1 for a wave 2 entry, the high of wave 1 for a wave 4 entry in an uptrend.
• Target – a Fibonacci projection of wave 1, or the prior high for wave 5.
• Exit – a completed fifth wave is read as a warning that an A-B-C correction may follow.

• Subjectivity – the same chart can often be counted in several valid ways. Keep an alternative count and know which price cancels the main one.
• Forcing a count – not every move is a clean five or three. If the rules do not fit, there is no count.
• Treating Fibonacci guidelines as exact targets.
• Counting only a low timeframe without the larger wave it belongs to.
• Using the count as a forecast instead of a plan with a stop.