The Elliott Wave theory is a theory in technical analysis used to describe price movements in the financial market. The theory was developed by Ralph Nelson Elliott after he observed and identified recurring, fractal wave patterns. Waves can be identified in stock price movements and in consumer behavior. Investors trying to profit from a market trend could be described as riding a wave. A large, strong movement by homeowners to replace their existing mortgages with new ones that have better terms is called a refinancing wave.

The Elliott Wave theory was developed by Ralph Nelson Elliott in the 1930s. After being forced into retirement due to an illness, Elliott needed something to occupy his time and began studying 75 years worth of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across various indexes.

The theory gained notoriety in 1935 when Elliott made an uncanny prediction of a stock market bottom. It has since become a staple for thousands of portfolio managers, traders, and private investors.

Elliott described specific rules governing how to identify, predict, and capitalize on these wave patterns. These books, articles, and letters are covered in R.N. Elliott's Masterworks, which was published in 1994. Elliott Wave International is the largest independent financial analysis and market forecasting firm in the world whose market analysis and forecasting are based on Elliott’s model.1

He was careful to note that these patterns do not provide any kind of certainty about future price movement, but rather, serve in helping to order the probabilities for future market action.1 They can be used in conjunction with other forms of technical analysis, including technical indicators, to identify specific opportunities. Traders may have differing interpretations of a market's Elliott Wave structure at a given time.

The Basic Elliott Wave Pattern

In the theoretically perfect world, Elliott Waves occur in sets of five sub-waves – three up and two down  After the 5th wave, the trend reverses and corrects the prevailing trend in three large corrective waves. The market doesn’t move linearly and the purpose of having a 5-wave move is to allow for variations.

In Elliott Wave Theory, there are two main sub-types of waves in the Elliott Wave Pattern:

• Motive Waves (waves 1,3 and 5; A and C) which tend to be smooth and firm.
• Corrective Waves (waves 2 and 4; B) with tends to be messy and choppy.

Motive Elliott Wave Patterns

Each the Motive waves (1, 3 and 5) are in the direction of the trend, and the declining Corrective waves (2 & 4) are smaller than the motive waves and go against the prevailing trend.  If you see this pattern play out in full, it serves to reinforce the idea that we’re moving in a trend and points to the direction of the trend.

A genuine Elliott Wave (EW) pattern must satisfy three essential rules for the five-wave move to be confirmed  

• Wave 2 never retraces more than 100% of Wave 1. Usually, the retracement is between 50% and 61.8% of wave 1.
• Wave 4 never retraces more than 100% of wave 3 — usually, declines between 38.2% and 50% of wave 3.
• Wave 3 always travels beyond the end of wave 1, and it’s never the shortest one; Wave 3 will usually extend 161.8 x wave 1.

These rules ensure that there is progress in a trend, which makes for a more detailed version of Dow Theory that the market moves in several big swings. Other guidelines to keep in mind are as follows:

• Usually, wave 1 and 5 tend to have the same length in price and time;
• Corrective wave A and wave C tend to be the same length.
• The waves must be symmetrical in both time and price;
• The law of alternation, if wave 2 is a simple Elliott Wave Pattern, wave 4 must be a complex Elliott Wave pattern and vice versa.

Corrective Elliott Wave Patterns

Unlike Motive waves, Corrective waves sub-divide into three sub-waves, with the primary objective or correcting the Motive waves. Corrective waves are labelled using letters rather than numbers to distinguish the three different types of corrective wave structures.

Flat EW pattern

A flat Elliot Wave pattern is made up of three waves A, B and C of higher degree that follows a 3-3-5 wave structure, meaning that wave A subdivides into 3 waves, wave B into 3 waves and wave C into 5. There are three different types of flat EW patterns: Regular, Irregular and Expanded or Running flat.

Zigzag EW pattern

The Zigzag Elliott Wave pattern is made up of three waves A, B and C that follow a 5-3-5 wave structure, meaning wave A subdivides into 5 waves, wave B into 3 waves and wave C into 5. Zigzags have a sharp look and usually occur in wave 2 of an impulsive wave.

Triangle EW pattern

The Triangles Elliott Wave pattern is made up of five waves A, B, C, D, E of higher degree, that follows a 3-3-3-3-3 wave structure.   All five waves are subdivided into 3 sub-waves. There are three different types of triangle patterns: Contracting, Barrier and Expanding.

Trading Using The Elliott Wave Pattern

A useful strategy for trading using the Elliot Wave Patterns is called Channeling. Draw a I-III channel line connecting the peaks of wave I and III, to identify the bottom of the IV (fourth) wave by extending that line from the II wave.  As the Elliott wave principle states that following the 5 waves, there will be 3 corrective waves; a trader can establish directional bias, and place take-profit orders accordingly.