One of the most popular trading theories is represented by Elliott Waves. In principle, it is a very simple theory but exactly this simplicity makes it complex as traders end up being confused about the count.
To begin with, it should be mentioned that Elliott divided market moves in impulsive and corrective waves.
An impulsive wave is a five wave structure, labeled with numbers (1-2-3-4-5), and a corrective wave is a three wave structure, labeled with letters (a-b-c). Therefore, the overall theory could be resumed as a five waves corrected with three waves.
Out of those five waves that make up an impulsive wave, the second and the fourth ones are corrective, and the first, the third and the fifth ones are impulsive. This takes place of a lower degree, and the overall 1-2-3-4-5 move should be considered an impulsive wave of a bigger degree.
This is what makes Elliott Waves theory so difficult to understand: the fact that different degrees (cycles) should be taken into account and when a new move starts it is very difficult to know exactly what kind of a cycle started.
There are multiple types of impulsive waves and it is being said that an impulsive wave has at least one wave that is extended and it refers to the three impulsive waves of a lower degree: waves one, three and five. This means that one wave should be bigger than 161.8% then the other two and that is the minimum distance for the extension to be valid.
Based on which wave finally extends, impulsive waves are classified in: first wave, third wave and fifth wave extensions. The most popular is the third wave extension, with the fifth wave extension being the one that forms very rare.
Double extended impulsive waves are also being very common, especially on the forex market, when brokers are seeing a lot of margin calls being triggered on client’s accounts.
The reason for that comes from the fact that by the time the third wave travels more than 161.8% when compared with the length of the first wave, many traders are opening positions in the opposite direction on the idea that the extension is already completed.
In reality, if it is a double extended impulsive move that if forming, then the fifth wave will be so powerful that it will be minimum 161.8% when compared with the already extended third wave, therefore triggering a lot of stops.
Despite general belief, impulsive waves are not that common. Market spends a lot of time in consolidation and this makes corrective waves very common.
Moreover, some trading sessions are having less volatility than others, with the Asian session being the slower one overall. Because of that, chances are that most of the times during the Asian session market is consolidating, while travelling in the London and/or North American session.
According to Elliott Waves, there are only three types of corrective waves: flats, zigzags and triangles. These are being called simple corrections and are labeled only with letters.
However, there are multiple complex corrections that involve connective or intervening waves, or x waves, and this is where the Elliott Waves theory becomes confusing.
Elliott Waves cannot exist without Fibonacci as everything is related to a Fibonacci retracement or extension level.
For example, in a flat pattern, which is an a-b-c structure, wave b is mandatory to retrace more than 61.8% of wave a. Therefore, the thing to do is to measure the length of wave a and look to see if the b wave is retracing more than 61.8%. If yes, most likely the market is forming a flat pattern.
A zigzag on the other hand should not have the b wave retracing more than 61.8% as again the golden ratio holds the key to correctly interpret the pattern, and the examples can go on and on.
Triangles are very common and despite the fact that they are corrective waves, they actually have a five wave structure (a-b-c-d-e). A triangle has no more no less than five waves and all these waves are corrective waves as well (either a flat, zigzag, triangle or complex corrections based on these three corrective waves).
In some cases, Elliott Waves theory allows a trader to put a time horizon to a price target and if price is not doing that, or not going at that specific level in that amount of time, the trade should be closed.
In this instance it means that the stop loss or invalidation is being also given in time and not only in price and mastering Elliott will offer the opportunity to trade with price and time, which is a great competitive advantage when it comes to forecasting future prices.
As mentioned earlier, complex corrections are having at least one x wave and maximum two x waves, or intervening x waves. It should be noted here that an x wave is always a corrective wave, so no impulsive wave should be labeled as an x wave. I would say this is obvious as being labeled with a letter implies the move is not impulsive.
Based on the length of the x wave, complex corrections are subdividing even more, into corrections with large or small intervening wave, opening the gates for multiple possibilities when it comes to the patterns price can form.
To sum up, Elliott Waves represents five waves up corrected with three waves down (in a bullish trend) or five waves down corrected with three waves down (in a bearish trend), and these moves can be either impulsive or corrective.
In order to make a valid forecast though, one needs to know exactly the conditions for these impulsive and corrective waves and what are the targets and stops that result from labeling them.
