This theory, which was created by Ralph Nelson Elliot, appeared for the first time on the Financial World magazine in 1939. The theory was then deepened by Hamilton Bolton between 1950 and 1960 (after the death of Elliot).

Inspired by Charles Dow, Dow's theory and the observation of natural phenomena, Elliot took advantage of a period of convalescence to study the movements of the stock markets, concluding that the movements of the stock markets (such as the movements of any other phenomenon present in nature) can be predicted by simply observing their behaviors, identifying repetitive behaviors (patterns). Elliot in fact thought that all the natural phenomena, not just the stock market, were regulated by these waves identified by him.

 

The Elliot Wave Theory – in practice

Elliot discovered that a trend was created by means of 5 waves, which were promptly corrected by 3 successive waves:

This formation is visible, according to Ellito, in all time frames, on any chart.

Here is the explanation of the individual phases of a trend

0. It is were the trend originates from
1. The first rise, in the case of an uptrend, is usually a decided rise.
2. The first increase undergoes a correction which, generally, reaches the level equal to 50% of the first movement. This fall is attributable to sellers who still think they are in a bearish trend.
3. The bears, obviously, were wrong and the trend starts up again on the upside. The sellers' stop losses are reached and, when they are taken, they feed the price to rise even more.
4.  Buyers begin, gradually, to take profit, which generates a second period in which the market corrects downwards.
5.  Seeing the correction in progress, all the buyers who have remained dry for now, open up bullish positions, pushing the upward trend, above the 3 wave
.

Generally, the force is no longer strong as the one that was present in wave 3, and the market is now preparing for an inversion.

At this point, according to Elliot, the real corrective phase begins, represented by three waves of opposite sense, then downward, which can be of three different types:

 

1. Zig zag

It represents the classical and more common formation, with the wave B that retraces inside the wave A and with the wave C that retraces inside the wave B.

2. Flat

This is a flat movement in which the market does not have a well-defined direction.

3. Triangle

This type of correction is generally formed by 5 internal waves.

Summing it up, there is an impulsive movement formed by 5 waves, followed by a corrective movement formed by 3 waves. Whatever happens on one-time frame (e.g. daily) will happen in the other time frames too.

Elliot waves price characteristics and objectives

The various waves have different probable objectives. The analyst's goal is to search for price zones in which one has to obey oneself. These zones become particularly important levels to be used both as entry points and as exit points (target price).

Wave 1 generally begins with a sharp reversal of the trend.

Wave 2 generally retraces wave 1 by 50% or 62%.

Wave 3 is often characterized by the presence of gaps and the volume is always very strong. Wave three, in general, is 162% long, or 175% or 262% of wave 1.

Wave 4 is a corrective wave, where traders make a profit. At this stage there are many false faults, also due to the low presence of volumes. This wave retraces wave 3 generally by 30% / 50%.

Wave 5 is the last attempt to continue the trend. This last wave is 62% long, or 100%, or 162% of wave 1.

In order to know when we are at the end of the 5 wave cycle, we can use this simple calculation.

Example for an upward trend:

- We calculate the length between the zero point and the end of the wave 3, after which I add this length to the minimum of the wave number 4, obtaining the target A for wave 5.

- We calculate the length between the zero point and the end of the wave 3 and multiply it by 0.62. I add what was obtained number with wave 4 obtaining the target B of wave 5.

The area between points A and B is an area where wave 5 is most likely to end its course.

The numbers we used as multipliers (0.62; 1.62 etc) are numbers extrapolated from the Fibonacci numerical series.

How to recognize Elliot Waves with MACD indicator

Bill Williams and Tom Joseph have created a method to recognize the different waves, through the use of a well-known technical analysis indicator, the MACD.

These gentlemen have discovered that, on  wave 3, the indicator produces the maximum extension of the histogram, on wave 4 it reaches and exceeds the zero line and, on  wave 5, the indicator does not exceed the height that had in conjunction with wave 3.

Summarizing we can say that wave 3 is signaled by the maximum height of the indicator, wave 4 is signaled by the indicator that passes below zero and that wave 5 is detected thanks to the divergence between price and indicator.