Knowledge, tools, technical analysis indicators need to be mastered when participating in the stock market - Part 2: Elliott wave principle

June 25, 2021

History of Elliott Wave Theory

The Elliott Wave Theory is named after Ralph Nelson Elliott (July 28, 1871 – January 15, 1948). He is an American accountant and author.

By analyzing historical stock data over many years, Elliott concluded that stock market movements can be predicted by observing and identifying repeating wave patterns.

Later wave theory was not only applied to stock market analysis but also widely used in other financial markets, the Forex market was no exception.

The Elliott Wave Theory is a detailed description and behavior of groups of people. It shows the change of crowd psychology from pessimism to optimism and vice versa in a natural chain that forms distinct patterns that can be measured.

One of the most obvious places to observe this phenomenon is in financial markets where changes in investor sentiment are recorded in the form of price movements.

Elliott distinguished 11 price movement patterns, also known as wave patterns. He named, defined, and illustrated these patterns. He describes how patterns are formed and their larger versions.

The Elliott Wave Theory is a set of price patterns and possible position interpretations in the overall development of the market. The market often follows development periods, alternating with periods of neither growth nor weakness, building segments according to similar patterns of increasing size.

Inventor of the Elliott Wave Theory: Ralph Nelson Elliott

Portrait of Ralph Nelson Elliott

In 1938, Elliott first published his theory of market patterns in a book titled The Wave Principle.

In 1939, he summed up the wave theory in a series of articles in the Financial World magazine.

Finally, in 1946, Elliott addressed wave theory most comprehensively in his last major work, Nature's Laws: The Secret of the Universe.

Elliott wave pattern structure

The Elliott Wave Theory suggests that the market moves in 5-wave patterns within the mainstream and then retraces in 3-wave or 5-wave corrections before continuing to return to the mainstream.

Patterns in the mainstream always follow 5-wave patterns and are marked with the numbers 1-2-3-4-5. Patterns that move against the mainstream are generally 3-wave patterns but can be 5-wave patterns and are marked with the letters A-B-C (D-E).

In an Elliott wave pattern, the main and corrective waves alternate in all levels of the trend, in all time scales.

An impulse wave consists of 5 lower waves and moves in the same direction as the trend of the higher wave.

A corrective wave always consists of 3 lower waves and moves in the opposite direction of the trend of the higher wave.

The Three Rules of Elliott Waves

A valid Elliott wave pattern must adhere to the following 3 rules:

1. Wave 2 does not retrace beyond the start of wave 1.

2. Wave 3 is not the shortest of the main waves 1-3-3.

3. Wave 4 did not breach the price area of wave 1.

Wave within wave in Elliott wave theory

Following the illustration below shows the structure that forms the wave-in-wave phenomenon of the Elliott wave theory.

The first link is an impulse wave pattern that ends at peak 1 (wave 1). This pattern shows that price swings belonging to the larger wave level are also in an upward direction. It also signals the start of a 3-wave correction, wave 2. Waves 3, 4, and 5 complete the larger master wave chain (1).

The main wave structure of wave 1 shows that the price swings belong to a larger wave level than wave (1) in an upward direction. The correction in wave (2) followed by wave (3), wave (4) and wave (5) will complete the master wave link of the larger level wave [1].

Again, a 3-wave correction of the same wave level occurs as wave [2]. So in turn development completes the whole process.

Elliott wave level

Elliott wave level is a term that defines the time periods so that the analyst can determine the position of the wave in the overall market view.

There are 9 major wave levels from the multi-century time cycle (Grand super cycle) to the cycle of just minutes (Subminuette).

Grand super cycle

Super cycle

Cycle

Primary

Intermediate

Minor

Minute

Minuette

Subminuette

In fact, you don't even need to remember the names of these wave levels, as long as you master the theory of trading with Elliott waves.

Names and symbols of 11 wave patterns

Impulse Model (denoted as IM)

Model Leading Diagonal Triangle (denoted LD)

Ending Diagonal Triangle pattern (denoted as ED)

Zigzag pattern (denoted as ZZ)

Double Zigzag pattern (denoted as DZ)

Triple Zigzag pattern (denoted as TZ)

Flat model (denoted as FL)

Double Three pattern (denoted as D3)

Triple Three pattern (denoted T3)

Contracting Triangle model (denoted as CT)

Extending Triangle model (denoted ET)

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