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Elliott Wave Theory

According to the Elliott Wave Principle, mass crowd psychology common to exchange market participants passes through certain cycles: expansion, enthusiasm, euphoria, sedation, decline, and depression.

Basic tenets
(1)(3)(5)(А)(С) – impulsive waves
(2)(4)(B) – corrective waves
A five-wave growth phase (impulse) is followed by a three-wave corrective movement. Corrective waves are labeled (A), (B), and (C). Regardless of the wave degree, the trend will always develop in an eight-wave cycle. Waves may divide (3 or 5). This division depends on the direction of a larger wave. Thus, waves (1)(3)(5) are broken down into five sub-waves each, with wave I being a rising structure. Waves (2)(4) are divided into three sub-waves of a smaller degree as these two waves move against the trend. Waves (A)(B)(C) make up larger-degree corrective wave II. (A)(C) are divided into five sub-waves as they coincide with the direction of a senior trend II. (B) consists of three sub-waves as it moves against trend II.

Rule 1:
Correction cannot consist of five waves.
A five-wave decline in an overall uptrend indicates with a high degree of certainty wave I of a three-wave (A)(B)(C) decline, which means that this decline will continue. In a bear market, a downtrend should resume following a three-wave advance. In turn, a five-wave impulse warns of an upcoming stronger upward movement of prices. This wave may prove to be wave I in a bearish trend. Below we will look at some characteristics of Elliott waves regardless of their hierarchy.

  • Wave 1
    Almost half of all first waves occur at a market bottom and represent a rebound from the lowest levels. As a rule, wave 1 is the shortest of all five impulsive waves. It tends to be very dynamic at a market bottom.
  • Wave 2
    It usually retraces all or almost all of wave 1 but still remains above the first wave bottom.
  • Wave 3
    It is the longest and most dynamic of all five impulsive waves. The crossing of wave 3 and the top of wave 1 records all types of classical breakouts and sends out a signal to open long positions. This wave usually generates the greatest trading volume. Wave 3 can never be the shortest of five impulsive waves.
  • Wave 4
    Wave 4 has a complex structure. As well as wave 2, it represents the phase of correction or consolidation but differs in structure (according to the rule of alternation). It may often form triangles.

Rule 2:
The bottom of wave 4 should not overlap the top of wave 1.

  • Wave 5
    Wave 5 is much less dynamic than wave 3. During this wave, many technical indicators (oscillators) lag behind the price movement. Negative divergence occurs indicating an upcoming market peak.
  • Wave A
    Wave A appears once the movement is divided into five smaller waves. An increase in trading volume corresponds to a price decline.
  • Wave B
    This wave reflects an upward rebound in prices in a new downtrend. In this case, the price forms a double top. Wave B usually has a low volume and may even exceed the peak of wave 5.
  • Wave C
    Wave C is often reduced below the bottom of wave A. Notably, the Head and shoulders pattern appears on a price chart as a result of drawing a trend line under the bottom of wave 4 and wave A.

Wave extensions

FIRST WAVE EXTENSION
BULL-BEAR


THIRD WAVE EXTENSION
BULL-BEAR

FIFTH WAVE EXTENSION
BULL-BEAR

* Only one of the impulsive waves may be extended while the other two retain the same timing and length.

Double correction of fifth wave extensions

Diagonal Triangles
Rising wedge

* This bearish formation occurs in the last fifth wave, representing a weakening market. The rising wedge pattern has five waves, each of them is broken down into three sub-waves. Trend lines always converge. A break of the steepest line signals a significant reversal of the prior market trend.

Falling wedge

* This is the opposite formation of the rising wedge. Falling wedge is always a bearish pattern.

FAILURES
BULL-BEAR

* Occurs in the final fifth wave. Wave 5 is broken down into five sub-waves but the last one does not reach the top of wave 3.

Corrective waves
Rule: Corrective waves are never divided into five sub-waves (except for triangles). Corrective waves consist of three sub-waves. They fall into four main categories: zigzags, flats, triangles, double and triple threes.

Zigzags are simple three-wave countertrend sequences (5-3-5). Wave (B) is lower than the start point of wave (A). Wave (C) noticeably overlaps the end of wave (A).
BULL-BEAR

Double zigzag
Often occurs in large patterns (M), (W).

Flats
These waves form a 3-3-5 sequence. Wave (A) consists of three sub-waves. A flat is rather a consolidation than a correction.
Wave (B) reaches the top of wave (A), indicating a higher market potential. The final wave (C) terminates near the end of wave (A) or slightly lower, and vice versa for a bearish trend.
BULL-BEAR

There are two exceptions to 3-3-5 flats.
The top of wave (B) is noticeably higher than the peak of wave (A). Wave (C) is below the bottom of wave (A) in a bull market, and vice versa in a bear market.
BULL-BEAR

Inverse irregular flat correction
Wave B reaches the top of wave A while wave C does not fall to the bottom level of wave A. In this case, a bull market has a higher potential, and vice versa for a bearish trend.

Running correction
This pattern occurs in very rare cases and indicates an extremely strong market potential.

Triangles


Triangles tend to occur in the fourth wave. They may also appear in wave (B) that is part of a corrective sequence (A)(B)(C). Therefore, during an upward trend they may be characterized as a bullish and bearish formation at the same time. A triangle usually represents a continuation pattern unless it is not a peak. As a rule, it continues the current trend after another impulsive wave.
Triangle peak (i.e., the point where all trend lines meet) often corresponds to the termination point (5) of the last wave.

Double threes

Rule of alternation:
If wave 2 is a simple corrective model (a)(b)(c), then wave (4) is most likely to form a triangle, and vice versa.

Critics of the Elliott Wave Theory claim that interpretations of this method are extremely subjective and the basic principles are too difficult to grasp. Indeed, several analysts may interpret the same data and come up with completely different forecasts based on this theory. In order to minimize errors when making trade decisions, we recommend using a number of additional technical indicators along with the Elliott Wave analysis.

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