Basic Elliott for the Identification of Impulses and Corrections.
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Ralph N. Elliott (1871-1948) was an American accountant who developed his work through the 1930s. The Elliott Wave theory tries to improve the prediction of market trends postulating the existence of a number of patterns (Elliott waves) which are repeated in the pricing structures of trading.
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Elliott's theory suggests that when the market moves in the direction of the trend it does so in five waves or sub-stretches. When the trend bullish, the development is three up and two down. When the main trend is bearish, three down and two up.
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Moreover, when the market moves against the main trend it does so in only three waves or sub-stretches. |
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The waves that move with the main trend are impulsive, waves that move against the main trend are corrective. We are talking about the sawtooth pattern produced in the stock market movements, but appropriately classified.
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Movements basically occur in two ways; in stretches of five waves and three wave bands. Assume for a moment, for simplicity, that the waves of each section are of the same length.
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Usually the five-wave stretches are denoted by numbers from 1-5 and three letters (abc) for easy distinction.
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The concept of impulse moves and correction is extremely important even outside the Elliott theory, because when trading, it will enable us to assess our situation better. Impulsive movements are larger in scope and time, suitable for lower risk trading but required to be able to maintain broader positions. Corrective movements are always more risky and therefore should entail tight stop loss and particularly close monitoring
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Corrections vs Failures
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The three wave corrective movements may be more complex and can actually be subclassified: |
- Correction: A correction is a movement against the main trend, it corrects the previous motion, whether bullish or bearish. If three upward waves are a correction, they will of course occur in a bearish trend.
- Fifth Wave Failed Impulse Moves: In this case, we should talk about an impulse move, i.e. a movement within the main trend, where the fifth wave has failed.
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Proportional Corrections: Fibonacci.
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After developing his theory, Elliott admitted the presence of an essential concept: Fibonacci numbers. This sequence of numbers (0,1,1,2,3,5,8,13,21 ...) and the proportions derived from them are common in nature, social processes, and so on. Fibonacci numbers appear in a systematic pattern postulated by Elliott and therefore incorporated in his theory.
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The most common Fibonacci retracements are:
- 61.8% - correction more likely
- 38.2% and 50% - the two following correction levels with most probability
- 100% - Called “back-to-origin” correction.
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Therefore, Fibonacci retracements allow us to establish, a priori, support or resistance levels where reversal can be expected during correction of a previous movement. |
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This is a simplified approximation to Fibonacci ratios. Within Elliott theory there are various levels of probability for each retracement depending on the type of wave or sub-wave you are in, which is beyond the scope of what is written here.
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Elliott theory is broad and complex. We recommend this book to readers who wish to study this area further:
- "High Performance in the Stock Exchange and Other Financial Markets," Carlos Jaureguízar. Financial Analysis Editorial Noesis.
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Technical Analysis 