Elliott
Wave theory is based on a belief that financial market prices can be described
by an interconnected set of cycles. The cycle periods can range from a few
minutes to centuries.
Waves
refer to chart patterns associated with Elliot wave theory. The theory
identifies a series of impulsive waves followed by corrective waves following
the trend. In prevailing uptrend, upward moves in prices consist of five waves
(impulsive) and downward moves occur in three waves (corrective). If prevailing
trend is down, downward moves have five waves (Impulsive) and upward moves have
three waves (corrective). Each of these waves, in turn, is composed of smaller
waves of the same general form (i.e., a series of five impulsive and three
corrective waves). The pattern starts again after the sequence of five and
three.
The
figure above represents an uptrend. Waves numbered 1 – 5 are impulsive waves
and the waves a, b and c are corrective waves. An Elliott wave is characterized
by a number of rules:
- Wave 4 does not overlap with the price range of wave 1.
- Wave 3 is not the shortest of the three impulsive waves 1, 3 and 5.
- The retracement of wave 2 is less than the 100% of wave 1.
The sizes of these waves are thought to
correspond with Fibonacci ratios. Fibonacci numbers are found by starting with
0 and 1, then adding each of the previous two numbers to produce the next
(0,1,1,2,3,5,8,13,21,….). Elliott wave theorists believe that the ratios of
Fibonacci numbers are useful for estimating price targets. For example, a down
leg can be 1/2 or 2/3 the size of an up leg, or a price target can be 13/8 of
the previous high. Ratios of consecutive Fibonacci numbers converge to 0.618
and 1.618 as the numbers in the sequence get larger.