A Guide to the Elliott Wave Theory (Elliott Wave Principle)

The Elliott Wave Theory was created, or perhaps discovered, by R.N. Elliott during the 1920’s. Mr. Elliott was an accountant, and during his life-time, he held many important positions at very high levels, and was at one time the Chief Accountant for an entire country in Latin America, which was held by the USMC at that time. When he was around 60 years old, he suffered from a disease which he had contracted in the Middle Americas, and he began studying the stock market and price patterns therein. After a while he discovered what he first called the Wave Principle, or Elliott Wave Theory (EWT) as it is more commonly refered to today.

Ralph Nelson Elliott - Discoverer/Founder of the Elliott Wave Theory / Wave Principle

Above: Photograph of Ralph Nelson Elliott.

The essence of EWT is that price for a financial instrument (in fact any commodity traded with sufficient number of participants) develops in certain waves and patterns. The waves are combined to wave patterns, sometimes referred to as price patterns. A complete sequence of waves can be said to consist of 8 major waves, divided into two smaller trends, that play out in a greater trend. The greater trend is divided into the smaller trends, and the two lesser trends are termed as an impulse and a correction. The two trends consist of a total of 8 waves, of which 5 waves are constituents of the impulse wave, and 3 waves are constituent of the corrective wave. This is somewhat of a simplification, but it will do for now.

So, what are impulses and corrections? If we were to summarize the market development in very generalizing terms, we could look at how human beings learn something new: 2 steps forward, 1 step backward – just like when we were babies learning how to walk. After a while the baby learns how to walk a few clumsy steps, and then falls down. It seems that Nature always works in this way, and the financial markets are seem to be no exception. So, the impulse is simply put an unrestrained force in either direction, which is then corrected by a corrective formation, which is some form of retracement from the top levels (or bottom levels in a falling impulse) reached by the impulse.

Let’s continue by including some pictures and simple graphics. Technical analysis and especially the Elliott Wave Theory is a rather visual science, after all.

 

Impulses / Impulsions.

What is an impulse?

Let’s start the visual study of EWT by looking at impulses. What is an impulse? An impulse is the first initial force or movement, in some direction, primarily upwards, which – in the context of financial instruments – creates an increase of value. They are strong and dominating market forces, impulses therefore tend to occur in breadth, which means that during strong impulsive trends on the market, most stocks participate in the same direction. Let’s look at a few simple illustrations. Please remember that when one analyzes waves with the Elliott Wave Theory, the end of the waves is always the place to mark them up with numbers or letters, depending on what formation one labels. For example: In figure 01 below, wave 3 goes from number 2 to number 3 in the graph, and the end point (which is the start point of the next wave) is marked.

A complete Elliott Wave pattern with an impulse and a correction.

Fig. 01 – A complete wave pattern with an impulse and a correction.

Elliott Wave Theory Wave 3, impulse wave upwards.

Fig. 02 – Wave 3, impulse wave upwards.

Elliott Wave Theory Wave A, impulsive wave downwards.

Fig. 03 – Wave A, impulsive wave downwards.

Figure 01 shows a complete wave pattern with an impulse (wave 1-2-3-4-5) and correction (wave A-B-C) following it. An impulse always consists of – regardless of whether it is directed upwards or downwards – 5 distinct major waves, and the components of impulse waves are always marked with numbers. A correction in its simplest form, consists of 3 waves – regardless of its direction. Actually, there are other corrective formations as well, we will get back to them further on.

The impulse (wave 1 to 5) consists of three lesser impulses – wave 1,3 and 5 with an upward direction – and two smaller corrections, wave 2 and 4. Wave 1, 3 and 5 are the primary power in the entire impulse (waves 1 to 5).

Corrections also contain impulses that are then in a downward direction, se fig. 03. However, a correction can never be just one impulsive wave. The impulses that occur in corrections are always parts of other structures.

The Waves repeat, in different size but the same form.

In figure 01, the 3rd wave is the longest wave, that’s most often the case (more on that later). In figure 02, I have isolated wave 3 from the complete impulse. As we can see, wave 3 consists of the same components as the entire impulse in figure 01 does. So does wave 1 and wave 5. That means that if I zoom in on wave 1, wave 3 or wave 5, I will see the same pattern as in figure 02.

The entire Elliott Wave Theory is built on the premise or foundation that the waves are created and combined in the same way regardless of the degree of size that we observe. In other words, the wave pattern looks the same in a 30-minute chart as it does in a yearly chart.

Marking up the Wave pattern.

Since waves appear in different sizes over all time frames, it is necessary to develop some sort of labeling systems in order to keep components separate from each other.

Impulsive labels. Corrective labels.
I II III IV V – Smallest degree a b c d e – Smallest degree
1 2 3 4 5 A B C D E
(I) (II) (III) (IV) (V) (a) (b) (c) (d) (e)
(1) (2) (3) (4) (5) (A) (B) (C) (D) (E)
[I] [II] [III] [IV] [V] [a] [b] [c] [d] [e]
[1] [2] [3] [4] [5] [A] [B] [C] [D] [E]
{I} {II} {III} {IV} {V} {a} {b} {c} {d} {e}
{1} {2} {3} {4} {5} {A} {B} {C} {D} {E}
<I> <II> <III> <IV> <V> <I> <II> <III> <IV> <V>
<1> <2> <3> <4> <5> <A> <B> <C> <D> <E>
-I- -II- -III- -IV- -V- -a- -b- -c- -d- -e-
-1- -2- -3- -4- -5- – Largest degree -A- -B- -C- -D- -E- – Largest degree

The above table contains our choice of labels. As long as you know which label goes with which degree, you can choose a different set than what we use.

Extended impulses.

In a 5-wave impulse sequence, one of the impulsive waves 1, 3 or 5 can develop into an extended impulse wave. The figures below illustrate the different forms of extensions.

Elliott Wave Theory Impulse, with Extended 1st wave.

Fig. 04 – Extended 1st wave.

Elliott Wave Theory Impulse, with Extended 3rd wave.

Fig. 05 – Extended 3rd wave.

Elliott Wave Theory Impulse, with Extended 5th wave.

Fig. 06 – Extended 5th wave.

When do impulse waves become extended? The most common position for a wave extension is the 3 rd wave. Extended 5th waves are perhaps more common in commodity futures. Extended 1st waves are not particularly common.

(Leading and) Ending Diagonal Triangles.

Diagonal triangles are a special sort of impulsive formation that can be described as either a weak impulse, or a mix between an impulse and a correction. Some rising/falling wedges (a formation in classical TA) are in fact diagonal triangles from EWT. There are two basic forms of diagonal triangles.

Elliott Wave Theory Ending Diagonal Triangle / Terminal Failure.

Fig. 07 – Ending Diagonal Triangle

Elliott Wave Theory Leading Diagonal Triangle.

Fig. 08 – Leading Diagonal Triangle

Fig. 07 shows an Ending Diagonal Triangle, sometimes referred to as a Terminal Impulse. They occur in wave position 5 or C, and nowhere else. There is an extending variation on the Ending Diagonal, which basically has expanding trendlines instead, and the last segment is the longest. Elliott was of the opinion that these patterns most often occured at the the end of a 3rd wave or at the end of a strong correction. Fig. 08 shows a more uncommon pattern, a so called “Leading Diagonal Triangle”. Leading Diagonals are disputed – some analysts claim they do not exist at all. Leading Diagonals have a leading role to play in larger wave patterns, they are formations which can occur as wave 1 or wave A. Fig. 08 shows a 1st wave Leading Diagonal, simply point it downwards to illustrate an A-wave Leading Diagonal.

 

Corrections.

Q: What is a correction and why does it occur?
A: A correction is just what the name implies – a correction of a previous event or outcome in the market.

Corrections are generally much tougher to analyze and forecast in comparison with an average impulse pattern. Corrections move against the underlying primary trend, and are as such a conflict between two large forces, whereas impulses, at least the ones in the direction of the major trend, do not conflict with the major trend, since they are a part of it.

Simple corrections.

Let’s initially discuss corrections at a very rudimentary level to get a grasp on them.

Elliott Wave Impulse, followed by a Correction.

Fig. 09 – An impulse followed by a correction.

Elliott Wave 2nd Wave, downward Correction.

Fig. 10 – Wave 2, downward correction.

Elliott Wave B-wave, upward Correction.

Fig. 11 – Wave B, upward correction.

Let’s start from fig. 09 which shows an impulse followed by a correction. In the impulse (1 to 5), wave 2 and 4 are corrections. In the sequence A-B-C (which is a ZigZag-variant), only wave B is a correction – the entire sequence A-B-C on the other hand is a correction, which is correcting the sequence 1-2-3-4-5, which is an impulse. So, a complete corrective formation can in itself have impulsive subwaves, and an impulse has a few corrective subwaves (2 and 4).

In fig. 10 I have zoomed in on wave 2 from fig. 04. I fig.11 I have isolated and zoomed in on wave B from fig. 09. These examples, while they can and do occur in real life, are somewhat simplified. In all corrective wave positions, other corrections than a ZigZag-ABC (as shown i fig. 09) can and do occur. We’ll have a look at these formations later.

But let’s first have another look at fig. 09. The small wave 2 in the start of the impulse is a corrective formation. It consists of waves A-B-C, but of one (1) degree smaller size than the subsequent A-B-C waves which occur after wave 5 is complete.

Fig. 11 is a zoom-in on the middle wave B of fig. 10. It is another and smaller ABC-formation, in this correcting wave A in fig. 10.

This concludes our initial discussion on corrections. Further on we’ll look at some different corrective formations.

2nd and 4th corrective wave – and the alternation guideline.

Before we have a closer look at some different simple and complex corrective formations, let’s first take a look at the alternation guideline. This guideline simply says that if wave 2 is a quick ZigZag-formation (or something else), chances are high that wave 4 will not only not be a ZigZag, but it will probably be more drawn out time wise. Price wise they are often similar, but far from always.

Elliott Wave Theory - Most Common Alternation.

Fig. 12 – Most common alternation.

Elliott Wave Theory - Reversed Alternation.

Fig. 13 – Reversed alternation.

Fig. 12 shows the most common way alternation occurs, that is, wave 2 is a simple ABC-formation, often much less in time than fig. 12 indicates, followed by some sort of more drawn out and complex correction in wave 4. In fig. 12 I’ve drawn a small triangle, but it could also be a Flat-formation, or a complex correction. Fig. 13 shows a far less common alternation, with a small triangle-like formation as wave 2, and a sharper and simpler ZigZag as wave 4.

Corrective formations.

Now, let’s have a look at the different corrective formations.

ZigZag.

The first one is the ZigZag.

Elliott Wave Theory - ZigZag in falling correction.

Fig. 14 – ZigZag in falling correction.

Elliott Wave Theory - ZigZag in rising correction.

Fig. 15 – ZigZag in rising correction.

As fig. 14 and 15 show, a ZigZag consists of 3 main phases. The A-wave is an impulsive formation. In both fig. 14 and 15 I’ve drawn wave B as another smaller ZigZag, but wave B can actually be any type of correction (except running variations on Flats and combinations). *It is not allowed to retrace more than Fibonacci-61,8% of wave A at its conclusion.* As with all corrections, ZigZags can take place in any direction.

Flats.

Next category to have a look at is the Flat-formation. Elliott gave this formation its name because of the tendency of Flats to mostly waste time and enact what is often a not too significant correction of the previos impulsive wave.

There are 3 main types of Flats, they are Regular, Expanded and Running. The Running formation is not shown in this guide, and it is uncommon.

Elliott Wave Theory - Regular Flat.

Fig. 16 – A “Regular Flat “.

Elliott Wave Theory - Expanded Flat.

Fig. 17 – An “Expanded Flat”.

All Flats have a corrective A-wave, a corrective B-wave, and an impulsive C-wave. Wave A is frequently a quick type of correction, either a ZigZag as shown in fig. 16 and 17, or a Double or Triple ZigZag. Wave B can be any type correction, including another Flat-formation in the middle of the bigger one (!). Wave B is frequently significantly more drawn out timewise than wave A, I generally look for at least 100% of the time of wave A. Wave C can be any impulsive formation, including all forms of Ending Diagonal Triangles. In most Flats, Wave C reaches to or beyond the end point of wave A.

Fig. 17 shows an Expanded Flat where wave B is longer than wave A, and wave C then becomes even longer then wave B. If wave B is longer than wave A, and wave C fails to become longer than wave B, the formation is usually referred to as an Irregular Failure.

Triangles.

The last main corrective formation is the triangle. There are 2 main types of triangles in basic Elliott Wave Theory, they are Contracting Triangles and Expanding Triangles.

Elliott Wave Theory - Contracting Triangle.

Fig. 18 – A “Contracting Triangle”.

Elliott Wave Theory - Contracting Triangle with flat baseline.

Fig. 19 – Another contracting triangle, but with a flat baseline. The roof can also be flat instead.

Elliott Wave Theory - Expanding Triangle.

Fig. 20 – An “Expanding Triangle”.

Triangles are corrective formations which consist of 5 main subwaves instead of 3 subwaves which is the case in ZigZags and Flats. Every subwave in a triangle is a corrective formation in itself, usually variations of ZigZags and Flats, or impulse-like Double and Triple Threes or ZigZags. The 3 pictures above show a few fairly common variations, but a couple more exist, such as the Running Triangle. The triangle shown in fig. 19 is a triangle with a flat baseline. Actually, the roof can be flat instead. And, expanding triangles can also have one flat trendline, but that is uncommon. Triangles can occur as both falling and rising formations, but all examples above are shown as correcting a rising primary trend.

It is important to remember that the E-wave in a triangle doesn’t have to reach the A-C-line, in contracting triangles it frequently does not, while in expanding triangles on the other hand, the A-C-line is very often breached by wave E.

Triangles occur in wave position 4 or B, or as part of complex corrections.

Complex corrections.

Corrections are sometimes extended in different ways. The market does this by creating an ABC-structure (or a triangle, if close to the end of the pattern), and then glueing it together with another corrective formation by throwing in an X-wave between the ABC-structures.

X-waves can be large or small, and very often they have no discernable internal structure and are similar to a shaky line. Larger X-waves can and often do develop an ABC-structure, and they are counted as corrective waves.

Wave labelling in complex corrections is somewhat different than in normal corrections. Since the entire complex correction in itself consist of several ABC-sequences, each ABC-sequence has to be given another wave label than just A, B or C, otherwise confusion would arise. So, each completed ABC-sequence in the ain direction of the formation is called W, Y or Z, with the in-between waves called X (see above).

Elliott Wave Theory - Complex 'Double Three' Correction.

Fig. 21 – A “double three”.

Elliott Wave Theory - Complex 'Triple Three' Correction.

Fig. 22 – A “triple three”.

Elliott Wave Theory - Complex correction with ZigZag and a Triangle.

Fig. 23 – A ZigZag and a Triangle.

Fig. 21 shows 2 ZigZags linked by an X-wave inbetween them. Fig. 22 shows 3 ZigZags with 2 X-waves in between them. Often, a second X-wave is labeled XX, but fig. 22 shows it as just a second X. If the patterns in fig. 21 and fig. 22 have a greater downward slope, they are called Double ZigZag and Triple ZigZag respectively. A Double Three and a Triple Three can also have other patterns than just ZigZags, for instance, Flats are allowed. And fig. 23 shows a ZigZag (W), an X-wave and a Triangle (Y) which finishes the formation.

Rules for Elliott Wave Theory analysis.

The Elliott Wave Theory has only a handful of absolute rules for pattern analysis. Here they are:

  • Wave 2 (the first correction of an impulse) can never pass the startpoint of wave 1.
  • Wave 3 (the middle wave of an impulse) can never be shorter than both wave 1 and 5. And can be shorter than either, both not shorter than both at the same time.
  • Wave 4 (the second correction of an impulse) can never enter the price territory of wave 1, unless the market is forming an Ending Diagonal impulsive pattern (or the much rarer Leading Diagonal).

Rules can only be broken in leveraged markets and thinly traded financial instruments. Which makes the Elliott Wave Theory less suited for analyzing derivatives or very thin stock exchanges and indicies, since you have to spend time determining if you have the count wrong or a “legitimate” formation break occured. For example, that is why we do not analyze the index Dow Jones Industrial 30 Average, commonly referred to as “the Dow” or “Dow Jones”. It is too thin. Instead, we go with the broader S&P500 and NASDAQ Composite indices.