Elliott Wave Theory: Taking the Simplest One

According to Elliott wave theory of price movements on the е can be conventionally divided into two types of wave cycles: five-wave (1-2-3-4-5) cycles (see Fig. 1) or three-wave (A-B-C) cycles (see Fig. 2).

Fundamentals of Wave Theory

Example of a 5-wave cycle

Figure 1. Example of a 5-wave cycle.

Example of cycle A-B-C

Figure 2. Example of cycle A-B-C.

In fact, these are the two main elements of wave analysis, to which are also added various types of corrections (regular, irregular, triangular, rectangular, etc.), lengthened, truncated waves, and so on. All this classification is designed to help traders find the minimum on the uptrend (the most profitable price for a buy) and the maximum on the downtrend (it is more profitable to sell at a higher price).

This raises legitimate questions: why the number of works on wave analysis is growingif there are only TWO (!) directions on it - UP or DOWN, and the trader only needs to open a trade in the right direction (out of two)? How to see in REAL time modewhat kind of correction now: flat, triangular, or something else? How to understand whether the wave was truncated or it was an X wave in a double zigzag? All the markup can be easily seen on the chart after the fact: it is easy to find the five-wave impulse, where the 5th impulse wave became truncated and could not break through the top of the 3rd wave (yes, there is such an element in wave analysis, about it below), but how to do it during the development of the structure?

In this article I would like to offer you a simplified model (only part of it, expect the continuation in the next issues of ForTrader.org), where there are no "wrong" elements and where each wave, even in correction, has its own criteria, simple and visible to everyone trader.

Five-wave cycle

So, first of all, let's analyze the main element of Elliott's wave theory: the five-wave cycle. Five-wave cycle (see Figure 1) consists of three impulse waves (labeled with odd numbers 1, 3, and 5) and two correction waves (labeled with even numbers 2 and 4). Briefly about the criteria of each wave:

1)    Wave "1" - impulse, is the beginning of a new trend on the timeframeThe wave is the one you fix it on (you "fix" it in real time, not find it on the history). The bullish wave "1" as

go beyond the base of wave "1".

3)    Wave "3" - impulse, the longest in the 5-wave cycle, it breaks the top of the previous impulse "1".

4)    Wave "4" - correction to wave "3". Its main criterion: to be entitled to be called "4th", it must NOT go below the top of wave "1" or roll back more than 50% from wave "3". If at least one of these criteria is not met, then the entire cycle of sub-waves at the moment has no right to be called a 5-wave, because the "4th" wave does not meet the necessary conditions for that.

5)    Wave "5", the last impulse in the 5-wave cycle, interrupts the top of wave "3".

You can easily find points 1-4 in the literature on wave analysis. But the description of the 5th wave, for example, in the book by Frost and Prekter, personally raises the most questions for me. According to the authors, the 5th wave may be truncated, i.e. it may NOT interrupt the top of the 3rd wave. But in this case the main postulate of wave analysis is violated: the impulse is always longer than the correction! It turns out that the 5th wave is shorter than the corrective 4th wave.

Example of a truncated 5th wave by Frost and Prekter

Figure 3. Example of a truncated 5th wave by Frost and Prekter.

This little nuance is often confusing. And imagine how many times we have to change the markings on the chart if the 5th turns out to be truncated. It takes time and effort, and we just need to take the movement in the right direction.

Since it is hard to tell in real time whether the 5th was truncated or not, we can try to abandon the truncated waves and make the pulses longer than the previous corrections, or at least equal to them.

We take as a basis the absence of truncated 5-waves   We take as a basis the absence of truncated 5-waves

Fig. 4. We take as a basis the absence of truncated 5-waves.

Otherwise, in the case of Figure 3, wave 4 will become a new impulse against the old one trendand the 5th is a corrective "2" or "B".

And seeing the formed impulse in real time on the chart, you have a clear idea of what to do now: to wait out the wave of correction and look for the most profitable entrance to a new impulse. The pullback wave has a single criterion: it must not interrupt the base of the previous pulse. If it is interrupted, then we wait for a pullback to the formed impulse and enter a new impulse after it, if the correction has survived its main criterion this time.

In the following articles we will look at three-wave cycle A-B-C, Let's analyze its criteria and add Fibo levels as an integral element of wave analysis.

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