Elliott Wave Theory

Elliott Wave Theory says that market prices move in repeating patterns of waves driven by the swing of crowd psychology between optimism and pessimism. Ralph Nelson Elliott developed the idea in the 1930s from decades of stock market data and set it out in a series of articles and booklets. Interest revived in 1978, when A. J. Frost and Robert Prechter published Elliott Wave Principle, which is still the standard reference.

The basic pattern

In its simplest form, a market moves in a five-wave pattern in the direction of the main trend, followed by a three-wave correction against it:

Impulse (with the trend):    1 - 2 - 3 - 4 - 5
Correction (against it):     A - B - C

Waves 1, 3 and 5 move with the trend; waves 2 and 4 are pullbacks within it. The A-B-C correction then gives back part of the whole advance. The same pattern repeats at every scale: each wave is made of smaller waves, and each complete 5-3 cycle is itself one or two waves of a larger cycle. Elliott named the degrees of trend from the multi-decade Grand Supercycle down to the Subminuette, which lasts hours.

Three rules define a valid upward impulse (a down impulse is the mirror image):

• Wave 2 never falls below the start of wave 1.
• Wave 3 is never the shortest of waves 1, 3 and 5, and is often the longest and strongest.
• Wave 4 does not fall into the price range of wave 1.

How traders use it

• Riding wave 3. The most popular setup is buying near the end of wave 2, after a valid wave 1, in the hope of catching wave 3, usually the biggest move. The start of wave 1 is the natural stop: if price falls below it, the count is wrong.
• Fibonacci targets. Elliott practitioners measure waves with Fibonacci ratios. Common guidelines are that wave 2 retraces 50% to 61.8% of wave 1, wave 3 extends to about 1.618 times wave 1, and wave 4 retraces about 38.2% of wave 3. These are tendencies, not rules.
• Late in the trend. A completed five-wave advance warns that a correction is due. Momentum often diverges in wave 5: price makes a new high while oscillators such as RSI or MACD make a lower one.
• Corrections. After an impulse, traders expect an A-B-C move against it and look for the next impulse to start once the correction ends, often near a Fibonacci retracement of the whole five-wave move.

Strengths and common mistakes

• Subjectivity. Two analysts can count the same chart differently, and counts are often revised as new bars arrive. Treat a count as a working hypothesis with a clear level that proves it wrong.
• Forcing a count. Many price moves don’t fit the textbook shape. If you can’t count it cleanly, skip it.
• Ignoring the rules. The three impulse rules are the only firm part of the theory. A count that breaks one of them is not an impulse.
• Mixing degrees. A five-wave rally on an hourly chart may be only wave 1 or wave C on the daily chart. Check the larger timeframe first.

Live chart: SPY (S&P 500 ETF), daily, with ZigZag lines that connect swings of 7% or more, the raw material for counting waves. The chart updates every trading day.

Screen for it on MarketInOut

Our formula language has Elliott Wave functions that apply the impulse rules to closing prices automatically. Stocks above their 200-day average where a potential wave 3 up has just started, with wave 2 ending within the last 10 bars:

exch(nyse,nasdaq) and type(stock) and price > 1 and advol(21) > 1
and elliott_3up_start(5, 128, 10) and price > sma(200)

Stocks that have just completed a five-wave up impulse, with the default settings:

exch(nyse,nasdaq) and type(stock) and price > 1 and advol(21) > 1
and elliott_5up

Related: Fibonacci retracements, Chart patterns, Trend lines.