Elliott Theory is a wave patterns theory inspired by the Dow Theory. Founder Ralph Nelson Elliott (1871-1948) was an American accountant and author who primarily worked in executive positions in railroad companies in Central America and Mexico. Throughout his career, Elliott managed a successful accounting business, worked in many railroad companies, become the Chief Accounted for Nicaragua, and publish two books before he found the Elliott Theory.
Elliott began to study markets after his retirement. He based part of his work on Dow Theory, discovered the fractal nature of market action. His first book about Elliott Theory was published in 1938.
What is Elliott Theory?
According to Elliott, market trends unfolding in 5 waves which is called “Motive (Impulse) Waves” while corrections, moves against the direction of the trend create 3 waves and, are called “Corrective (ZigZag) Waves”. These 5 motive (1, 2, 3, 4, 5) waves and 3 corrective (A, B, C) waves formed a cycle. Each cycle includes a minor cycle in them and a super cycle which includes them. Elliott acknowledged 9 cycles from the monthly time frame to half an hour time frame.
Elliott Theory also includes Fibonacci Retracement and Fibonacci Extension for predicting price ranges of waves. Each wave has its own specifications which are affected by human behaviors. These specifications also change the use of Fibonacci numbers.
Elliott Theory founded for the stock markets but can be used for commodities and forex. But forex markets sometimes tend to use 3 waves instead of 5.
Wave 1 and Wave 2
During the first wave, a new bull market begins. The previous bearish trend is still in effect, the fundamental and technical analysis still showing a downside. After the first wave, the second wave begins like supporting the bearish sentiment but downward moves remain limited.
Wave 2 is expected to continue until near %50, %61.8 or %76.4 Fibonacci retracement levels.
Wave 3 is usually the most healthy and strong bullish wave, especially for stocks. For commodities, however, wave 5 mostly becomes the largest. In the third wave, the market is now aware of the bull market, and volume increases. After the price breaks the top of the first wave (perhaps the best time to enter a long position) bullish sentiment increases dramatically. Corrections start to become small or horizontal and considered as buying opportunities.
Wave 3 is expected to continue until near %161.8, %200, %261.8 Fibonacci Extension of Wave 1 and 2.
Wave 4 usually becomes the first major correction of the third wave. But this correction remains limited and considered a buying opportunity by traders who couldn’t catch the bullish trend. But sometimes cycles end after the third wave and because of that, wave 4 may be the most difficult to predict of all waves.
Wave 4 is expected to continue until near %23.6, %38.2, %50 Fibonacci Retracement levels of wave 2 and 3. It is not expected to fall more than %50 but in our example, it fell until %61.8 level.
Wave 5 is the final wave of motive waves. Everyone is now bullish and the price is rising with less and less volume.
There are different ways to predict the fifth wave. In our example, we use Inverse Fibonacci Retracement levels of waves 3 and 4. The price is expected to increase until near -%123.6 or -%161.8. Some of the other ways are equal of the first wave and %61.8 of wave 1 and 3.
Wave A and Wave B
Wave 5 is the first wave of a bear market. Usually looked at as a simple correction. The volume starts to increase relative to the final times of wave 5. Most traders are still bullish and because of that, wave B is formed as a correction of wave A. During wave B a double top or head and shoulders formations is likely to form.
Wave B is expected to continue until near %61.8, %76.4 Fibonacci Retracement of Wave 5 and A.
Wave C is the final wave of the cycle. After the price breaks the bottom of Wave A, almost everyone realizes the bear market and volume increases.
Wave C expected to continue until near %161.8, %200, %261.8 Fibonacci Extension of Wave A and B