Basics of Elliot Waves, a prediction tool




The Elliot Waves theory is very popular among traders. Proposes that trends in price results from traders' predominant psychology, with the same recurring movements in fractal "waves" patterns. So, price action is divided into impulsive and correction moves. Trends show the main direction of prices, while corrections move against the trend.





The theory is extensive, many books and strategies are developed from them, and some traders only trade using this theory.  I think that for use as an additional tool for our day trade analysis, we just need to manage the basics of impulse and corrective waves, for a preception of the price structure and identify repeatable patterns.

The Elliot Waves Theory has three rules and more guidelines to follow, and usually what you see sometimes didn't match with another trader view.

1. Five impulsive waves 12345 moves in the direction of the main trend, followed by three waves ABC in a correction (totaling a 5-3 move). The underlying 5-3 pattern remains constant, though the time span of each wave may vary. Check the graph above.

2. The five-wave impulse, in turn, forms wave 1 at the next-largest degree, and the three-wave correction forms wave 2 at the next-largest degree.

3. If we start from a position 0, after an impulse, a correction will come and then, at least, another impulse.

4. To be considered an impulse wave 12345, waves have to satisfy some conditions:

- Wave 2 cannot retrace more than 100% of Wave 1. (Rule 1)
- Wave 3 may not be the longest, but it will never be the shortest of waves 1,3 and 5. (Rule 2)
- Wave 4 should not overlap wave 1. (Rule 3)
- Wave 4 in no case will completely reverse wave 3.
- In order to compare two waves and treat them as similar, the second wave must measure at least 33% of the previous wave. If not, we will be before a wave of lesser degree.
- We should be able to draw a trend line cleanly between the end of wave 2 and the end of Wave 4. And this line 2-4 cannot be invaded.
- Wave 5 will generally exceed the maximum reached by Wave 3, or at least 38% of the length of the Wave 4.

This are the basics we need to know, to add this weapon to our trading arsenal. Remember, Elliot Waves are much more: labeling wave degrees, wave extensions, wave truncations, diagonal waves, corrections (flat, zigzag) and combinations, as you can review in many Youtube channels dedicated to this topic or here in StockCharts.