Elliott Wave Theory
Understand market structure through wave patterns. Learn the 5-3 wave pattern that governs all financial markets.
What is Elliott Wave Theory?
A method of technical analysis that identifies repeating wave patterns in price charts, discovered by Ralph Nelson Elliott in the 1930s.
Elliott observed that market prices move in predictable patterns he called "waves." These waves reflect the collective psychology of market participants - optimism and pessimism, fear and greed.
The basic structure consists of 5 waves in the direction of the main trend (impulse waves), followed by 3 waves against it (corrective waves). This 5-3 pattern repeats at every scale, from minute charts to multi-decade cycles.
The Basic Pattern
5
/\
/ \ B
/ \ /\
3 X \
/\ A C
/ \
/ 4
1
\ /
\ /
2
5 impulse waves (1-2-3-4-5) followed by 3 corrective waves (A-B-C)
The 5 Impulse Waves
Impulse waves move in the direction of the main trend. Waves 1, 3, and 5 are motive (trending), while 2 and 4 are corrective (counter-trend).
Wave 1
The initial move in the direction of the new trend. Often goes unnoticed by most traders. Small group of investors start buying.
- Usually the shortest impulse wave
- Often occurs during pessimism
- Low volume, hesitant start
Wave 2
A corrective move against Wave 1, never retracing more than 100% of Wave 1. Tests the conviction of early bulls.
- Retraces 50-78.6% of Wave 1
- Cannot go below Wave 1's starting point
- Often a sharp, sudden decline
Wave 3
The most powerful wave, never the shortest. Strong momentum as the trend becomes obvious to the broader market.
- Usually the longest wave
- High volume confirmation
- Breakouts through resistance
- 1.618x Wave 1 is common target
Wave 4
A corrective wave that prepares for the final push. Cannot overlap with Wave 1's territory.
- Often sideways consolidation
- Less sharp than Wave 2
- May form triangles or flats
- Cannot enter Wave 1 price territory
Wave 5
The final move of the impulse. Often driven by retail traders joining late. May show divergence with momentum indicators.
- Equal to or 61.8% of Wave 1
- Momentum divergence common
- Volume often lower than Wave 3
- Euphoria in uptrends, despair in downtrends
The 3 Corrective Waves
After the 5-wave impulse, a 3-wave correction follows. These waves move against the main trend and are labeled A, B, C.
Wave A
The first leg of the correction against the main trend. Many traders see this as a pullback to buy.
- Often mistaken for a dip
- Sharp decline from Wave 5
- Volume starts to increase
Wave B
A counter-trend rally within the correction. Traps traders who think the trend is resuming.
- Bull trap in downtrends
- Usually weaker than Wave A
- Lower volume
- Can nearly reach Wave 5 highs
Wave C
The final corrective wave. Often extends to 1.618x Wave A. Capitulation of the previous trend.
- Usually equals Wave A in length
- Can extend to 1.618x Wave A
- High volume, panic selling/buying
- Completes the correction
Fibonacci Relationships
Elliott waves are closely tied to Fibonacci ratios. Use these relationships to project wave targets and validate counts.
| Wave | Typical Relationship | Note |
|---|---|---|
| Wave 2 | 50% - 78.6% of Wave 1 | Must not exceed 100% |
| Wave 3 | 1.618x - 2.618x Wave 1 | Never the shortest |
| Wave 4 | 38.2% - 50% of Wave 3 | Cannot enter Wave 1 territory |
| Wave 5 | Equal to Wave 1 or 0.618x Wave 1 | May extend to 1.618x Wave 1 |
| Wave C | Equal to Wave A or 1.618x Wave A | Often extends in strong corrections |
Rules & Guidelines
Elliott Wave has three unbreakable rules and several guidelines. Breaking a rule means your wave count is wrong.
The 3 Unbreakable Rules
Wave 2 Cannot Retrace Beyond Wave 1's Start
If Wave 2 breaks below Wave 1's starting point, your wave count is wrong.
Wave 3 Is Never the Shortest
Wave 3 must be longer than at least one of the other impulse waves (1 or 5).
Wave 4 Cannot Enter Wave 1 Territory
In an uptrend, Wave 4's low cannot overlap with Wave 1's high. No overlap allowed.
Guidelines (Not Rules)
Alternation
If Wave 2 is sharp, Wave 4 tends to be sideways (and vice versa).
Wave 3 Volume
Volume should be highest during Wave 3, confirming the trend strength.
Fifth Wave Divergence
RSI often shows bearish divergence at Wave 5 tops (higher price, lower RSI).
Channel Lines
Waves 2 and 4 bottoms can be connected to form a channel. Wave 3 often exceeds it.
Trading with Elliott Wave
Practical applications of wave theory for real trading decisions.
Entry Points
Enter at the start of Wave 3 (after Wave 2 correction) or Wave 5 (after Wave 4 correction). Wave 3 entries have the best risk/reward.
Profit Targets
Use Fibonacci extensions to project wave targets. Wave 3 often reaches 1.618x Wave 1. Wave 5 often equals Wave 1.
Stop Loss Placement
Place stops just below Wave 2 low when entering Wave 3, or below Wave 4 low when entering Wave 5.
Trend Reversal Signals
After a 5-wave impulse, expect a 3-wave correction. Use ABC patterns to identify the end of corrections.
Pro tip: Don't trade Wave 1 or Wave A - too uncertain. Focus on Wave 3 entries (highest probability) and Wave 5 (end of trend). Always confirm with price action and other indicators.
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Elliott Wave FAQs
Common questions about wave analysis.
Is Elliott Wave Theory reliable?
Elliott Wave provides a framework for market structure, but it's subjective and open to interpretation. Two analysts can see different wave counts on the same chart. It works best combined with other analysis methods (Fibonacci, support/resistance). Don't rely on it exclusively.
How do I know which wave I'm in?
This is the hardest part of Elliott Wave. Use the three rules to eliminate invalid counts. Look at volume, momentum divergence, and Fibonacci retracements for clues. Wave 3 has highest volume, Wave 5 often shows divergence. Practice identifying completed patterns before trading live.
What timeframe works best for Elliott Wave?
Elliott Wave is fractal, meaning patterns exist on all timeframes. Higher timeframes (Daily, Weekly) give clearer patterns but fewer trades. Lower timeframes (1H, 4H) have more noise. Start with 4H or Daily charts to learn, then zoom in for entries.
Can I use Elliott Wave for day trading?
Yes, but it's more challenging on lower timeframes due to increased noise. Day traders typically use Elliott Wave on 1H charts for structure, then drop to 15min or 5min for entries. Always align with higher timeframe wave counts.
Do I need special software for Elliott Wave analysis?
No. Any charting platform with trend lines and Fibonacci tools works. TradingView has Elliott Wave drawing tools built-in. MetaTrader platforms have similar capabilities. The analysis is manual - there's no reliable automated wave counting software.
Ready to Apply Elliott Wave?
Practice identifying waves on historical charts first. Then test your analysis with a demo account before risking real money.
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