Fig.1 The basic Elliott Wave pattern
The Elliott Wave principle is a system of empirically derived rules for
interpreting action in the markets. Elliott pointed out that the market
unfolds according to a basic rhythm or pattern of five waves in the direction
of the
trend at a larger scale and three waves against that trend, on a smaller
scale.
In a rising market, this five-wave/three-wave pattern forms one complete bull market/bear market cycle of eight waves.
The five-wave upward movement as a whole is referred to as an impulse wave, and the three-wave counter-trend movement is described as a corrective wave (See Fig.1).
Within the five-wave bull move, waves 1, 3 and 5 are themselves impulse waves, subdividing into five waves of smaller scale; while waves 2 and 4 are corrective waves, each subdividing into three smaller waves.
As shown in Fig.1, subwaves of impulse sequences are labeled with numbers, while subwaves of corrections are labeled with letters:
Fig.1 The basic Elliott Wave pattern
Following the cycle shown in this illustration, a second five-wave upside movement begins, followed by another three-wave correction, followed by one more five-wave up move. This sequence of movements constitutes a five-wave impulse pattern at one larger degree of trend, and a three-wave corrective movement at the same scale must follow. Fig. 2 shows this larger-scale pattern in detail.
As the illustration shows, waves of any degree in any series can be subdivided and re-subdivided into waves of smaller degree or expanded into waves of larger degree.
Fig. 2 The larger pattern in detail
The following rules are applicable to the interpretation of Elliott Waves:
Furthermore, smaller-scale movements link up to create larger-scale movements possessing the same basic form. Conversely, large-scale movements consist of smaller-scale subdivisions with which they share a geometric similarity. Because these movements link up in increments of five waves and three waves, they generate sequences of numbers that the analyst can use (along with the rules of wave formation) to help identify the current state of pattern development, as shown in Fig. 3:
Fig. 3 A complete market cycle
As the market swings of any degree tend to move more easily with the
trend of one larger degree than against it, corrective waves are often
difficult to interpret precisely until they are finished. Thus, the terminations
of
corrective waves are less predictable than those of impulse waves, and
the wave analyst must exercise greater caution when the market is in a
meandering, corrective mood than when prices are in a clearly impulsive
trend.
Moreover, while only three main types of impulse wave exist, they can link up to form extended corrections of great complexity. A most important thing to remember about corrections is that only impulse waves can be “fives”. Thus, an initial five-wave movement against the larger trend is never a complete correction, but only part of it.
In any given five-wave sequence, a tendency exists for one of the three impulse subwaves (i.e., wave 1, wave 3, or wave 5) to be an extension – an elongated movement, usually with internal subdivisions.
At times, these subdivisions are of nearly the same amplitude and duration as the larger degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence.
In a nine-wave sequence, it is sometimes difficult to identify which wave is extended. However, this is usually irrelevant, because a count of nine and a count of five have the same technical significance. Fig. 4 shows why this is so. Examples of extensions in various wave positions make it clear that the overall significance is the same in each case.
Extensions can also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves, as shown in Fig 5.
Fig. 4 Elliott Wave extensions
Fig. 5 Elliott Wave extensions
Extensions can provide a useful guide to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Thus, if the first and third waves are of about the same magnitude, the fifth wave probably will be extended, especially if volume during the fifth wave is greater than during the third.
There are some patterns familiar from Technical Analysis theory, particularly two types of triangles, which should be observed in the context of Elliott Wave analysis.
The diagonal triangle type 1 occurs only in fifth waves and in C waves, and it signals that the preceding move has, according to Elliott, "gone too far, too fast."
All of the pattern’s sub-waves, including waves 1, 3, and 5, consist of three-wave movements, and their fourth waves often enter the price range of their first waves, as shown in Figs. 6.and 7.
A rising diagonal triangle type 1 is bearish, because it is usually followed by a sharp decline, at least to the level where the formation began. In contrast, a falling diagonal type 1 is bullish, because an upward thrust usually follows.
Fig. 6 Diagonal triangles - bullish pattern
Fig. 7 Diagonal triangles - bearish pattern
The diagonal triangle type 2 occurs even more rarely than type 1. This pattern, found in first-wave or A-wave positions in very rare cases, resembles a diagonal type 1 in that it is defined by converging trendlines and its first wave and fourth wave overlap, as shown in Fig. 8. However, it differs significantly from type 1 in that its impulsive subwaves (waves 1, 3, and 5) are normal five-wave impulse waves, in contrast to the three-wave subwaves of type 1. This is consistent with the message of the type 2 diagonal triangle, which signals continuation of the underlying trend, in contrast to the type 1 's message of termination of the larger trend.
Fig. 8 Converging trend lines
Elliott described as a failure an impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave. Figs. 9 and 10 show examples of failures in bull and bear markets.
As the illustrations show, the truncated fifth wave contains the necessary impulsive (i.e., five-wave) sub-structure to complete the larger movement. However, its failure to surpass the previous impulse wave's extremity indicates weakness in the underlying trend, and a sharp reversal usually follows.
Fig. 9 Bull market failure
Fig. 10 Bear market failure
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