If there’s one trading theory that fascinates investors, it’s the Elliott Wave Theory (Elliott Wave Principle). Despite being developed in the United States stock markets over three-quarters of a century ago, the theory can still be applied to any market today, FX market included.
Ralph Nelson Elliott was an accountant. He loved patterns and used a logical approach to everything in his life.
He developed the concept of a cycle, and each cycle has two parts:
- one impulsive
- one corrective
Elliott Waves Theory is named after the constantly forming waves of the sea.
So, if you have ever heard of Elliott investors counting waves, this is exactly what they do. Elliott established a complex logical process, claiming he had found “the secret of the universe” as his theory incorporated human sentiment like no other.
The main challenge in trading comes from psychological factors, and Elliott Theory incorporates both optimistic and pessimistic outlooks of different market cycles.
After all, the market is the sum of investors’ buying or selling actions. These actions influence supply and demand levels causing the price to move in bullish or bearish trends, or in tight ranges.
Elliott Waves 101
Throughout this forex trading article, we’ll cover the Elliott Waves Theory multiple times, from basic to complex concepts. This lesson aims to discuss the basics of the theory, so investors can form a general understanding of it.
The Motive Wave is the first half of an idealized Elliott Wave pattern. It always advances in the direction of the trend of one larger degree. Five smaller waves are seen in this pattern, which are labeled 1, 2, 3, 4, and 5. Even deeper within the Motive Wave, there are two types of smaller sub-waves: The Impulse Wave and the Diagonal Wave.
Waves 1,3 and 5 are called actionary sub-waves that advance. Waves 2 and 4 are called corrective sub-waves as the correct or move downward (opposite direction of the larger trend).
There are three rules that must be satisfied for the Motive Wave formation to form:
- Wave 2 always retraces less than 100% of Wave 1.
- Wave 4 always retraces less than 100% of Wave 3.
- Wave 3 always travels beyond the end of Wave 1 and is never the shortest wave.
The corrective wave is a three-wave structure that has its sub-waves labeled as A, B, and C. This is often misleading as not all corrective waves are three-wave structures.
As mentioned earlier, an Elliott cycle has an impulsive and a corrective wave; in other words, two market reactions labeled differently.
Elliott used numbers to label impulsive waves and letters to label corrective waves. According to Elliott when the market forms an impulsive wave, it does so in five separate waves. However, only three waves are needed to form a corrective wave.
Hence, the correct labeling of a market cycle under the Elliott Waves Theory is: 1-2-3-4-5 / a-b-c. The numbers show impulsive activity, and the letters, corrective activity.
Therefore, in a bearish cycle, the market declines in a five-wave structure and corrects in a three-wave structure.
So far, so good, however, the problem arises from the various degrees in which a cycle can be identified, depending on your time frame.
For instance, the 1-2-3-4-5 above may be the 1st wave of a larger impulsive wave pattern. And, the a-b-c in the image above could be the 2nd wave of the same impulsive wave pattern.
Alternatively, the 1-2-3-4-5 from above could be the a wave of a corrective wave pattern, and the a-b-c that follows could be the b wave belonging to the same corrective wave pattern.
Part One Summary:
- Elliott Waves Theory incorporates human sentiments like optimism and pessimism
- Investors label waves as impulsive and corrective
- Impulsive waves are five-wave patterns, corrective waves are three-wave patterns
- An Elliott cycle is formed out of an impulsive and corrective wave
Elliott Wave Theory: ZigZag Patterns Explained
A zigzag is the most deceivingly simple corrective pattern within the Elliott Waves Theory. And, for good reason.
When we discussed corrective waves within Elliott Theory in the previous section, we introduced the notion of a zigzag for the first time: an a-b-c or a three-wave structure that has two impulsive waves and one corrective wave. Please note, that the b-wave should not retrace more than 61.8% of the previous a-wave.
A-waves and c-waves are impulsive, and the b-wave is the only one to show corrective activity. The reason why it can deceive investors is that a zigzag has little or no pullbacks.
The b-wave retracement level is minimum of 1% of the a-wave and rarely exceeds the 38.2% level. If it does, the market most likely will not form a zigzag.
Moreover, a zigzag is the only corrective wave that can resemble impulsive activity. Therefore, it is relatively easy for investors to get “lost” in counting the wrong way because the market moves fast in a zigzag pattern.
Indeed, it resembles impulsive activity because it has not one, but two, impulsive waves in its structure. However, the overall pattern is corrective, not impulsive. Here’s how it breaks down. What would you make of the following market move?
When the market advances or declines in such an aggressive way, many investors count it as an impulsive wave. However, this is simply a zigzag formation.
On the left of this image, we can see the correct interpretation, and on the right, we see a wrong count. Most investors apply the wrong count despite the rules of an impulsive wave not being respected: namely, the 3rd wave in an impulsive wave MUST be impulsive too, which is not the case here, as there is no apparent five-wave structure.
The zigzag on the left has two five-wave structures, and therefore two impulsive waves (a- and c- waves denoted in blue). Note, the b-wave’s retracement is so small that by the time the second impulsive wave begins, another powerful sell-off takes market participants by surprise.
Based on the length of the c-wave, three types of zigzag can exist:
- normal – the most common one; c-wave is between 61.8% and 161.8% of the a-wave
- truncated – infrequent pattern; the c-wave is smaller than 61.8% of the a-wave
- elongated – suggests a triangle in the larger cycle; c-wave is longer than 161.8% of the a-wave
Part Two Summary
- Three types of zigzag exist; normal, truncated, and elongated
- The b-wave in a zigzag is smaller than 61.8% of the a-wave
- A zigzag is the only corrective wave that resembles the impulsive activity
- Elongated zigzags indicate triangle formations
Elliott Wave Theory: Introducing the X-Wave
The concept of the x-wave is often misunderstood in Elliott Waves Theory.
Elliott’s intention was to create a logical process to explain market moves; all of them!
He started by dividing moves into impulsive and corrective moves which we have covered in previous lessons, but there is much more to the Elliott Waves Theory.
There are various types of corrective waves, that form far more often than impulsive waves, and the key to understanding them is the x-wave.
Even the name should tell you this is always a corrective wave. Why? Well, it is labeled with a letter and, as we know, Elliott used letters to label corrective waves and numbers to label impulsive waves.
The x-wave is a connective wave; a wave that connects two simple corrections.
Think of the x-wave as links in a chain, connecting simple corrections in such a way that it defines the complex correction.
The x-wave tells us the nature of the complex correction, but we will discuss this further in another lesson. As a corrective wave on its own, the x-wave can also be simple or complex. For example, the x-wave can be a flat pattern, a zigzag, a triangle, or a complex correction in itself (albeit one of a smaller degree). Focus on the count in the magenta color in the below example.
The different colors on the image above show different cycles within the Elliott Waves Theory. In this case, the x-wave in magenta connects two simple corrections:
- An elongated flat pattern is an initial correction, labeled a-b-c, in magenta
- A zigzag is the following correction, also labeled a-b-c, in magenta
The connecting x-wave is a flat of a small degree. Or, a flat that belongs to a cycle one degree smaller (illustrated here with green letters).
So, we have a flat and a zigzag, with the x-wave acting as a connection between the two. The entire pattern is a complex correction and multiple types of corrections like this exist.
In this case, the x-wave is a simple corrective wave, a flat pattern. However, as mentioned earlier, it can also be a complex correction.
What if it were a complex correction? In that case, after the green a-b-c, an x-wave of the same degree would follow, and then another simple correction (flat, zigzag or triangle).
As we mentioned in previous lessons, trading with Elliott Theory can sometimes be a complicated and time-consuming process. It is not a technique, as it has no specific rules of entry or exit, nor is there one “right” way to use it in trading
However, if followed correctly, investors may gain insight into the most likely outcome for future price action. And in the end, this is what really matters when trading financial markets: to be right.
- The x-wave is always a corrective wave
- The x-wave can be a simple or a complex correction
- Corrective waves are more numerous than impulsive waves
- The x-wave acts as an intervening wave between two simple corrections
Elliott Wave Theory: Other Flat Patterns
As a simple correction, a flat pattern has two corrective waves (a-wave and b-wave) and an impulsive wave (c-wave). Moreover, the b-wave must retrace more than 61.8% of the a-wave.
In other words, the minimum condition for a flat is that the b-wave exceeds 61.8% of the previous a-wave. Once again, the golden ratio plays an important role in the Elliott Waves Theory.
For a pattern with three large swings, there are many types of flats. Elliott looked at the b-wave’s length to split flats into three categories.
The name refers to the inability of the b-wave to retrace much more than 61.8% of the previous a-wave. In fact, it’ll stop before the 80% retracement level.
Now that we have determined the b-wave’s retracement, the c-wave’s length tells us the type of flat pattern:
- B-failure – the c-wave is longer than the b-wave but no more than 138.2%
- Double failure – the c-wave is shorter than the b-wave
- Elongated flat – the c-wave is longer than 161.8% of the b-wave
This time the b-wave retraces beyond 80% of the a-wave, but no more than a full retracement. The types of flats in this category are:
- Common – the c-wave is longer than the b-wave but no more than 138.2%
- C-failure – the c-wave is shorter than the b-wave
- Elongated flat – the c-wave is longer than 161.8% of the b-wave
In this category, the b-wave retraces well beyond the start of the a-wave. The types of flats are:
- Irregular failure – the c-wave is shorter than the b-wave
- Irregular – the c-wave is longer than the b-wave but no more than 138.2%
- Elongated flat – the c-wave is longer than 161.8% of the b-wave
While it may look confusing with all these types of flats, the reason why they are listed like this is to emphasize what they have in common. Namely, the conditions that give the types of flats are similar for all categories; only the b-wave retracement criteria differ!
Let’s play a little game. Name the two types of the flat below based on the definitions above:
Remember, the key is the b-wave’s retracement. This will tell you the category. Next, focus on the c-wave’s length, as it will tell you the type of flat.
In the first example, the b-wave retraces between 80% and 100% of the a-wave, and the c-wave slightly exceeds the b-wave’s length. That’s a common flat!
On the right side, the b-wave exceeds the a-wave start, and the c-wave is much bigger than 161.8% of the b-wave. That’s an elongated flat!
You might say: so what? Well, Elliott established clear rules and places where each flat typically appears. Therefore, if you can correctly identify the type of the flat, it becomes easier to identify the larger wave, or, where you are with the count and what wave to expect next.
Part Three Summary:
- There are three categories of flat patterns; weak, normal and strong
- The length of the b-wave indicates the category and the length of the c-wave gives the type
- A 61.8% retracement is the minimum retracement for the b-wave
- Flats are the most common of simple corrective waves
Fibonacci Levels in the Elliott Wave Theory
If there is something that ties all of Elliott Waves Theory together, it is the Fibonacci ratios or levels. Every single pattern or concept within the theory depends on a Fibonacci ratio.
The Golden Ratio
The golden ratio or the 61.8% level alone is responsible for many rules within the theory:
- the b-wave of a flat pattern must retrace beyond the 61.8% of the a-wave
- the b-wave of a zigzag must retrace less than 61.8% of the a-wave
- in a horizontal triangle, the b-wave should not end around 61.8% of the a-wave
- the x-wave in a double or triple combination, zigzag or flat, should NOT exceed 61.8% of the previous correction
- the x-wave in a running correction will ALWAYS be longer than 61.8% of the previous correction
These are just a few examples showing the importance of the golden ratio in the Elliott Waves Theory. Some of them appear in the image below:
The 161.8% Level
The 161.8% level defines the minimum length of an impulsive move’s extended wave, and is the second most important Fibonacci ratio, following the golden ratio.
An impulsive wave has an extended wave, one that stands out from the rest. For any five-wave structure to qualify as an impulsive move, either the 1st, 3rd or 5th waves must be longer than 161.8% of the next longest wave.
The 161.8% ratio emphasizes the difference between different types of flats too. In this section of the course, we will cover all the various flat patterns. Some flats have a c-wave longer than 161.8% of the previous b-wave; these are elongated patterns and have a unique interpretation within the Elliott Theory.
The 38.2% Level
There are two cases in which the 38.2% level plays a crucial role:
- when trading the fourth wave in an impulsive move:
- the 4th wave rarely retraces beyond 38.2% of the previous 3rd
- when trading the b-wave of a zigzag:
- typically, the b-wave of a zigzag is just a small pullback;
- if the market has the power to retrace beyond the 38.2% level, the chances are it will form another pattern and not a zigzag.
The 23.6% and 123.6% Levels
These two levels refer to zigzags and flats. Most of the time the b-wave of a zigzag retraces only 23.6% of the previous a-wave, and the minimum retracement condition is just 1%.
As for the 123.6% level, the more of a flat’s c-wave that exceeds this level (when compared with the previous b-wave), the smaller the probability that the future price action will retrace the entire flat pattern.
Part four summary:
- The golden ratio is key to the Elliott Waves Theory
- The 161.8% is the second most important level after the golden ratio
- 2% is used when trading the b-wave of a zigzag, or the 4th wave of an impulsive move
- The minimum retracement level for the b-wave of a zigzag is 1%
Elliot Waves – Complex Corrections
A complex correction in Elliott Waves Theory consists of two or three simple corrective waves connected by one or two intermediary waves. Double or triple combinations are various combinations of simple corrective waves connected by one or two x-waves, respectively.
As we know from a previous lesson, simple corrective waves in Elliott Waves Theory can be:
- a flat,
- a zigzag, or
- a triangle
One important rule to keep in mind is that no complex correction can start with a triangle; any other combination is possible. A complex correction can take on the following forms:
- flat – x-wave – triangle
- zigzag – x-wave – flat
- flat – x-wave – flat
- zigzag – x-wave – zigzag – x-wave – triangle
We won’t list them all here, but they can be combined in every way possible, keeping in mind that:
- a complex correction must never start with a triangle; and
- there is a maximum of two x-waves connecting three simple corrections.
We will now take another look at the example we used in a previous lesson to discuss the concept of the x-wave. The difference this time is that we will build a so-called triple combination.
As the name suggests, a triple combination has three simple corrective waves connected by two x-waves.
In complex corrections, the length of the x-wave is essential. For example, in double and triple combinations, double and triple zigzags, and double and triple flats, the x-wave is “small”, meaning it retraces less than 61.8% of the previous correction.
In other cases, complex corrections have a large x-wave, which retraces more than the 61.8% level.
In any case, a triple combination has two small x-waves, and the second one may unfold as shown below:
Elliott found that a complex correction almost always ends with a triangle. According to this rule, the pattern following the second x-wave or the third simple correction will almost always be a triangle.
In this example, we used a horizontal contracting triangle, but it could be any of type of triangular formation:
- irregular triangle
- expanding triangle
- non-limiting triangle
- running triangle
This is crucial to understanding the concept behind the Elliott Waves Theory. It is especially important when trading the currency market due to complex market swings and high-volatility driven by trading algorithms.
The following lessons covering Elliott Theory will use the concepts explained so far. Keep in mind that this theory combines everything until the appropriate path is revealed.
Part Five Summary:
- Complex corrections have minimum one and maximum of two x-waves
- Complex corrections never start with a triangle
- Complex corrections are combinations of simple corrections connected with x-waves
- There is a maximum of 3 simple corrections in any given complex correction
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