Elliott Wave Rules

Based on Ramki N Ramakrishnan

Elliott Wave Cycle and Rule
Ralph Elliott found that in an uptrend, or a bull phase of the market, prices went up
in five waves. Three of these waves were in the upward direction, and he called
these waves ‘impulse waves’. Each of the three waves was followed by a downward
movement, which he called a ‘corrective wave’. Here is a clue that is not often very
clear! Whereas the first and second impulse waves were followed by a smallish
correction, the downward move that came after the fifth wave up was a larger
move. This was so because this last mentioned downward move corrected not just
the preceding impulse wave (the 5th wave) but also the entire five wave sequence.

So to recap, in a bull market, we will see three upward moves and two downward
moves. Once the five waves are completed, we will get a correction that will be
bigger than the two previous corrections because this downward move corrects not
just the fifth wave, but the entire set of five waves up.

If a sequence of five waves plus three waves is completed as above from a significant
low, then the completed cycle will represent the first and second waves of a cycle in
the time frame of the nest higher degree. Every impulse wave is actually made up of
a five-wave sequence within itself. Corrective waves are usually made up of three
waves, or combinations of three-wave sequences.

• Wave 2 can never exceed the start of wave 1

• Wave 3 can never be the shortest impulse
wave
• Wave 4 can never overlap wave 1 (i.e. cross
into the same price area) expect within a
diagonal triangle
 Waves…additional points
Wave Personality
In addition to giving us the rules of Elliott Wave Theory, Ralph Elliott also discussed the personality of the waves at various positions in the cycle. For
example, the third wave is usually the steepest wave, and is accompanied by expanding volume. A corrective wave in the fourth wave position is
usually complex in nature. You will see sudden departures from normative behavior. Also, just when you think a correction is almost finished, a
complex fourth wave will add another level of complexity to the formation. These are just some examples of wave personality.
Alternation between waves
Another feature of Elliott Waves is the tendency of waves to alternate between
long and short, between simple and complex, between the length s of time that
alternating waves spend etc. For example, if wave 2 was a simple correction, you
should expect wave 4 to be complex. These are valuable clues to the trade that
can offer a real edge in the market, the so-called Elliott Wave Edge.

Fibonacci Ratios in Elliott Waves

Any explanation of Elliott Wave Theory, however brief, will be incomplete without a
mention of the use of Fibonacci Ratios. These ratios are computed from the Fibonacci
number series that start of like this 1,1,2,3,5,8,13,21…. As you can see, each number is
the sum of the preceding two numbers. Fibonacci Ratios are computed from these
numbers. The key ratios used in Elliott Wave Analysis are 38.2%, 50%,61.8%, 100%,
138.2% and 161.8%

Generally speaking, the following relationships work.

 Wave 1 is corrected by wave 2 by between 50% to 100% (note that 50% is obtained by dividing 1 by 2 in the Fibonacci series of numbers)

 Wave 3 is usually 161.8% of wave 1

 Wave 4 is often 38.2% of wave 3. Occasionally, when wave 1 was a shallow correction, we can see wave 4 coming down by 50% of wave 3, and
very rarely 61.8% of wave 3. If wave 3 was an extension, then wave 4 is more likely to terminate around the 23.6% retracement level.

 Wave 5 is often computed by taking either a 38.2% measure or a 61.8% measure of the distance traveled from the start of wave 1 to the end of
wave 3. If Wave 3 had extended, then there is a high chance for wave 5 to be equal to wave 1.

 Within corrections, in a zigzag correction, wave C is often 161.8% of wave A. If the correction is a flat correction, then wave C is usually equal to
wave A or no more than 138.2% of wave A.
Examples of Fib drawn on Elliott Wave
 Corrective Waves
Corrective Waves
Most traders encounter difficulties when dealing with corrective waves. Elliott Wave theory has broadly classified corrections as Zigzags, Flats
and Triangles.

A zigzag correction often corrects the previous impulse wave by a significant extent. A zigzag correction is made up of two sets of mini-impulse
waves separated by a corrective wave. Thus the sub-waves of a zigzag correction tend to be 5-3-5 waves sequence.

A flat correction, on the other hand, will only correct a smaller portion of the previous impulse wave. Furthermore, the sub waves of the flat
correction will be made up of a 3-3-5 sequence. Notice that in the zigzag as well as flat correction, the last sub wave is a five wave affair!

Triangles are further classified as horizontal triangles and leading or ending triangles. The sub-waves of these triangles have their own
personality traits. If it is a leading diagonal triangle, the sub waves are made up of 5-3-5-3-5 waves. But if it is an ending diagonal triangle, the
sub waves are 3-3-3-3-3 waves.

Don’t be alarmed, but sometimes corrections tend to become complex whereby we see combinations of zigzags, flats or triangles. This is why I
always advise traders to avoid trading complex corrections. You can identify a complex correction using the tendency of waves to alternate in
complexity. Occasionally wave 2 becomes a complex wave, in which case your stop loss is anyway supposed to be placed below the start of the
wave 1!

The Elliott Wave Edge

When a trade uses Elliott Wave Analysis to determine where we are in the big picture, and then computes likely levels where a turn is highly
probable, then he/she has what I would like to call the Elliott Wave Edge. Once he uses all the rules, his knowledge of the personality of the
waves, and the price targets using Fibonacci Ratios, the trader will be able to determine a price level where he could initiate a position in the
market place. After that, it all boils down to money management. The determination of a low-risk entry level is the key benefit of doing Elliott
Wave Analysis. A trader who has the Elliott Wave edge will find that the consistent application of the Elliott Wave analysis to his trading activity
will produce a series of winning trades that will make him money over time. You can read more about the Elliott Wave Edge here.