Elliot Waves: phases and rules
Elliott Waves are a popular form of technical analysis which were developed by Ralph Nelson Elliott in the 1930’s. Elliott had observed that markets tend to move in recognisable patterns (like all technical analysis!) and these were created by recurring investor behaviour - which he termed behaviours based on either ‘fear’ or ‘enthusiasm’.
An Elliott Wave has two basic phases known as the:
- impulse or motive phase
- reactionary or corrective phase
Whilst this may seem complicated at first, these types of phases are much easier to understand once visualised on a chart (see below).
In summary though Elliott described the impulse phase as always moving in the direction of the trend, whereas the corrective phase always moves against it. What this means is that, in a bull market, the impulse phase will be moving upwards while the corrective phase will be moving downward. Conversely, in a bearish market the impulse phase will move downward and the corrective phase will move upward. When you look at long term charts you can indeed see that these types of phases can be observed - check out virtually any instrument or market and you will see that is rarely a straight line either up or down.
Moving on, the author then describes that to complete an Elliott Wave sequence you need eight waves which consist of five waves in the impulse phase (1, 2, 3, 4 and 5) and three waves in the corrective phase (A, B and C). The impulsive phase waves 1, 3 and 5 move in the direction of the trend, while waves 2 and 4 are corrective and move against the trend. Within the corrective phase, waves A and C move against the trend and are corrective, and B is an impulse wave. Below are examples of the sequences and phases discussed for further understanding.
Finally, Elliott stipulated that there are certain rules that must be applied to confirm his idea of an Elliott setup. These are:
- Wave 3 cannot be the shortest wave
This rule means that Wave 3 is always longer than at least one of the other two waves (Waves 1 or 2). Usually, Wave 3 is longer than both these waves.
- Wave 4 cannot overlap the price ‘territory’ of Wave 1.
This means the end of Wave 4 should not trade below the peak of Wave 1.
Elliott Waves are a famous setup and well known within trading. Many experienced traders use them over longer time frames to help them visualise the market from a top-down perspective. As you learn more about trading you will see that many of the ideas that Elliott outlined are indeed correct (for example, downtrends occurring within an overall uptrend). We believe that whilst Elliott waves are an advanced form of technical analysis to learn, the approach holds many important techniques that can help you in the long run. Once you have mastered the number of waves and phases that he describes Elliott Waves should be more easy to spot.
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