# Elliott Wave Theory

### Reviewed by Subject Matter Experts

Updated on September 04, 2023

## What Is the Elliott Wave Theory?

Elliott Wave Theory is a technical analysis approach that attempts to forecast financial market trends and cycles by identifying repeating patterns in market price movements.

The theory is based on the idea that market prices move in waves, and that these waves can be classified as either impulsive waves (trending waves) or corrective waves (counter-trend waves).

The theory also incorporates Fibonacci ratios to determine price targets and retracement levels.

Ralph Nelson Elliott, an American accountant and stock market analyst, developed the theory in the 1930s. He observed that market prices tend to move in predictable patterns, and that these patterns are influenced by human psychology and emotions.

According to Elliott Wave Theory, market prices move in five-wave patterns in the direction of the trend, followed by a three-wave corrective pattern against the trend. The five-wave pattern is known as the impulsive wave, while the three-wave pattern is called the corrective wave.

Elliott Wave analysts use chart patterns and technical indicators to identify these patterns and determine the direction of future price movements.

While Elliott Wave Theory has its supporters, it is also criticized by some traders and analysts for its subjective nature and the potential for interpretation bias.

## Basic Concepts and Terminology

Elliott Wave Theory is built on several fundamental concepts and terminologies that traders and investors should be familiar with. These concepts include motive waves, corrective waves, and wave degrees.

### Motive Waves

Motive waves are the main trend waves in the Elliott Wave Theory, consisting of five waves that move in the direction of the primary trend. There are two types of motive waves, impulse waves and diagonal waves.

#### Impulse Waves

Impulse waves are the most common type of motive wave in the Elliott Wave Theory. They are composed of five waves, three of which are the main upward (or downward) trend, while the other two are corrective waves in the opposite direction.

In an upward trend, the impulse wave consists of three upward waves (1, 3, 5) and two downward waves (2 and 4). Conversely, in a downward trend, the impulse wave comprises three downward waves (1, 3, 5) and two upward waves (2 and 4).

#### Diagonal Waves

Diagonal waves are less common than impulse waves and consist of five waves that move in a diagonal pattern. There are two types of diagonal waves, namely leading diagonal and ending diagonal.

A leading diagonal moves in the direction of the primary trend, while an ending diagonal moves against the primary trend.

### Corrective Waves

Corrective waves are counter-trend waves that occur after a motive wave has been completed. They consist of three waves that move in the opposite direction to the primary trend. There are three types of corrective waves, zigzags, flats, and triangles.

#### Zigzags

Zigzags are the most common type of corrective waves, and they are composed of three waves. In an upward trend, the first wave (A) is a downward wave, followed by an upward wave (B), and finally, another downward wave (C).

In a downward trend, the first wave (A) is an upward wave, followed by a downward wave (B), and then an upward wave (C).

#### Flats

Flats are corrective waves that move in a sideways pattern. They consist of three waves, with the second wave retracing at least 80% of the first wave. In an upward trend, the first wave (A) is an upward wave, followed by a sideways wave (B), and finally another upward wave (C).

Conversely, in a downward trend, the first wave (A) is a downward wave, followed by a sideways wave (B), and then another downward wave (C).

#### Triangles

Triangles are corrective waves that move in a triangular pattern. They consist of five waves that move in a converging pattern.

In an upward trend, the triangle is formed by a series of higher lows and lower highs, while in a downward trend, the triangle is formed by a series of lower highs and lower lows.

### Wave Degrees

Wave degrees are used to categorize the magnitude of the trend waves in the Elliott Wave Theory. There are nine wave degrees, ranging from the smallest sub-minuette to the largest grand supercycle. The nine wave degrees are:

1. Grand Supercycle - lasts several centuries

2. Supercycle - lasts several decades

3. Cycle - lasts several years

4. Primary - lasts several months to a year

5. Intermediate - lasts several weeks to a few months

6. Minor - lasts several weeks

7. Minute - lasts several days

8. Minuette - lasts several hours

9. Sub-minuette - lasts several minutes

## Rules and Guidelines of Elliott Wave Theory

To apply the Elliott Wave Theory effectively, traders and investors must follow certain rules and guidelines. These rules are designed to help identify and confirm wave patterns, as well as to anticipate future price movements.

### Wave Counting Rules

Wave counting is a crucial component of the Elliott Wave Theory. To accurately identify wave patterns, traders must follow specific wave counting rules. Some of the most important wave counting rules include:

#### Rule of Alternation

The rule of alternation suggests that the corrective waves in a pattern should alternate in their form and complexity. For example, if the first corrective wave is a zigzag, the second corrective wave should be a flat or triangle.

#### Rule of Equality

The rule of equality suggests that the second impulse wave in a pattern should be equal in length to the first impulse wave. This rule applies to motive waves but not corrective waves.

#### Rule of Proportionality

The rule of proportionality suggests that the waves in a pattern should relate to each other in a specific proportion. For example, if wave 1 is 100 points, wave 3 should be 161.8% of wave 1, and wave 5 should be 61.8% of wave 3.

### Fibonacci Relationships

Fibonacci relationships are an essential component of the Elliott Wave Theory. Fibonacci ratios are mathematical ratios derived from the Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.).

These ratios are used to identify potential support and resistance levels and to project future price targets. The three most commonly used Fibonacci ratios in the Elliott Wave Theory are:

#### Retracement Levels

Retracement levels are used to identify potential support or resistance levels during a corrective wave. The most common retracement levels are 38.2%, 50%, and 61.8% of the previous wave.

For example, if wave 1 is 100 points, the potential retracement levels for wave 2 would be 38.2 points, 50 points, and 61.8 points.

#### Extension Levels

Extension levels are used to project potential price targets for a wave. The most commonly used extension levels are 161.8%, 261.8%, and 423.6% of the previous wave.

For example, if wave 1 is 100 points, the potential extension levels for wave 3 would be 161.8 points, 261.8 points, and 423.6 points.

#### Fibonacci Time Zones

Fibonacci time zones are used to identify potential time targets for a wave. These time zones are derived from the Fibonacci sequence and are used to identify potential turning points in the market.

The most commonly used Fibonacci time zones are 38.2%, 50%, and 61.8% of the time taken for the previous wave to complete.

## Practical Applications of Elliott Wave Theory

Elliott Wave Theory is a valuable tool for traders and investors who wish to analyze financial markets and make informed trading decisions. In this section, we will discuss some practical applications of the Elliott Wave Theory.

### Identifying Market Trends

One of the most important applications of the Elliott Wave Theory is identifying market trends. By analyzing wave patterns, traders can determine whether the market is in an uptrend, downtrend, or consolidating.

This information can be used to make informed trading decisions and to anticipate future price movements.

### Forecasting Market Reversals

Another important application of the Elliott Wave Theory is forecasting market reversals. By identifying the completion of a wave pattern, traders can anticipate a potential reversal in the market. This information can be used to enter or exit trades and to manage risk.

### Risk Management and Trading Strategies

The Elliott Wave Theory can also be used to develop risk management and trading strategies. Some common strategies include:

#### Entry and Exit Points

Traders can use wave patterns to identify potential entry and exit points for trades. For example, a trader might enter a long position at the start of an impulse wave and exit the trade at the end of the wave.

#### Stop Loss Placement

Traders can use wave patterns to determine appropriate stop loss levels for trades. For example, a trader might place a stop loss below the start of an impulse wave to limit potential losses.

#### Position Sizing

Traders can use wave patterns to determine appropriate position sizes for trades. For example, a trader might increase their position size during an impulse wave and decrease their position size during a corrective wave.

### Combining with Other Technical Analysis Tools

Finally, the Elliott Wave Theory can be combined with other technical analysis tools to improve the accuracy of trading decisions. Some common tools include:

#### Moving Averages

Moving averages can be used to confirm wave patterns and to identify potential support and resistance levels.

#### Relative Strength Index (RSI)

The RSI can be used to confirm wave patterns and to identify potential overbought or oversold conditions.

#### Stochastic Oscillator

The stochastic oscillator can be used to confirm wave patterns and to identify potential trend reversals.

## Limitations and Criticisms of Elliott Wave Theory

While the Elliott Wave Theory is a valuable tool for analyzing financial markets and making informed trading decisions, it is not without limitations and criticisms. In this section, we will discuss some of the main limitations and criticisms of the Elliott Wave Theory.

### Subjectivity in Wave Counting

One of the main criticisms of the Elliott Wave Theory is the subjectivity involved in wave counting. Wave patterns can be open to interpretation, and different analysts may identify different wave counts.

This subjectivity can lead to disagreements and inconsistencies in the analysis of market trends.

### Hindsight Bias

Another limitation of the Elliott Wave Theory is hindsight bias. This occurs when analysts apply the theory to historical price data and adjust wave counts to fit the data after the fact. This can lead to overfitting of the data and can make the theory less reliable for future price predictions.

### Inability to Predict External Factors

The Elliott Wave Theory is based solely on the analysis of price data and does not take into account external factors that may influence market trends, such as political events, economic data releases, or unexpected news.

This can limit the accuracy of the theory in predicting future price movements.

### Reliance on Historical Data

The Elliott Wave Theory relies heavily on historical data to identify wave patterns and predict future price movements.

However, market conditions and dynamics can change over time, which can make historical data less relevant for predicting future price movements. This can limit the effectiveness of the theory in volatile or rapidly changing markets.

## Final Thoughts

The Elliott Wave Theory is a technical analysis approach that attempts to forecast financial market trends and cycles by identifying repeating patterns in market price movements.

The theory is based on the idea that market prices move in waves, and these waves can be classified as either impulsive waves or corrective waves.

The Elliott Wave Theory has several fundamental concepts and terminologies, including motive waves, corrective waves, and wave degrees.

It also has rules and guidelines that traders and investors must follow to identify and confirm wave patterns, as well as to anticipate future price movements.

The practical applications of the Elliott Wave Theory include identifying market trends, forecasting market reversals, and developing risk management and trading strategies.

However, the theory also has its limitations and criticisms, such as the subjectivity involved in wave counting, the potential for hindsight bias, the inability to predict external factors, and the reliance on historical data.

Overall, the Elliott Wave Theory is a valuable tool for traders and investors who wish to analyze financial markets and make informed trading decisions.

However, it is important to balance its strengths and limitations to avoid potential pitfalls and increase the chances of success in the financial markets.