Elliott Wave Rules: Counting Waves With Fibonacci Levels

The idea of Elliott Waves emerged in 1934, when Ralph Nelson Elliott discovered that price movement on charts does not move randomly, but is in fact linked in a specific way. Elliott saw the same patterns forming in repeating cycles, and these cycles reflected the prevailing sentiment of investors and traders through swings of rises and falls. He divided these movements into what he called waves.

According to Elliott’s observations, a trending market moves in a pattern of five waves followed by three waves. The first five waves, initially called the main waves, later became known as the motive waves in the larger trend.

Elliott Waves in Brief:

After the five waves are completed in one direction, a larger corrective move happens in three consecutive waves. Letters instead of numbers are used to track them, and these three waves form the ABC corrective pattern, sometimes called the threes. The chart below shows what the five-wave motive move and the three-wave corrective move look like.

In Elliott Wave theory, waves 1, 3, and 5 are also called impulse waves. Wave 2 is a correction of wave 1, and wave 4 is a correction of wave 3, and the complete 1-to-5 sequence is then corrected by the ABC sequence.

Elliott waves occur across multiple timeframes. This means a complete five-wave sequence on a small timeframe, such as the 15-minute chart, may represent only the first wave of a larger Elliott wave sequence found on the 1-hour chart.

In other words, every wave is part of a larger wave pattern found on the higher chart, and the 1-to-5 sequence completes one wave of a higher degree — meaning Elliott waves belong to the next higher level of wave sequences.

So the move from wave 1 to wave 5 completes either wave 1, 3, or 5 of the higher degree, while the ABC sequence completes either wave 2 or wave 4 of the higher degree.

Moving down to lower degrees, each wave in the sequence can be broken down into smaller waves following the same Elliott wave movement.

In the chart above you can see how wave 1 of the higher degree is made up of a smaller 5-wave impulse pattern, and wave 2 is made up of a smaller 3-wave corrective pattern. Each of these waves is in turn always made up of smaller wave patterns — this is what Elliott waves look like.

In the mid-1970s, fractals appeared in Benoit Mandelbrot’s studies, and Elliott had in fact described the fractal nature of financial markets 50 years before that term was used for them. Elliott Wave theory rests on a striking observation: freely traded markets are not driven by outside forces, but instead oscillate internally by nature — swinging endlessly between two extremes, and this oscillation can be tracked through Elliott waves.

Here, a trader’s main goal is to identify the wave forms with the greatest impact on price, whether that is a third wave or a C wave. In the forex market, some authors argue that the longer wave count matters most, since the larger the wave a trader intends to trade, the greater the chances of profit.

These waves are often expressed at extended overbought and oversold readings on technical oscillators, and many retail traders who follow this signal fail when trying to trade against the trend — except for those experienced in reading Elliott waves. Below are some basic rules that help identify and measure Elliott waves:

Elliott Wave Rules

• Wave 2 will not retrace beyond the starting point of wave 1. In practice, this means that if price is moving upward, the price after wave 2 completes cannot be lower than the starting price of wave 1.
• Another Elliott wave rule states that wave 3 is usually, but not always, the longest — and never the shortest — in the full sequence, and it always finishes above the top of wave 1.
• The theory also states that wave 4 cannot overlap the end of wave 1, which is the same as saying wave 4 can never retrace more than 100% of wave 3.

As we can see above, Elliott waves do not form perfectly when looking at real charts, and it is sometimes difficult to label them — this takes a lot of practice. On top of that, there are many variations within the basic principles that make Elliott Wave theory more complex.

But the most important point for you right now is to think of the market, from an Elliott wave perspective, as made up of sub-waves. This should train you to handle volatility in a real trading environment, and not to expect a trend to run endlessly in one direction without any pullback — you should recognize the potential for those pullbacks and use them as lower-risk entry points for your trades.

There is one type of motive wave known as extensions — extended moves in the direction of the main trend, which can appear in one of the impulse waves, meaning waves 1, 3, or 5.

Diagonals are another form of motive wave. This interesting formation is usually a wedge-shaped pattern made up of two converging lines. Diagonals are made up of five waves and occur at the end of a strong trend, especially when wave 3 moves sharply within a short time.

Diagonal waves can also be found in wave C of a corrective sequence, signaling that the move at the higher degree is ending.

Each of the five Elliott waves in a diagonal is made up of three sub-waves rather than the usual five-wave structure. In a diagonal, wave 4 can overlap wave 1, unlike the basic rule, and in these patterns wave 5 tends to overshoot or fall short of the target at the main trendline. The figure below shows several types of Elliott waves, including diagonals.

There is also what is called the expanding triangle, a very rare Elliott wave pattern. In the book “Sentiment in the Forex Market,” Jamie Saettele explains why these patterns do not repeat often: “Think about why the expanding triangle is rare — triangles, whether diagonal or not, reflect a balance between bullish and bearish forces that creates a volatile environment.

By contrast, volatility increases in an expanding or diagonal triangle, and it is genuinely rare for volatility to increase despite sideways movement, which highlights the point where there are three trend classifications: up, down, and sideways. Chart patterns reveal more about the market’s psychological state than beginners often realize.”

So expanding triangles are divergent, wedge-like patterns where wave 5 must extend beyond the end of the previous wave 3 to qualify as such, as in the figure below.

When wave 5 fails to move beyond the top of wave 3, it is called a failure of the pattern. In this case, the move is still considered a corrective reversal within the main trend, but in chart theory it is known as a double top.

Within the variations of the ABC corrective sequence, as identified by Elliott and later researchers, the basic forms are known as zigzags, flats, double threes, and triangles. There are other complex corrective forms split into further categories that do not repeat regularly in the markets.

This is why the forex market behaves the way it does — so how can you trade through such heavy volatility? Here, in order to survive and succeed in the forex market, it is necessary to measure profit targets against expected losses at any given time.

Elliott Wave theory can also provide the shape and structure of price movements, since many analysts combine these principles with Fibonacci ratios to measure the potential of each price move, including its likely time duration.

On their own, Fibonacci ratios are less useful for forecasting market moves in price and time. But combined with a solid framework like the one Elliott Wave theory provides, the Fibonacci tool can become valuable, since it gives you a broader view of what is happening in the market at any given time. What mainly makes the combination of Elliott waves and Fibonacci ratios distinct is:

• Fibonacci ratios usually mark important levels of supply and demand — the same as support and resistance. Potential Elliott motive or corrective waves are typically measured as a percentage of the length of the prior wave, and the most common Fibonacci levels are 38%, 50%, 61.8%, and 100%.
• Shape is always the primary factor in Elliott Wave theory, and Fibonacci ratios help with timing — meaning those moments spaced 13, 21, 34, 55, 89, and 144 periods or candles apart deserve special attention, where the number of periods or candles depends on the timeframe used.
• Wave 3 in a five-wave sequence is influenced by wave 1, and it usually shows a ratio of 61.8% of wave 1, while the other two waves are typically minor in length and roughly equal to each other.
• The corrective move that follows an impulse move from a significant low or high usually retraces 50% to 61.8% of the prior Elliott motive wave, and wave 4 usually corrects about 38.2% of wave 3.
• Since wave 2 in most cases does not retrace the full 100% of the start of wave 1, the start of wave 1 is the ideal level for placing stop-loss points. The target for wave 5 can also be calculated by multiplying the length of wave 1 by 3.236 (2 × 1.618).

Note: there is an indicator that plots Elliott waves automatically, but it is best not to rely on it, since it is not precise and can make some plotting errors.

To sum up, in this article we covered Elliott waves in brief. This is not everything there is to learn about Elliott Wave theory, but it will help you understand the collective psychology behind exchange rate moves. It is a useful tool for gauging market sentiment alongside the tools mentioned above, and Elliott waves will also help you read chart patterns better in your trading.

Frequently Asked Questions:

What is wave analysis in trading?

Wave analysis in trading (Elliott Wave Analysis) refers to a technical method used to analyze and estimate future price direction in financial markets. It rests on the premise that prices move in waves and follow repeating, similar patterns, so future trends can be estimated based on these patterns. Wave analysis relies mainly on charts, which can be used to study price patterns and movements, along with technical indicators such as the Fibonacci ratio and MACD. Supporters of wave analysis say this method can help with investment decisions and with reading price direction. That said, wave analysis carries a degree of risk and should not be relied on alone for investment decisions.

Is wave analysis the same as Elliott waves?

Yes. Wave analysis is a theory and method traders use to analyze financial market charts, built on the idea that prices move in a repeating, wave-like way, following a set pattern with a defined number of waves. Elliott Wave theory was developed by Ralph Nelson Elliott in the 1920s, and it rests on concepts such as main and sub-waves, price corrections, and their chart formations.

What are the types of wave analysis?

There are two types of wave analysis. Classic wave analysis is based on Elliott Wave theory and focuses on analyzing corrective, directional, and structural waves, using specific wave formations to identify the start and end of price moves. Harmonic wave analysis tries to analyze harmonic oscillations and deviations in price movement using support and resistance points and technical indicators such as the Fibonacci ratio. Wave analysis requires deep, thorough study of financial markets and the use of multiple technical analysis tools to estimate price movement, and it carries some risk, so it should not be used as the sole source for investment decisions.

How many Elliott waves are there?

In theory, Elliott Wave theory holds that price movement can be analyzed by identifying five directional waves and three corrective waves, repeating in cycles. This full cycle is called the “complete Elliott wave cycle.” The numbers 1, 2, 3, 4, 5 represent the directional waves, while the letters A, B, and C represent the corrective waves. So the total number of Elliott waves is 8 repeating waves that make up one complete cycle.

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