Elliott Wave Theory: A Concise Guide

Key takeaways
* Elliott Wave Theory interprets market price movements as recurring, fractal wave patterns driven by investor psychology.
* Price action alternates between motive (impulse) waves and corrective waves; impulses typically subdivide into five waves, corrections into three (with exceptions).
* Wave relationships often align with Fibonacci ratios (commonly ~38% and ~62%), which traders use to estimate targets and retracements.
* Wave counting is inherently subjective; combine Elliott analysis with other technical tools and risk management.

What is Elliott Wave Theory?

Elliott Wave Theory, developed by Ralph Nelson Elliott in the 1930s, describes how financial markets move in recurring patterns (waves) that reflect collective investor sentiment. These patterns are fractal: the same basic structure appears across timeframes, allowing analysts to interpret short-term and long-term trends simultaneously.

Core principles
* Markets alternate between trend-following (motive/impulse) phases and countertrend (corrective) phases.
* Motive phases push the market in the direction of the larger trend and typically subdivide into five waves.
* Corrective phases move against the larger trend and most often take three-wave forms, though other corrective structures exist.
* Wave structure and relationships often conform to Fibonacci ratios, which help estimate retracements and extensions.
* Interpretation is probabilistic, not deterministic—wave counts can be relabeled as new information appears.

Impulse waves (motive structure)
* An impulse consists of five sub-waves labeled 1–5:
* Waves 1, 3, and 5 are motive (in the direction of the larger trend).
* Waves 2 and 4 are corrective (shorter retracements).
* Key rules for a valid impulse:
1. Wave 2 cannot retrace beyond the start of Wave 1.
2. Wave 3 cannot be the shortest among Waves 1, 3, and 5.
3. Wave 4 must not overlap the price territory of Wave 1.
4. Wave 5 often ends with momentum divergence (price makes a new high/low while an oscillator does not).
* If any rule is violated, the structure should be relabeled—it’s not a valid impulse.

Corrective waves
* The most common corrective form is the three-wave A–B–C structure, which moves against the trend of the next-largest degree.
* Diagonals (a type of corrective/motive-looking pattern) can appear as expanding or contracting wedges and may be subdivided differently:
* Diagonals sometimes display five sub-waves but with characteristics that distinguish them from standard impulses (overlaps and differing internal counts).
* Sub-waves within diagonals may not always follow the standard five/three counts; rules vary by diagonal type.
* Corrective patterns can be complex (combinations of simpler corrections) and are generally harder to count reliably than impulses.

Fibonacci relationships
* Elliott observed frequent relationships between wave lengths and Fibonacci ratios.
* Common retracements for corrective waves include roughly 38% and 62% of the preceding impulse.
* Traders use Fibonacci extensions and retracements alongside wave counts to estimate targets and invalidation points.

Applying Elliott Wave to trading
* Typical approach: identify the current wave degree and structure, enter trades in the direction of an identified impulse, and exit or reverse when the impulse completes and a corrective phase begins.
* Because wave interpretation is subjective, many traders confirm counts with other technical tools (moving averages, oscillators, volume) and use strict position sizing and stop-loss rules.
* Automated tools and indicators (e.g., Elliott Wave Oscillators or algorithmic wave-scan systems) can assist but do not remove the need for judgment.

Limitations
* Wave counts are subjective and can change as new price data arrives.
* Patterns do not guarantee outcomes; they indicate probabilities and scenarios rather than certainties.
* Reliance solely on Elliott analysis without complementary techniques increases risk.

Conclusion

Elliott Wave Theory offers a structured way to analyze market psychology and price action through fractal wave patterns. When used with other technical tools and sound risk management, it can provide useful insight into likely trend continuation and reversal points—but it requires practice, flexible labeling, and cautious application.