Elliott Wave Theory: A Guide For Traders

The Elliott Wave Theory is a technical analysis tool used by traders to identify market trends and make informed investment decisions. It was first introduced by Ralph Elliott in the 1930s and remains a popular method for analyzing market behavior to this day.

A snapshot of the SPX using 1 minute candlesticks taken on 2/9/23

Basic Elliott Wave Pattern

Market prices move in predictable patterns and cycles, known as waves, which are made up of impulse waves going in the direction of the main trend and corrective waves going in a counter-trend direction. Impulse waves are broken down into 5 sub-waves labeled with numbers: 1, 2, 3, 4, and 5. Corrective waves are divided, into 3 sub-waves labeled with letters: A, B, and C.

Impulse Waves

Impulse waves are the building blocks of the Elliott Wave theory. They are made up of five waves that move in the direction of the main trend and are separated by three corrective waves. Impulse waves are labeled as 1, 2, 3, 4, and 5 and provide information about the direction and strength of the market trend.

Wave 1 is the first wave in the impulse wave and signals the start of a new trend. It is usually the shortest wave and moves in the direction of the trend.

Wave 2 is a correction that retraces a portion of wave 1 and tests the strength of the trend.

Wave 3 is the longest and strongest wave in the impulse wave and signals a strong trend in the market. It usually extends beyond the end of wave 1 and confirms the trend.

Wave 4 is a shallow correction that retraces a portion of wave 3 and provides a buying opportunity for traders.

Finally, wave 5 is the final wave in the impulse wave and signals the end of the trend. It is usually the shortest wave and often extends beyond the end of wave 3.

There are rules for determining impulse waves:

Wave 3 is never the shortest wave. It may be equal in length to wave 1 or 3 to be the shortest. In such a case where 1 and 3 are the shortest and equal in length then wave 5 would be the longest and extended wave. Similarly, if 3 and 5 are the shortest, then wave 1 would be the longest.
Waves 2 and 4 do not overlap. If wave 4 reaches into the area of wave 2, then an alternate count should be suggested.

Diagonals

Diagonal waves are a variation of an impulse wave in the sense that they have 5-3-5-3-5 structure, but slopping and overlapping waves where waves 2 and 4 tend to overlap.

Corrective Waves

Corrective waves, also known as retracement waves, are the contra building blocks to Impulse waves. They move counter to the direction of the main trend and are separated by two impulse waves. Corrective waves are labeled as A, B, and C and provide information about the correction of the market trend.

Wave A is the first wave in the corrective wave and signals the start of the correction. It retraces a portion of the previous impulse wave and moves in the opposite direction of the trend.

Wave B is a shallow correction that retraces a portion of wave A and provides a buying opportunity for traders.

Wave C is the final wave in the corrective wave and signals the end of the correction. It usually extends beyond the end of wave A and confirms the correction of the trend.

There are several types of corrective waves, including flat corrections, zigzag corrections, triangle corrections, and double and triple combinations. The type of correction depends on the pattern of the retracement waves and can provide valuable information for traders and investors.

Zigzags

Flats

Triangles

A triangle is a common pattern in the Elliott Wave theory, and it is considered a corrective pattern. Triangles occur when the price moves in a narrow range between two converging trendlines, with each subsequent price move followed by a corrective move in the opposite direction. Triangles are characterized by five overlapping waves, labeled as A, B, C, D, and E, and can be either symmetrical, ascending, or descending.

In a symmetrical triangle, the A and C waves are impulsive moves in opposite directions, while the B and D waves are corrective moves in the opposite direction. The E wave typically breaks out in the direction of the previous trend, and the triangle is complete.

In an ascending triangle, the upper trendline is flat, while the lower trendline is rising. This pattern signals a bullish reversal, with the price expected to break out to the upside after the completion of the triangle.

In a descending triangle, the lower trendline is flat, while the upper trendline is falling. This pattern signals a bearish reversal, with the price expected to break out to the downside after the completion of the triangle.