Background on the Elliott Wave theory
The word Elliot Wave comes from Ralph Nelson Elliot. He worked as an accountant from 25 and held many successful businesses for decades.
After working as a chief accountant for Nicaragua in the year 1924, he began his journey in studying the stock market charts.
In the year 1934, he concluded his analysis and coined the term “Elliott Wave.” The same year, he proposed a theory that the Dow Jones was at its final low.
It was a strange time with strange predictions in his book ‘The Wave principle.’ This principle was later named —the Elliot Wave and brought a large number of followers.
The logic behind the Elliot Wave is a Fibonacci number and its sequence. Not long ago, the great mathematician Leonardo of Pisa discovered a natural pattern named the Fibonacci sequence.
Ralph Nelson Elliot used the science behind his Elliot Wave. One more thing, Finobacci also perceived the golden ratio as 1.61, which helps to determine the resistance in chart analysis.
What is Elliott Wave
Elliot wave is a pattern analysis theory that follows a distinct wave movement. These waves follow three impulses and two correction phases. The first three impulses have a bull momentum and wave six to eight have a retracement pattern called ABC.
The first three impulses of the Elliott wave
The first, third, and fifth waves are impulsive, while the last three are corrective.
(a) The first impulse
Line 1 makes the first wave which follows the corrective wave line 2. The first wave is the start of the upward trend in the market. Remember that the second corrective wave should stay above the beginning point of wave 1.
(b) The second impulse
Wave 3 makes the second impulse and is the longest of all. It follows the corrective wave 4.
(c) The third impulse
Wave 5 is the last impulse in the Elliott wave theory. It follows the retracement pattern ABC. Lots of traders mark wave five as a selling opportunity.
(d) The retracement pattern ABC
Waves A, B, and C come after the three impulsive waves. According to Ralph Nelson Elliott, the retracement pattern ABC is imminent after the 5th impulse wave.
When Fibonacci found the wave in nature, he proposed it was fractal. Similarly, Elliott’s findings were that such a pattern in the stock market or forex market is complex. One should analyze all the time frames and deduct this pattern.
The hidden Elliott wave exists in all chart patterns.
One of the distinct philosophies of Elliott Wave theory is that it exists in all charts. Multiple impulse waves and correction waves occur.
In a more complex chart, the first wave replaces the whole 1 to 5 impulse then ABC retracement. In a similar manner, the third wave replaces the five-impulse patterns. Each wave completes the inner Elliott wave pattern. For example:
In some cases, the third follows multiple five impulses. The expert traders take Elliott wave seriously and follow its every principle. Once you understand its working mechanism, you can earn profits in any market.
The Three Rules of Elliot Wave theory
The corrective wave 2 should never retrace the point below wave 1. In other words, the bottom of the second wave should always be higher than the start of the first wave. However, one should keep in mind that retracement should never go below the impulse. Every new impulse makes a new high.
Wave 3 is the longest wave among the first three impulses. The Elliott pattern in the chart extends randomly. Ralph Nelson Elliott found that the third wave extends more than the fifth. Some traders sell their position in this wave and miss another bullish move on the fifth wave. The trick is to identify the third-wave support point.
The bottom of the 4th wave should never retrace the top of the 1st wave. If the fourth wave goes below the top of the first wave, the pattern should start over.
When impulse wave 3 is the longest in the Elliot wave pattern, impulse wave 5 will be equal to wave 3.
The two corrective waves, 2 and 4, will always alternate. If wave 2 has a sharp correction, wave 4 will have a flat correction. Likewise, if wave 2 is flat, wave 4 will fall sharply.
After the 5th impulse, the ABC correction will always fall near the level of wave 4 low.
When the third wave extends, the first and fifth waves exist on the Fibonacci ratio. We can find this level by using the Fibonacci tools.
We advise you to understand this pattern thoroughly before you apply it in your analysis. Of course, the pattern exists if you learn to see it through. The Elliott wave theory has worked for many expert traders. Please learn to distinguish the third and fifth waves on a deeper level.