Elliott Wave Theory
This theory was created by Ralph Nelson Elliott, an accountant from the early 20th century, influenced by Dow Theory. He observed that the market followed certain cyclical patterns, which varied in amplitude and time. Thus, he established the three most important aspects of his theory: pattern, relationship, and time.
Defined that the market follows a cyclical rhythm of 5 waves of advance and three of decline. Waves 1, 3, and 5 are the impulse waves and follow the main trend, while waves 2 and 4 are the corrective waves.
Therefore, three correction waves begin, subdividing into an ABC structure. After this cycle, a new one may begin. Each correction wave (ABC) is divided into three smaller ones, with two in the direction of correction and one in the opposite direction, correcting the correction.
In addition to the shape of the wave, the size of the wave is also considered, which determines the duration of each wave. Elliott defined nine cycles, the longest of which, called the grand super cycle, lasts 200 years. I will also skip this theoretical approach to focus on what matters in the trader's day-to-day.
The use of this theory is simple: just identify the main wave to choose the moment to buy the asset, and sell when a reversal is identified. Follow this tactic as the cycles shorten until the main wave resurfaces.
Elliott's characteristics in a bull market:
Five-wave pattern - bullish trend
Wave 1:
It is quite difficult to identify the beginning of a cycle, but when the first wave of a bull market begins, the fundamental scenario and sentiment research are still pessimistic. At this stage, volume begins to increase, but still without attracting much attention from analysts.
Wave 2:
In a bull market, the correction of Wave 1 occurs, but without going below the start of the first wave. The scenario remains pessimistic, and the volume should be lower than in the first wave, prices will not be lower than 61.8% of Wave 1 (Fibonacci) and will drop as a pattern of 3 waves.
Wave 3:
This is the longest wave of the trend. It has a still timid start, and upon reaching the top of Wave 1, several stops are triggered. If it is a large quantity, gaps will open on the chart confirming Wave 3. It is at this moment that news and market sentiment become optimistic again, attracting more investors to the asset and leading to a faster and shorter price rise, with small and brief corrections, and the rise can extend to a ratio of 1:1.618 of Wave 1.
Wave 4:
This is the correction of Wave 3, but prices may remain lateralized for a while. Generally, the correction goes up to 38.2% of Wave 3, with a much lower volume. This is a good point to buy, but it is quite difficult to identify Wave 4.
Wave 5:
This is the last upward leg of the asset, when investors and the overall scenario are still quite optimistic and euphoric, attracting new investors who buy the asset at its maximum prices of the cycle. The volume is lower than during wave 3 and divergences in indicators begin to appear.
Three-wave pattern - bearish trend
Wave A:
At this stage, the scenario is still quite optimistic and the reversal is not yet clear. The first drops in price seem more like a normal correction than a reversal. There is still an increase in volume, volatility, and open contracts in the futures market.
Wave B:
The price peaks upwards, starting to draw the graphic pattern of Head and Shoulders, and the volume is already lower than in Wave A.
Wave C:
The values drop more rapidly in waves of pattern 5 and it is in this phase that the downward trend becomes quite evident.
