Elliott Wave Theory for Beginners

To the untrained eye, the ebbs and flows of the market can seem random and chaotic.

Imagine if you could decode these patterns and use them to predict future market movements with greater accuracy. Elliott Wave Theory offers precisely that—a structured approach to understanding and forecasting market trends based on well-defined wave patterns.

In this article, you’ll get an introduction to Elliott Wave Theory. We will discuss the basics of identifying impulse and corrective waves and explain how Fibonacci tools are used in this context. By the end, you’ll have a foundational understanding to start exploring the world of Elliott Wave Theory and its application in market analysis.

The Basics of Elliott Wave Theory

Elliott Wave Theory is a popular method of technical analysis used by traders to predict market movements. It was developed by Ralph Nelson Elliott in the 1930s and is based on the idea that market prices move in predictable patterns due to investor psychology.

Elliott Wave Theory suggests that financial markets move in a series of waves, which can be divided into two types:

1. Impulse Waves: These move in the direction of the overall trend and consist of five smaller waves.
2. Corrective Waves: These move against the overall trend and consist of three smaller waves. A correction can never take place in five waves.

An entire market cycle is made up of eight waves: five impulse waves (1, 2, 3, 4, 5) followed by three corrective waves (A, B, C).

Impulse Waves

1. Wave 1: The market starts to move in the direction of the new trend.
2. Wave 2: The market pulls back but does not retrace the entirety of Wave 1.
3. Wave 3: The strongest and longest wave, moving significantly in the direction of the trend.
4. Wave 4: Another pullback, but less severe than Wave 2.
5. Wave 5: The final move in the direction of the trend, often not as strong as Wave 3.

Corrective Waves

1. Wave A: The market moves against the trend.
2. Wave B: A temporary reversal back in the direction of the trend.
3. Wave C: The market moves again against the trend, completing the correction.

Using Fibonacci Numbers with Elliott Wave Theory

When combined with Fibonacci numbers, Elliott Wave Theory becomes a powerful tool for making trading decisions.

Fibonacci was an Italian mathematician born around 1170 who introduced the Fibonacci sequence to Western mathematics.

Elliott Wave Theory and the Fibonacci numbers are intertwined because the wave patterns identified by Elliott follow the Fibonacci sequence.

The Fibonacci sequence begins with 0 and 1, and each subsequent number is the sum of the previous two. The sequence goes 0, 1, 1, 2, 3, 5, 8, 13, 21, etc. This sequence gives rise to several important ratios used in predicting market movements, such as 0.618 (61.8%), 0.382 (38.2%), and 1.618 (161.8%), which are crucial in predicting market movements.

Here’s how the key Fibonacci ratios are calculated:

1. 0.618 (61.8%)

This is known as the “Golden Ratio.” It is derived by dividing a number in the sequence by the number that follows it. As you progress further along the sequence, the ratio approaches 0.618. For example:

• 13 ÷ 21 ≈ 0.619
• 21 ÷ 34 ≈ 0.618

2. 0.382 (38.2%)

This ratio is derived by dividing a number in the sequence by the number that is two places to the right. As you move along the sequence, this ratio approaches 0.382. For example:

• 13 ÷ 34 ≈ 0.382
• 21 ÷ 55 ≈ 0.382

3. 1.618 (161.8%)

This is the inverse of 0.618. It is calculated by dividing a number in the sequence by the number that precedes it. As you progress along the sequence, the ratio approaches 1.618. For example:

• 21 ÷ 13 ≈ 1.615
• 34 ÷ 21 ≈ 1.619

Why are these ratios important in predicting market movements? Traders believe that these ratios can help identify potential reversal points in the market.

Here’s the deal:

• 0.618 (61.8%): This ratio is considered the “golden ratio” and is thought to represent the point at which a correction in the market is likely to end.
• 0.382 (38.2%): This ratio is seen as a secondary reversal point, where the market might change direction.
• 1.618 (161.8%): This ratio is used to identify potential target levels for price movements.

In Elliott Wave Theory, these ratios are used to predict the length of waves in market trends. For example, wave 3 is often 1.618 times the length of wave 1. Wave 2 often retraces 50% or 61.8% of Wave 1. Wave 4 often retraces 38.2% or 50% of Wave 3.

Key Concepts:

• Retracement Levels: Fibonacci retracement levels help identify potential support and resistance levels where corrections might end. Common retracement levels include 38.2%, 50%, and 61.8%.
• Extension Levels: Fibonacci extension levels project potential future price targets beyond the initial move. Important extension levels are 100%, 138.2%, and 161.8%.

Key Fibonacci Ratios:

• 0.382 (38.2%): Common retracement level.
• 0.500 (50%): Significant psychological level.
• 0.618 (61.8%): Another common retracement level.
• 1.000 (100%): Represents a full retracement.
• 1.618 (161.8%): Common extension level, often used for projecting wave targets.

Key Fibonacci Retracement Levels

The “original move” or “initial move” when discussing retracements and extensions refers to the price movement that establishes the beginning of the wave sequence. This typically corresponds to Wave 1, which is the initial impulse wave in the direction of the new trend.

38.2% Retracement: This ratio suggests that the stock might retrace 38.2% of the initial move before continuing in the original direction. For example, if a stock rises from $100 to $110, a 38.2% retracement would be calculated as follows:

Retracement = Difference x 0.382 = (110 – 100) x 0.382 = 10 x 0.382 = 3.82.

So, the retracement level is: 110 – 3.82 = 106.18.

50% Retracement: This ratio is often used as a significant psychological level where traders expect a reversal. Using the same rise from $100 to $110:

Retracement = 10 x 0.50 = 5.

So, the retracement level is: 110 – 5 = 105.

61.8% Retracement: This is another key level, often used by traders to predict deeper corrections within an overall trend. Again, for a rise from $100 to $110:

Retracement = 10 x 0.618 = 6.18.

So, the retracement level is: 110 – 6.18 = 103.82.

Key Fibonacci Extension Levels

100% Extension: This level suggests that the stock will move the same amount as the original move. For example, if a stock initially rises from $100 to $110, the 100% extension would suggest another $10 move from a retracement low.

Extension = 10.

So, if the retracement low is $105, the extension level is: 105 + 10 = 115.

138.2% Extension: This level projects the stock to move 1.382 times the initial move. From $100 to $110, a 138.2% extension would be calculated as follows:

Extension = 10 x 1.382 = 13.82.

If the retracement low is $105, the extension level is: 105 + 13.82 = 118.82.

161.8% Extension: This level suggests the stock will move 1.618 times the original move. For the $100 to $110 rise:

Extension = 10 x 1.618 = 16.18.

If the retracement low is $105, the extension level is: 105 + 16.18 = 121.18.

Real-Time Example of Elliott Wave Counting and Trading

Let’s walk through a hypothetical scenario where a stock starts at $90 and moves up to $100, forming the first wave (Wave 1) of a larger five-wave Elliott Wave structure. This guide will use Fibonacci retracements and extensions to help you understand how to identify and trade based on Elliott Wave Theory.

Wave 1 Analysis: Identifying the Five-Wave Structure

Wave 1 consists of a five-wave structure moving upwards from $90 to $100. Here’s a breakdown of the price movements within Wave 1:

1. Wave 1 of 1:
   • Price Movement: $90 to $92
   • Analysis: The stock begins its ascent from the low of $90, reaching $92. This is the first leg of the five-wave structure.
2. Wave 2 of 1:
   • Price Movement: $92 to $91
   • Analysis: After the initial rise, the stock pulls back slightly to $91, marking the second wave, which is a corrective wave.
3. Wave 3 of 1:
   • Price Movement: $91 to $96
   • Analysis: The stock price surges from $91 to $96, forming the third wave, which is typically the strongest and longest in the sub-wave sequence.
4. Wave 4 of 1:
   • Price Movement: $96 to $94
   • Analysis: Another pullback occurs, bringing the price down to $94. This is the fourth wave, another corrective wave.
5. Wave 5 of 1:
   • Price Movement: $94 to $100
   • Analysis: The stock price completes its five-wave structure by rising from $94 to $100, concluding Wave 1.

Summary of Wave 1:

• Starting Price: $90
• Ending Price: $100
• Net Movement: +$10

Wave 2: The ABC Correction

Wave 2 is a corrective wave that retraces a portion of Wave 1. It typically consists of three smaller waves: A, B, and C. The retracement levels are usually 38.2%, 50%, or 61.8% of Wave 1. For this example, let’s assume a 50% retracement.

• Wave 2:
  • Price Movement: $100 to $95
  • Analysis: The stock price pulls back to $95, a 50% retracement of the $10 move from $90 to $100. This correction forms the ABC pattern, setting up the base for the next impulse wave.

Wave 3: Projected Using the 138.2% Extension

Wave 3 is an impulse wave and typically the most powerful. We use the Fibonacci extension tool to project the potential target for Wave 3. Measuring from the start of Wave 1 ($90) to the end of Wave 1 ($100), and then placing the extension tool at the end of Wave 2 ($95), we use the 138.2% extension level.

• Wave 3:
  • Price Movement: $95 to $108.20
  • Analysis: Using the 138.2% extension of the $10 move in Wave 1, we project Wave 3 to rise approximately $13.20 from the end of Wave 2 ($95), reaching $108.20.

Wave 4: Retracement to the 76.4% Level

Wave 4 is another corrective wave, and it retraces a portion of Wave 3. For simplicity, we’ll assume it retraces to the 76.4% Fibonacci level of Wave 3.

• Wave 4:
  • Price Movement: $108.20 to $102.16
  • Analysis: The stock price pulls back to $102.16, retracing towards the 76.4% level of the $13.20 move in Wave 3.

Wave 5: Projected Using the 176.4% Extension

Wave 5 is the final impulse wave in the sequence. Using the Fibonacci extension tool, we measure from the start of Wave 1 ($90) to the end of Wave 1 ($100), and then place the extension tool at the end of Wave 2 ($95). For Wave 5, we use the 176.4% extension level.

• Wave 5:
  • Price Movement: $102.16 to $117.64
  • Analysis: Using the 176.4% extension of the $10 move in Wave 1, we project Wave 5 to rise approximately $17.64 from the end of Wave 4 ($102.16), reaching $117.64.

Summary for Beginners

• Wave 1: Stock moves from $90 to $100 in five smaller waves.
• Wave 2: The stock pulls back to $95 in a three-wave correction.
• Wave 3: The stock then rises to $108.20, following the 138.2% extension.
• Wave 4: Another pullback to $102.16, retracing towards the 76.4% level.
• Wave 5: The stock finally rises to $117.64, following the 176.4% extension.

Using these Fibonacci tools and understanding the wave structures helps traders make informed decisions on when to buy and sell. Buy at the end of corrective waves (like Wave 2 or Wave 4) and sell at the peaks of impulse waves (like Wave 3 or Wave 5).

Conclusion

Elliott Wave Theory offers a structured approach to understanding market movements, based on the natural ebb and flow of investor psychology. By dividing market movements into five-wave impulse patterns followed by three-wave corrective patterns, traders can anticipate future price actions and identify high-probability trading opportunities.

The integration of Fibonacci tools enhances the predictive power of Elliott Wave Theory. By applying Fibonacci retracement and extension levels, traders can pinpoint potential support and resistance levels, helping them to make informed decisions about entry and exit points. For instance, retracement levels like 38.2%, 50%, and 61.8% help identify where corrections may end, while extension levels like 138.2% and 161.8% project where impulse waves might reach.

For beginners, it’s essential to remember that while Elliott Wave Theory provides a framework, it requires practice to master. Monitoring the waves and using Fibonacci levels can help you make educated predictions about where prices might go. When trading, look for high-probability setups where the wave structure aligns with Fibonacci retracement or extension levels.

However, be aware that waves can break down or become invalid if the market doesn’t follow the anticipated path. Signs of a wave breakdown include price movements that significantly exceed typical retracement levels or fail to follow the expected wave structure.

In summary, Elliott Wave Theory combined with Fibonacci tools offers a powerful method for forecasting market movements and making strategic trades. By understanding and applying these concepts, you can enhance your trading skills and potentially improve your trading outcomes. Remember, practice and continuous learning are key to effectively utilizing these techniques in real-time trading.