Technical Analysis: the Elliot Wave

The Elliot Wave was developed by Ralph Nelson Elliott in the late 1920s. Elliot believed that there were cycles of emotions that traders experience on a countless basis. These cycles repeated on so many occasions that it was believed that this was "a predominate psychology of the masses."

Elliott stated that the upward and downward swings of this mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he termed as waves.

Elliot has two different types of waves, an impulse wave and a corrective wave. An impulsive wave, which goes with the main trend, always shows five waves in its pattern on the upside trend. On the downside trend it can vary between three or five impulsive waves.

The waves themselves possess waves inside them. For instance, large-scale wave formations spanning years show many smaller waves when viewed on a monthly chart. Zooming in on a wave segment all the way to the daily scale can show even more wave formations inside, and so on.

An impulsive wave tends to be larger and longer than does the correction wave. Think that for every action, there is a reaction. Let's leave out the part where it states, "equal and opposite reaction" because it does not apply here.

So, for every impulsive wave there is a corrective wave. Corrective waves must be present in order to justify the impulsive wave.

When the price is moving upward, the waves in this type of order are called 1, 2, 3, 4 and 5. Waves 1, 3 and 5 are impulsive waves. Waves that are numbers 2 and 4 are corrective waves.

When price tends to drift down there are usually only three waves labeled A, B and C. A and C waves are impulsive waves, while B wave is a corrective wave.

This theory tends to play on longer time frames. If you are a day trader, this technique tends not to play so much on any charts except from the Dow Jones mini (YM), the NASDAQ mini (NQ), the S&P500 (SPX) and Russell mini (ER2) due to their liquidity. Mostly, these waves are best played on a time frame of six months or more - patience is advised.

Be advised that Elliot did not tell anyone how to play the waves. So, individual investors made their own ways to trade it, such as the following.

Going long:

ß Wait for the impulse wave 1 and corrective wave number 2 to be established.

ß Enter only after the high of the wave number one was breached. Fibonacci extensions can be used to notice where wave number 3 will be stopped. In my personal studies, I have found that Wave 1 is the largest, wave 3 is 2/3 of wave 1 and wave 5 is 2/3 of wave 3. Other technicians require that wave 3 be the largest wave in the formation. Thus, you can use these broad guidelines to establish your own technique.

Going short:

ß This part tends to be a little tricky. If shorting based on the Elliot wave, the Fibonacci numbers must be used.

ß After wave A has finished, you will have to plot the high and low of this wave. Finding the Fibonacci number can be easily achieved with basic software such as QuoteTracker (free), Esignal, NinjaTrader, etc. Corrective wave B tends to stall at 21.8 percent, 38.2 percent or 50 percent. If the price goes past the 50 percent mark, the trade should be abandoned. After the Fibonacci numbers hold, then a trade can be made. This strategy tends to be very aggressive, thus, stop orders must be used.

The basic rules: ß Every action is followed by a reaction. ß There are five waves in the direction of the main trend followed by three corrective waves (a "5-3" move). ß A 5-3 move completes a cycle. ß This 5-3 move then becomes two subdivisions of the next higher 5-3 wave. ß The underlying 5-3 pattern remains constant; the timespan may vary.

Source: Investopedia