Elliott Wave Theory was developed by Ralph Nelson in the 1920s. Nelson found that financial markets have movement characteristics, called waves, that repeat over and over again. Elliott Wave Theory is a broad and complex topic that takes practitioners years to master. Despite its complexity, there are elements of Elliott Wave that can be incorporated immediately and may help improve traders’ analytical skills and timing.
Impulsive and Corrective Waves
Prices move in impulsive and corrective waves. Knowing which kind of wave is likely underway currently and which type recent waves were helps traders forecast what the price is likely to do next.
An impulse wave is a large price move and has associated trends. If it’s an uptrend, it keeps reaching higher prices because the upward moves are larger than the downward moves that occur in between the large upward waves.
Corrective waves are the smaller waves that occur within a trend.
You should trade in the direction of the impulse waves because the price is making the largest moves in that direction. Impulse waves provide a better chance of making a large profit than corrective waves do.
Corrective waves are used to enter into a trend trade in an attempt to capture the next big impulse wave. Buy during pullbacks or corrective waves during uptrends, and ride the next impulse wave as it takes the price higher. Short sell during corrective waves in a downtrend to profit from the next impulse wave down.
The idea of impulsive and corrective waves is also used to determine when a trend is changing direction. If a price chart shows big moves upward with small corrective waves in between and then a much larger downward move occurs, that signifies the uptrend may be over. Since impulses occur in the trending direction, a big downward move larger than prior corrective waves and as large as the upward impulse waves indicates the trend is reversing.
If the trend is downward and a big upward wave as big as the prior downward waves during the downtrend occurs, then the trend is now up, and traders should look to buy during the next corrective wave.
Trend and Pullback Price Structures
Nelson found that when an uptrend is underway, it typically has three large upward price moves, interspersed with two corrections. This creates a five-wave pattern: impulse, correction, impulse, correction, and another impulse. These five waves are labeled wave one through wave five, respectively.
The uptrend is then followed by three lower waves: an impulse down, a correction to the upside, and then another impulse down. These waves are labeled A, B, and C.
Nelson also found that these movements are fractal, meaning the pattern occurs in small and large time frames. For example, the first impulse wave up within an uptrend on a daily chart is composed of five waves on an hourly chart. Corrective waves are composed of three smaller waves if viewed on a smaller time frame.
This fractal pattern spans decades, with smaller versions of the pattern even visible on one-minute or tick charts.
Just as impulsive and corrective waves help determine when to enter trades and in which direction the trend is moving, this price structure can do the same. Assume there was just a big upward move—an impulsive wave—you can assume a correction is likely to follow. That correction to the downside will often unfold in three waves: a drop, a small rally, and then another drop. Use this to improve trade timing by waiting for that second drop. Getting it right when the price starts to drop the first time is too early, as another drop is likely coming.
Similarly, once there have been three big moves to the upside, the uptrend may be nearing completion. An impulse wave to the downside then confirms that the price is likely to head down and the uptrend is indeed over.
This pattern tends to occur in widely traded markets with high volume, such as the SPDR S&P 500 ETF (SPY). The pattern is harder to spot, or doesn't occur at all, in individual stocks, which are more prone to movements based on the buying and selling of only a few individuals.
Typical Correction Size
When buying on corrections during an uptrend or selling on corrections in a downtrend, it is helpful to know how large the typical correction is.
Based on the five-wave pattern, wave one is the first impulse wave of a trend, and wave two is the first correction. Wave three is the next impulse, followed by a corrective wave four and an impulse wave five.
Based on Nelson’s research, wave two is typically 60 percent of the length of wave one. If wave one advances $1, then wave two will likely see the price drop by about $0.60. If it is the start of a downtrend and wave one was $2, the correction to the upside is often about $1.20.
Wave two is followed by impulse wave three. The third wave of a trend is often the largest, usually much bigger than wave one. Wave four comes next and is typically 30 to 40 percent the size of wave three. For example, if wave three rallied $3, the price is likely to drop $0.90 to $1.20 during wave four. The same concept holds true for a downtrend.
These are averages that have been seen over many trades and trends. Corrections may be smaller or larger than average on any single trade. However, even having an approximate idea of how big a correction is likely to be can help improve trade timing.
Combining the Three Concepts
Apply these three concepts by only taking trades in the direction of the impulse waves. Take trades during the corrective waves. Look for trade entry signals once the price has corrected the average amount. The correction isn't likely to stop exactly at the percentage levels described above, so taking trades slightly above or below the described percentage levels is fine.
Consider keeping track of each wave in the overall price structure. For example, after a five-wave pattern to the upside, a bigger three-wave decline usually follows. The direction of the impulse waves signals potential trend changes, and the signal is stronger if combined with a five-wave impulse pattern or three-wave correction pattern ending.
These three Elliott Wave concepts may improve your analysis skills or trade timing, but it is not without its own problems.
The theory can be complex to apply, as it isn't always easy to isolate the five-wave and three-wave patterns. The pattern also often isn't present in individual stocks and often only applies to heavily traded assets that aren't susceptible to the buying or selling of only a few traders. The concept of impulse and corrective waves is applicable to all markets and time frames, though, and can still be used even if the theory of the five-wave and three-wave price patterns isn't.