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So You Wanna Learn Elliott Wave Analysis?
For more reading on the basics of Elliott wave analysis, please read all parts of the series: Part I, Part II, Part III, Part IV, Part V
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In the first article of this series, you learned the basics of Elliott wave patterns. Now let’s take a look at how we can (or can't) identify completed wave structures in order to see where the market is within a larger pattern (or trend). Then we’ll use the Three Rules of Elliott to decide where it is likely to go, and use "alternate counts" to order the probabilities.
Impulse waves are the most readily identifiable waveform. Like the main current in a river, they are relatively smooth and laminar. But corrective waves are more like eddies along a riverbank, complex and tricky, swirling back against the current.
Below is a chart of an impulsive five-wave move up that completes a larger-degree impulse wave (1). It is followed by a three-wave move down within what is probably a larger corrective wave (2). This is our "working," or preferred count – the scenario most likely to be correct.
We know that wave (1) is complete. How? Because we see that a) its internal structure shows clear five waves of a smaller wave degree, and b) it is followed by a three-wave correction. But do we know that the corrective wave labeled (2) is complete?
The fact is we are not certain. But we can assign various probabilities to whether or not it's complete. That’s what Elliotticians call alternate wave counts, shown at the bottom as Alternate (A) and (B). Alternate counts are essential to using the Wave Principle properly. They are not "failed predictions," or "bad" pattern interpretations. Alternate counts allow you to narrow down the infinite number of ways the market can move to just two or three AND rank these probabilities from highest to lowest. That makes your trading or investment decisions a whole lot easier.
So, now that we see in the chart above that corrective-looking three-wave decline labeled ABC (that comprise the larger-degree wave 2), here are the three most likely possibilities – ranked in order of highest to lowest:
Most Likely: Wave (2) has ended and wave (3) is about to begin a strong upward move.
Less Likely: Wave (2) has not ended, and could develop into a more complex three-wave structure (which would still not change the preferred count).
Least likely: If Wave (2) continues much lower, retracing all of wave (1), the alternate count will become preferred: Waves (1) and (2) are then most likely waves (A) and (B) of an upward correction within a larger impulsive downtrend. That's what the labeled "Alternate (A) and (B)" count in the above chart shows.
Despite this seeming uncertainty, you will like the next part. Although the three alternate counts describe different scenarios, the implication of each – if you think about it – is the same: The larger trend is higher, so the market is likely to move upward! So, as you can see, a careful look at your alternate wave counts can quickly lead you to an actionable trading strategy.
You should always remember that only time can reveal the exact wave pattern. There can never be 100% certainty about the position of the market, but Elliott’s three specific rules limit the probabilities to a number you can work with – so you know when your primary count is valid, and when you should change to your alternate. The rules are:
Rule One: Wave 2 can never retrace more than 100% of wave 1.
Rule Two: Wave 3 is often the longest and never the shortest among waves 1, 3 and 5.
Rule Three: Wave 4 can never end in the price territory of wave 1.
The Three Rules of Elliott give you specific boundaries for any wave count. In the chart above, for example, if wave (2) continues below the start of wave (1), thus violating Rule #1, then your originally preferred count would be instantly invalidated, and one of the alternates becomes preferred. These rules help eliminate subjectivity, define your strategy, reduce your risk – and give you an instant edge in the markets.
In Part III, we will look at how Fibonacci ratios help you forecast the markets. In the meantime, our website is full of educational material: check out our Education, Traders and Free Stuff pages.
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