Despite how difficult Elliott Wave Theory seems – and it’s certainly not easy to interpret possible wave counts – there are really only three solid, objective rules that your wave count must follow – the rest is mere guidelines. What are these three main rules you ask?
Let me preface by saying that Elliott proclaimed that Impulse or Motive waves unfold in five wave sequences (three up separated by two corrective waves down) which forms the core of Elliott Wave. Interpreting corrective waves can be endlessly difficult, but it’s wise to start with the initial Impulse Structure and follow these unbreakable rules:
1. Wave #2 Cannot Retrace 100% of Wave #1
2. Wave #3 Cannot be the Shortest Wave (but does not have to be the longest)
3. Wave #4 Cannot Enter the Territory of Wave #1
Let’s look at these closely:
Rule #1: Corrective Wave 2 CANNOT Fully Retrace Wave #1
Generally, we look to Fibonacci retracements in terms of impulse moves – especially to 31.8%, 50.0%, or 61.8%. If you try a Wave Count and your possible Wave #1 fully (100%) retraces what you think is Wave #1, you need to re-label Wave #1 and start your count over. Often, it’s very difficult to trade real time in developing Wave 1 structures.
How does this look in an idealized example?
Wave #1 is Green and Wave #2 – the Corrective Wave – is Red. The Red Dotted line signals a wave ‘danger zone’ and if Wave #2 crosses the blue dotted line (the start of Wave #1), then the Wave Count violated Rule #1.
Often, Wave #2 will be a deep retracement of the first wave, and can retrace to 61.8% of the prior wave or slightly beyond.
Rule #2: Wave #3 CANNOT be the Shortest Wave
Often, Wave #3 moves are traders’ dreams, as they contain sustained price action in a given direction. These are also the zones of the “Sweet Spot” structures in price moves as well.
When I was first learning Elliott, I though that Wave 3 had to be the strongest, longest wave – not so. It just can’t be the weakest/shortest of the impulse waves. If wave #3 seems week, it could signal a stronger Wave #5 is possibly yet to come.
What does this rule look like?
I’ve highlighted Wave #3 in this example. Wave #1 is the shortest in this diagram, and Wave #3 is slightly longer than Wave #5 – this fits the criterion.
If you’re trying out a Wave Count and what you label as Wave 3 turns out to be shorter than your Wave #1 and Wave #5, you need to start again and re-label your chart according to Elliott.
Finally, Rule #3: Wave #4 CANNOT Enter the Price Territory of Wave #1
Wave #4 is known as a profit-taking wave, and as such, shouldn’t give back a large portion of Wave #3. Something’s wrong if Wave #4 is a very deep retracement. Let’s look at this on a diagram:
Wave #4 can be expected to retrace perhaps 31.8% to 50.0% of Wave 3, but start to worry if the retracement gets deeper than these levels. I’ve compressed this idealized image, but if what you think is actually a Wave #4 correction, you could place stops just beneath the top of Wave #1 – the black dotted highlighted line in my diagram. I’ve drawn an “X” at this level.
These are just the surface level basics of Elliott Wave Theory. We’re having to go deep within the concept, perform counts on multiple charts and multiple markets, and read multiple sources for the Chartered Market Technician (CMT) program from the Market Technician’s Association (www.mta.org). It’s eye-opening and perspective broadening and very interesting. The information above comes from these sources, which also can be found on a variety of sources online including the Elliott Wave International site.
I’ll continue to try to share insights and basic lessons learned.
Don’t try to become an expert overnight if you’re interested in Elliott Wave. However, if you do want to try it out on a few charts (it tends to ‘work better’ for broader indexes and markets than individual stocks), then memorize and apply these three rules to your proposed wave counts.