About Elliott Wave Theory
Elliott Wave theory understands that public sentiment and mass psychology moves in 5 waves within a primary trend, and 3 waves in a counter-trend. Once a 5 wave move in public sentiment is completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply a natural cause of events in the human psyche, and not the operative effect from some form of “news.”
In fact, the former Chairman of the Federal Reserve, Alan Greenspan, understood this fact well. During his tenure, in several hearings in front of the Joint Economic Committee, Mr. Greenspan noted that the idea that the Fed can prevent recessions is a "puzzling notion" . . . Rather, the stock market is “driven by human psychology” and “waves of optimism and pessimism.”
This concept is inherent in the aggregate actions of individuals. Based upon these concepts, it is clear that man's progress and regression does not take the form of a straight line, nor does it occur randomly in nature. Rather, it progresses in 3 steps forward, with two steps back within the primary trend.
This is the basis of the Elliott Wave theory. This mass form of progress and regression seems to be hard wired deep within the psyche all living creatures, and that is what we have come to know today as the “herding principle,” which is what gives the Elliott Wave theory its ultimate power.
This theory has been proven time and time again throughout history. This is the basis behind the Elliott Wave, which is enhanced through the concept of Phi ; the Golden Ratio. These concepts have been understood by Plato, Pythagoras, Bernoulli, DaVinci and Newton. Historic structures have been built by architects of famous Greek structures, such as the Parthenon, and even as far back as the architects of the Great Pyramid of Giza in Egypt, who recorded their knowledge of Phi as the building block for all man nearly 5,000 years ago.
For a more detailed understanding of this concept and application, I highly suggest reading Elliott Wave Principle, by Frost & Prechter.
Elliott Waves Basics
A move in the direction of the trend is considered an “impulsive” move, and will constitute 5 waves in the primary direction. A count-trend move is considered a “corrective” move, and constitutes 3 waves, which are counter to the primary direction.
Even within the impulsive 5-wave move, waves 1, 3 and 5 move in the direction of the primary trend, and waves 2 and 4 will be counter-trends in the opposite direction.
Since the market is “fractal” in nature, these impulsive and corrective movements of the market are occurring at all degrees and in all time frames. That means that the smaller components, or sub-waves, have the same basic shape, form, and pattern as the larger components.
Phi and “Fibonacci Pinball”
When following impulsive or corrective counts, Fibonacci calculations of extensions and retracements, based upon Phi (The Golden Ratio), are essential when following a 5 wave or 3 wave move.
In effect, a 5 wave move usually moves in the direction of the trend, while hitting Fibonacci levels and reacting. For example, the standard Wave 1 will extend to the .382 or .618 extension of the entire move. It then pulls back in a Wave 2, generally to the .500 or .618 retracement level of the Wave 1. It is then followed by a 3rd wave that subdivides, and this is where an Elliottician makes the distinction between an impulsive 5 wave move or a 3 wave corrective move.
This is something I lovingly call “Fibonacci Pinball.” Ultimately, the way that we know that a movement within the market is going to be a 5 wave move as opposed to a 3 wave move happens during the potential Wave 3.
See Avi's article, "The Basics of Fibonacci Pinball."
Corrective 3 waves
A standard 3 wave corrective move usually has a first wave (a-wave) that is equal to the third wave (c-wave). During a CORRECTIVE c –wave, the market will move up to the 100% extension of the a-wave, which means that the a-wave and c-wave will often be equal in length. If it is a corrective move, then the market will reverse in the other direction and not find a lower support in order to continue in the same direction.
Impulsive 3 waves
However, in a Wave 3 within a 5 wave move, the market targets the same 100% extension for the first 3 waves, however, the pullback, after hitting the 100% extension, usually finds support around the .618 extension. It then turns and proceeds to break through the 100% extension level to complete a Wave 3, usually well beyond the 100% extension at 1.382 or 1.618 extensions of Wave 1, or even much further, such as those that we have recently experienced in the market at the 2.618 or even 3.00 extensions. After it completes the Wave 3, the Wave 4 pullback usually finds support at this 100% extension level again (what people deem a “re-test” of the break out level), and then turns back up to complete the 5th wave.