Rules & Guidelines of Elliott Wave Theory

If you have ever looked at a chart of a market and been overwhelmed by the ups and downs of the price, you are not the only one. At first glance, markets often seem random, like a price is stirring without rhyme or reason. What if the price wasn't completely random? Years ago, Ralph Nelson Elliott illustrated the premise that markets move within repeating patterns stemming from collective psychology.

His ideas became known as Elliott Wave Theory. At the heart of Elliott Wave Theory lie rules and guidelines that explain how these waves form in the market and how they interact with each other. Rather than being merely theoretical and abstract, these rules and policies help traders introduce structure to their charts, identify opportunities more systematically, and avoid common rookie mistakes.

In this article, we highlight amendments to explain Elliott Waves Theory in a way that readers find easy and practical so that they can approach the markets with more confidence.

The Underpinnings of Elliott Wave Theory

Elliott Wave Theory is based on the premise that markets move in cycles. Cycles repeat over the course of time — humans having innate behaviour towards optimism, fear, taking profits, or speculation drives the cycles. Two primary wave types that Elliott identified were:

• Impulse Waves: A strong market move composed of five movements in the same direction (trend).

• Corrective Waves: A market move that retraces or moves against the impulse wave and is composed of three waves or movements.

Together, they create the natural flow of the market, five steps forward, three steps back. This flow can be seen on all timeframes from minutes to years. The Three Unbreakable Laws of Elliott Wave Theory

There are three hard and fast rules which must always be honoured when studying impulse waves. If any of them is violated, then the pattern is unusable.

Rule 1: Wave 2 Cannot Retrace 100% of Wave 1

Wave 2 will always retrace some of Wave 1, but cannot take back all of the move. The pattern becomes inexperienced if it pierces below the starting point of Wave 1 in an upwards trend (or above it in a down trend).  

Rule 2: Wave 3 Cannot Be the Shortest

From the three impulse legs, the three impulse waves (1, 3, and 5), Wave 3 cannot be the shortest. In the vast majority of cases, Wave 3 is the longest, strongest, and fastest wave and usually can be related to high volume and some momentum.

Rule 3: Wave 4 Cannot Overlap with Wave 1

In a standard impulse, Wave 4 cannot encroach into the price territory of Wave 1. For example, in an uptrend, Wave 4 must have a low which is above the high of Wave 1. This keeps the pattern clean and a more precise cut.

Because these laws are numerical, they are absolute and hard-to-follow rules. Once you violate one or the other of the first three rules, the entire wave count should be adjusted.

Tenets of the underlying rules of Elliott Waves

Outside of the complex and fast rules, Elliott Wave Theory has underlying guidelines. These guidelines are certainly not rules and will not apply to every situation, but they do show up often enough so that they can provide valuable clues.

Guideline 1: Wave 3 is Often the Longest.

Although the hard and fast rule says Wave three cannot be the shortest, the practical reality is that it is almost always the longest. Usually, this is the point in the trend where traders are starting to notice the move and accumulating positions for it.

Guideline 2: Wave 5 Often Shows Divergence

At the point we see Wave 5 beginning to form, the momentum is typically low. In this scenario, you may identify divergence with price. For instance, sometimes the RSI will tell you the price is making a new high (or low), but momentum isn't confirming that.

Guideline 3: Wave 2 vs. Wave 4 - Alternation

Waves 2 and 4 often show opposing structures. If wave 2 moves down deep and sharply, wave four will likely move shallow and sideways. This is to give a sense of equilibrium in the cycle of movement.

Guideline 4: Fibonacci Relationships

Elliott waves often follow Fibonacci ratios as well. For example:

• Wave 2 generally retraces 50 - 61. 8% of Wave 1.

• Wave 3 typically extends to 161.8% of Wave 1.

• Wave 5 may retrace to both Wave 1 and 3 using Fibonacci extensions.

In these examples, our ratios provide traders with a reasonable target to aim for, guiding them toward optimal entries and exits.

Example of an Impulse Wave in a Uptrend

Let's review a simple pattern within an impulse, with a bullish trend:

1. Wave 1: Price is moving higher to begin the move.

2. Wave 2: Price retraces lower; however, the price does not go lower than where Wave 1 started.

3. Wave 3: Strong move to the upside and probably the strongest move in the sequence

4. Wave 4: Price patterns are consolidating, but in effect, the price appears to stay above wave 1.

5. Wave 5: A final push to the upside, very likely, momentum looks weak.

All three of these rules must be kept in mind for the sequence to be termed an impulse sequence. If not, it will be necessary to re-evaluate the count.

Corrective Wave Structures

While impulse waves are propelling the trend forward, a corrective wave is allowing the market to "rest." Generally, there are three parts to corrective waves: A, B, and C, but they can take alternative forms:

• Zigzag: A sharp A-B-C correction, showing strong moves in A and C.

• Flat: A sideways corrective where Wave B retraces most of Wave A.

• Triangle: A contracting or expanding five-wave structure (A-B-C-D-E) which often signals consolidation before the next significant wave occurs.

Corrections can be challenging to identify as they have many different variations, but they are always a countertrend move.

Putting Rules and Guidelines into Action when Trading

Elliott Wave Theory isn't just about labelling charts; it is about structuring your thought processes to make a trade decision. Here is how traders utilise the rules and guidelines in real-life situations:

Identifying the Trend

Impulse waves are a confirmation of the direction of the larger trend. As you identify those waves, you avoid trading against the underlying momentum.

Identifying Entry Opportunities

Corrective waves often create pullbacks, which are ideal entry points into the primary trend.

Timing Exits

Wave 5 is characterised by weak momentum, but can serve as a good indicator for profit-taking in almost all corrective wave periods.

Managing Risk

The rules provide natural stop-loss locations. For example, if Wave 2 retraces beneath the start of Wave 1, the setup is no longer viable so that the trader can exit early.

Frequent Errors Traders Make

Despite the rules, one might not use Elliott Wave analysis properly. Some common errors are:

• Forcing Patterns: Every price movement does not fit the Elliott wave structure. When a trader must force a count, the result often leads to a poor decision.

• Neglecting Timeframes: A wave that appears to be an impulse on the daily chart may be corrective on the monthly chart. Always check multiple timeframes.

• Combining Rules and Guidelines: Traders frequently confuse rules with guidelines, leading to labelling errors.

Tips for Learning Elliott Wave Theory

• Use Simpler Charts: Start with clean, easy-to-see waves before making sense of complicated markets.

• Minimal Indicators: Too many indicators can clutter the analysis. Elliott works best with as few indicators as possible, focusing on price action.

• Use in Combination: Support/resistance and momentum indicators come in handy when verifying wave counts.

• Consistent Work: Study charts regularly. The process of locating valid impulses and corrections becomes more manageable.

Conclusion: Organisation in Chaos

The Elliott Wave Theory can appear complicated at first. However, once the rules and guidelines are understood, they provide an outstanding framework for understanding market behaviour. The three strict rules — Wave 2 must not completely retrace Wave 1, Wave 3 must not be the shortest wave, and Wave 4 must not overlap Wave 1 — are generally the framework. The guidelines — alternation of wave formations, Fibonacci relationships, momentum clues — add dimension and depth.

For traders, the theory gives something more than just a pattern on the chart; it provides insight into market psychology. Rules and guidelines ultimately introduce clarity into chaotic price action, help with the timing of entry and exit, and can help manage risk in a more disciplined manner.

No method is perfect; however, Elliott Wave Theory is one of the best, most meaningful ways to make sense of market action. Next time you are examining a chart, look for the waves. You may discover that the markets are not as random as they appear.