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Free Elliott Wave Tutorial





What's an Elliott Wave? (a tutorial)


Publication date: Sep 24, 2012
Last revised: 3/26/2015 | 
Author/source: Anthony Allyn 


I thought it would be good to explain what the Elliott Wave System (or EW "theory", as it is most often called) is; for traders who have never heard of it, or may not be familiar with the fundamentals that make it work. There are entire books written on the subject; this tutorial doesn't cover all aspects of the EW system. It's intended as an easy to understand handbook, and a guide to reading the market, as well as the EW charts I create. If you are already familiar with the Elliott Wave System,  I hope this tutorial will give you an even better understanding of this sometimes overly complicated system.

A brief history: Elliott Wave Theory is a method of market forecasting, which was discovered by Ralph Elliott - an American accountant and author - in the early 1930's. Ralph noticed recurring patterns in market behavior due to natural "animal instincts", or "herd behavior" - as I like to call it. He also discovered that market movements often correlate to key Fibonacci numbers which naturally occur, and repeat throughout nature. 

Ralph Elliott noticed that a bull market rallies into predictable 5 wave patterns. These patterns are plotted on a chart and labeled as waves 1 - 5, as seen below.  You can think of the entire cycle as 3 steps forward, 2 steps back. Forward in impulse waves 1, 3, & 5, and back in waves 2 & 4. In a bear market the direction is simply reversed, and alphabetical targets employed as we'll explore below. 

Have you ever noticed how things seem to come in 3's, or heard the saying, "third time is a charm"? Elliott Waves work in much the same way; 3 impulse waves (1, 3, & 5), and the cycle is complete.

Also take notice of how wave 1 subdivides into 5 sub-waves - labeled "I" (of 1) - "II" (of 1) - "III" (of 1) - "IV" (of 1) - and finally "V" of "1". As a new trend develops (in wave 1), few take notice. Wave one sets a new trend, yet the majority of investors are still skeptical that the previous trend has indeed changed, in fact in a bear market the bulls can hardly wait to come in an "buy the dip". 

Market Psychology in wave 1 is that of a lobster being slowly boiled. 
Wave 2 brings us to one of EWT's Golden Rules: "Wave 2 never extends past the end of the beginning of wave 1. In other words, if the price action makes a new low (in a supposed bull market), or a new high (in a supposed bear market), it's time to reassess the EWC (Elliott Wave Count). Wave 2 (labeled wave II on the chart above) is a simple corrective wave. Wave 2 is a pullback we will want to buy in a bull market, and sell in a bear. Investor sentiment is still at extremes in wave 2, and detractors may be publically mocked. The weak hands will inevitably be shaken out in wave 2, and at the worst possible time, because wave 3 is where the easy money is made.

Wave 3 is most often the most powerful, and the longest, of the 3 impulse waves (1, 3, 5), and is never the shortest in comparison with waves 1 and 5. This is another one of the EW systems golden rules; wave 3 is never the shortest wave. Most news may still be bearish, but all bad news is ignored, but you can bet good news is on the way when you see the herd in a buying frenzy. One of my own Elliott Wave Rules is, "never underestimate the power of a wave 3". 

Wave 4: Expect a lot of head scratching in wave IV, then expect boredom, and then expect traders to leave the market entirely as volume slows to a trickle. Wave 4's often trades into a complicated triangle patterns, and coming after a powerful wave 3, a long period of consolidation is expected. I would describe the action as wishy-washy, with plenty of head fakes along the way. Depiction of a running triangle in which wave B "runs" past the end of the previous target.

One of the golden rules which applies to wave 4 is that the price action between waves 1, and wave 4, may not interfere with each other (i.e. overlap), but there is an exception to this rule, and that is when trading into another type triangle. A bullish or bearish leading diagonal triangle. These type of triangle patterns may occur in waves A, 1, & 5.

Wave 5: The key to identifying wave 5 is slowing momentum, and maximum bullishness/bearishness. In a major wave 5, the media hype is at its highest and even the most bearish investors may finally throw their hands up (capitulate), but momentum slows in wave 5, and this is one of the keys to identifying a wave 5. The reason momentum slows in wave 5 is that the smart money is typically selling (at the top), while the dumb money (AKA the retail investor) having no doubt been tipped off by media reports, and internet chatter, is seen buying into the top. "There's a sucker born every minute", as they say. This is why we don't news, or opinions, only the charts.

History confirms time and time again; booms and busts are an inevitable and natural, occurrence. Those who look at a correction as something "gloomy", not only deny the past, but the future as well, while the shrewd investor looks at a correction as buying opportunity.
Now that wave 5 has completed we're expecting a larger correction. Corrective patterns typically consist of 3 predictable waves which are labeled "A-B-C", except when the pattern is identified as a triangle pattern (typically in wave 4 or B), which won't be covered in this tutorial. 


The most common correction is called a "Zigzag" pattern, which consists of 2 impulse waves (A & C), separated by a wave B correction.

Wave "A" is only the first pullback in a zigzag pattern, but wave "A" itself can take on many shapes, including a leading diagonal triangle, so it's imperative that you learn the difference between Bullish and Bearish triangle patterns. If you confuse wave A with a wave 4 triangle you're in for an unpleasant surprise.
To further complicate things, market sentiment is still extremely bullish, and hard to ignore. This is where it becomes imperative that you try to separate your emotions from your trade.
Wave "B" is a head fake, just as wave 2 is. This difficult to predict wave may also trade into a triangle pattern as the bulls and bears battle it out.
Wave "C": Wave C is a powerful wave, so much so that it may be confused with a wave 3, but one important thing to remember is that wave C of 2 - in a correction - fails to make as new low (in a bull market), or a new high (in a bear market). See the golden rule attached to wave 2, if you've already forgotten. When wave "C" reverses most investors are caught off guard. As their precious stock tumbles, retail investors will continue to argue that there is value where there is none, only to finally capitulate (give up), at the bottom, just as the bearish corrective pattern completes. Market sentiment is bearish here, and stocks are now on sale - at a discount.


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