The Trend is Your Friend: Basic Elliott Waves Explained

4 Okt 2020

In this post, I'll be providing an in-depth explanation on Elliott Waves, specifically Impulse Waves and Corrective Waves.
I personally use Elliott Waves a lot, and as it seems like the majority of my followers are beginner traders unfamiliar with the concept of waves, I decided to do an educational post on it.
The concept of Elliott Wave Counts are extremely technical and advanced, so in this post, I'll only be going over the two most common waves: The Impulse and Corrective Waves

Elliott Waves Background Information
The Elliott Wave Theory was named after Ralph Nelson Elliott, who concluded that the movement of assets could be predicted by observing and identifying a repetitive pattern of waves. He was able to identify specific characteristics of wave patterns, making detailed predictions based on the patterns.

Very simply put, the direction of a trend unfolds in 5 waves (impulse waves) and any correction against the trend takes place in 3 waves (corrective waves). The 5 impulse waves are labelled ‘12345’, and the corrective waves are labelled ‘abc’.
*A bear market would show a downward trend, indicating that we’d see five waves down, and three waves up.

Smaller patterns can be identified within bigger patterns. As demonstrated in the diagram above, we can see that the impulse and corrective waves in green, are combined to form a larger wave in black, which is also part of a larger wave in red.

In technical terms, this is the classification of wave degrees. On Tradingview, the smallest to largest, the degree goes as follows: Miniscule, Submicro, Micro, Subminuette, Minuette, Minute, Minor, Intermediate, Primary, Cycle, Supercycle, Grand Supercycle, Submillennium, Millennium, Supermillennium.

The idea of using smaller patterns fit into bigger patterns, can be coupled with the Fibonacci relationship of the waves, offering insight on optimal levels of trade opportunities, and calculations of risk reward ratios (RRR).

What are Fibonacci levels?
Simply put, Fibonacci levels are a series of numbers discovered by Leonardo Fibonacci, in which a golden ratio (1.681) is derived by dividing a Fibonacci number with another previous Fibonacci number.
The Golden Ratio derived through the Fibonacci can be found in predictable patterns in nature from atoms to huge stars in the sky, as nature uses this ratio to maintain balance. Such ratios are very commonly found in the financial markets as well.

Elliott Impulse Waves (12345)
The Elliott Impulse Wave, which unfolds in 5 waves, has a few guidelines in terms of the rules that must be kept, and references to the Fibonacci ratio.
- An Impulse Wave can be subdivided into 5 waves (For instance, the black wave in the diagram is subdivided into smaller green waves)
- Wave 1, 3, and 5 are impulsive.
- Wave 2 cannot retrace more than the beginning of wave 1
- Wave 3 cannot be the shortest wave of the three impulse waves
- Wave 4 cannot retrace below the peak of wave 1
- Wave 5 needs to end with a momentum divergence
- In terms of Fibonacci ratios, there is not set answer, but there are some references we need to keep in mind:
- Wave 2 is 0.5, 0.618, 0.764, 0.854 of Wave 1
- Wave 3 is 1.618, 2, 2.618, or 3.236 of Wave 1-2
- Wave 4 is 0.146, 0.236, or 0.382 of Wave 3, but no more than 0.5
- Wave 5 can be the inverse 1.23611.618 retracement of wave 4, or 0.618 of wave 1-3, or equal to wave 1.

Elliott Corrective Waves (ABC)
When referring to corrective waves, this can include the use of other wave counts. In this post, we’ll be specifically looking at a corrective count also known as the Zigzag.
- A Zigzag is a corrective 3 waves structure that is counted as ABC
- Subdivision of Wave A and C comes in 5 waves
- A Zigzag is a 5-3-5 structure (In the diagram above, we can see the black Zigzag waves, which consist of a 5-3-5 wave count in green)
- Wave B is 0.5, 0.618. 0.764, or 0.854 of wave A
- Wave C is 0.618, 1, or 1.236 of wave A
- If wave C is 1.618 of wave A, it can either be a 3 or 5 waves count.

Application
We can take a look at Bitcoin’s weekly chart as an example of how Elliott Waves work. While I haven’t included the specific counts for simplicity sake, it provides a good idea of how the market moves.
Overall, we can clearly see that the trend is bullish. However, prices don’t always shoot straight up without stopping. It breaks out, corrects slightly, and breaks out again. The repetition of impulse waves, and smaller corrective waves, is what completes the uptrend.
This is why ‘buying the dip’ is a smart move during a bull market. Corrections are inevitable even in the most bullish market, and taking into consideration the fact that the trend is your friend, such corrections would merely be a buying opportunity.
Almost all assets take one step back for two steps forward. This is how the market works according to the Elliott Wave Theory.

Limitations
Elliott Waves have a critical weakness: it’s extremely subjective. Even while looking at the same chart, traders can count different waves, as it’s difficult to pinpoint the beginning or end of a wave. As with many other tools in predicting the market, it seems that the most common case is that traders are almost 100% accurate, or completely wrong.
As such, I personally like to use this tool merely as a reference in weighing out probable scenarios, rather than solely relying on my rather subjective wave count.

Final Remarks
I tried to dissect the basics of the Elliott Wave theory in this post. The concept itself is extremely advanced, and the explanation I provided above is merely the tip of the iceberg. Understanding Elliott Waves, while it’s not a silver bullet in trading, can help traders understand the overall trend, identify probable scenarios, and calculate optimal risk reward ratios based on wave targets.

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I would also appreciate it if you could leave a comment below with some original insight.