Introduction to the Elliott Wave 5-3 Market Pattern

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Introduction to the Elliott Wave 5-3 Market Pattern

Most of the binary options trading strategies traders use are reactive to market events; such as buy if the price breaks to a new high or low, or buy if the price bounces off a support line for example. But very few techniques have a forecasting ability. Elliott Wave analysis is one of the few technical tools traders can use to develop a map for what is likely to occur in future. While it doesn’t mean you will be able to pin point exact tops and bottoms, or when they will occur, such a map does provide you with an overall context for trends and corrections. For example, a market has been trending higher, and then starts to pullback. What do you do? Elliott Wave can help you determine if the market is likely heading into a full reversal (trend change) or if the move is just a pullback in an overall uptrend that is likely to continue.

Elliott Wave Misconceptions

Many traders cringe when they hear the words “Elliott Wave,” as it can be a little overwhelming at first. To become an expert in this field will take many days, weeks and even years of chart study and practice. But to grasp the basic tenants only takes a short while, and is well worth the effort. Even a basic understanding can help you pick better trades, and avoid some bad ones.

Like everything, there are product salesmen out there telling traders they have found the Holy Grail of trading, found that one strategy that promises you foreknowledge of exact market turning points. Unfortunately Elliott Wave won’t do that for you…and no strategy or method ever will. That said, this form of analysis is predictive and often provides a rough approximation of where pullbacks and trends will begin and end.

5-3 Wave Pattern

While this pattern is often disguised in a sea of choppy movement and price volatility, highly liquid markets generally move in a 5-3 pattern. A 5-3 pattern means that a trend unfolds in 5 waves, and corrections take place over 3 waves. For example, an uptrend will have an up wave (1), down wave (2), up wave (3), down wave (4) and a final up wave (5). Since the trend is moving higher, waves 2 and 4–which are pullbacks–will be smaller than waves 1 and 3 which are impulse waves in the direction of the trend. This overall 5 wave pattern is then followed by sizable correction of 3 waves: down wave (1), up wave (2), down wave (3).

Confused already? Stick with me. There is one more important concept to cover, then we will look at a few illustrations to clear things up. All waves are “fractals.” This means that a 5-3 pattern on a one minute chart may compose just wave 1 on a 15 minute chart. That big 5-wave uptrend you see on a daily chart, may be a Wave 2 move higher in a much longer-term 3-wave correction.

Here are two illustrations to help clear up the basic 5-3 concept of market movements.

Figure 1. Elliott Wave Basic 5-3 Pattern

From the above illustration you can see the general pattern that markets follow. The trend moves up in 5 waves and then corrects in 3–labeled A-B-C. But remember, this is happening on all time frames at the same time, from a tick chart all the way up to yearly and decade charts (and longer). The next illustration shows how this plays out.

Figure 2. Fractal Nature of Markets

A 5 wave pattern creates Wave 1 on a larger time frame. This is followed by a 3-wave correction which creates Wave 2 on that larger time frame, and so on. The 5-3 patterns on a shorter time frame are the building blocks for longer-term 5-3 patterns.

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You may look at a price chart, and notice that markets rarely move in such a well defined way as the illustrations above depict. It’s never quite that easy. The two main problems traders face when they begin using Elliott Wave, and start labeling their charts accordingly, is that A: they either don’t see these patterns at all, or B: they think they see them everywhere but are labeling them all wrong.

While this is article is by no means a full explanation of Elliott Wave analysis, here are a few rules to help label these 5-3 waves.

  • Wave 2 never moves beyond the start of Wave 1
  • Wave 3 is the never the shortest wave; it must be longer than either Wave 1 or Wave 5, or both.
  • Wave 4 never enters the price territory of Wave 1 (in highly leveraged markets you can allow a slight overlap).

If the market is not playing out according to these rules, then you’re likely labelling the chart wrong or the price action is not representative of a 5-3 model on the time frame you are looking at (there are other Elliott Wave patterns which occur within this 5-3 pattern, but are beyond the scope of this article).

If you want to increase your forecasting ability, then delve more deeply into Elliott Wave analysis. The definitive book on the subject is Elliott Wave Principle: Key to Market Behaviour by Frost and Prechter. While this form of analysis can be helpful, you don’t need it to trade. I’d actually advise you not to trade based on this methodology until you have researched it fully and practiced your wave counting skills.

Just knowing the basic 5-3 pattern will get you started. Try labeling charts using the method and rules outlined above. Depending on the time frame you’re looking at, you may not always see a 5-3 pattern. That is ok, don’t try to force it. Other patterns also exist, so you may need to shorten or broaden your time frame in order to see the 5-3pattern discussed here.

If you explore further, you’ll find that Elliott Wave can provide profit targets, estimate market turning points and provide a context for all other price movements you see on a charts–such as a triangle or a trading range. You’ll also learn other patterns, such as extensions, diagonals and the multiple forms that corrections can take.

Introduction to Elliott Wave Theory

Ralph Nelson Elliott developed the Elliott Wave Theory in the 1930s. Elliott believed that stock markets, generally thought to behave in a somewhat random and chaotic manner, in fact, traded in repetitive patterns.   In this article, we’ll take a look at the history behind Elliott Wave Theory and how it is applied to trading.

Waves

Elliott proposed that trends in financial prices resulted from investors’ predominant psychology. He found that swings in mass psychology always showed up in the same recurring fractal patterns, or “waves,” in financial markets. 

Elliott’s theory somewhat resembles the Dow theory in that both recognize that stock prices move in waves.   Because Elliott additionally recognized the “fractal” nature of markets, however, he was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves.   Elliott discovered stock index price patterns were structured in the same way. He then began to look at how these repeating patterns could be used as predictive indicators of future market moves. 

Market Predictions Based on Wave Patterns

Elliott made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern. A corrective wave, on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found. 

This next pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically. 

In the financial markets, we know that “what goes up, must come down,” as a price movement up or down is always followed by a contrary movement. Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.

Introduction to Elliott Wave Theory

Table of Contents

Introduction to Elliott Wave Theory

Introduction

Elliott Wave Theory is a method of market analysis, based on the idea that the market forms the same types of patterns on a smaller timeframe (lesser degree) that it does on a longer timeframe (higher degree). These patterns provide clues as to what might happen next in the market. According to the theory, it does not depend on what timeframe you are analyzing; market movements follow the same types of patterns.

The theory was developed by R.N. Elliott in the 1930s and was popularized by Robert Prechter in the 1970s. It claims that crowd behavior produces patterns and trends we see in markets; wave pattern, as defined by Elliott, is the physical manifestation of mass psychology in our world. These patterns not only appear in markets but anywhere humans make decisions en masse. Examples might include housing prices, fashion trends or how many people choose to ride the subway each day.

In this section, we will introduce the rules of wave formation and the various patterns seen in Elliott Wave Theory. By the end of this section, you should have a good grasp on how Elliott Wave is applied and be able to form your own Elliott Wave analysis on charts. However, keep in mind that it takes practice to confidently apply Elliott Wave Theory.

Basic Sequence

Motive Waves

The first half of an idealized Elliott Wave pattern is the Motive Wave, a wave that always advances in the direction of the trend of one larger degree. It is subdivided into five smaller waves, which are labeled 1, 2, 3, 4 and 5, as illustrated in the above chart. Within the motive wave, there are two types of smaller sub-waves: the Impulse Wave and the Diagonal Wave. Each will be explained in Part 3 of this article series.

You will notice in the chart that three of these sub-waves advance (waves 1, 3 and 5) and two of them correct or move downward (2 and 4). Waves 1, 3 and 5 in the motive wave are called “actionary” sub-waves. These are usually motive waves themselves, in that they move in the same direction as the trend of one larger degree. Waves 2 and 4 are “corrective” sub-waves, moving in the opposite direction of the larger trend. The motive wave tends to move with relative ease in the direction of the larger trend. Consequently, it is easy to spot and interpret.

There are three rules for Motive Wave formation that must be satisfied:

If we consider the actionary sub-waves as having five waves each, and the corrective sub-waves as having three waves each, then the larger motive wave would look something like the chart below. In this case, the actionary sub-waves are five waves each because they are in the direction of the trend of one larger degree – the larger motive wave. This type of pattern is labeled as a 5-3-5-3-5 structure.

Corrective Waves

In general, the corrective wave is depicted as a three-wave structure, as seen in the chart above. The three-wave structure has its sub-waves labeled as waves A, B and C. This can be misleading since not all corrective waves are exactly three-wave structures. The specifics of corrective wave structures will be discussed later, but for our general purpose, we will start with describing them as having three sub-waves.

If we look at the structure, we will notice that Wave A and Wave C are both in the direction of the trend of one higher degree – in this case, the direction of the correction. Because of this (for this general example) we will show them as motive waves, each having a total of five waves. Wave B is traveling against the direction of the larger correction (trend of one higher degree) and will therefore be shown as having three waves. This type of pattern is labeled as a 5-3-5 structure.

Basic Cycle Structure

The combination of a motive wave and a corrective wave is the general structure of the complete Elliott Wave cycle. This is illustrated as a structure with a total of eight waves. There is a five-wave advance (motive) in the direction of the trend of one larger degree, followed by a three-wave correction against the higher degree trend.

The chart above shows the eight-wave sequence with a rising five-wave motive wave and a falling three-wave correction. You will notice that this movement, from beginning to end, finishes higher than it started (i.e., price increased). If you think about it, a 5-3 structure is the minimum requirement to achieve both fluctuation and progress in an up or down direction. Markets fluctuate – rise and fall – and they advance either up or down as they progress.

Elliott noticed that the market repeated this 5-3 structure again and again. This was the foundation of his theory and is the general Elliott Wave cycle structure.

Once the cycle ends, it begins again. It is expected that the market will make another five-wave advance after a correction ends.

Please note that this does not necessarily mean five waves up and three waves down. In a declining trend, the pattern will advance down and correct higher. That means there will be a five-wave down sequence followed by a three-wave up sequence.

The chart above shows this eight-wave structure in a declining market. Of course, it ends lower than where it started. If you saw this pattern on a chart, depending on the larger picture, you might expect another five waves down.

Please keep in mind that this is simply a motive wave and a corrective wave. All markets advance and correct. The Elliott Wave Theory provides specific types of patterns that the market uses to do this, which we will cover below, but it all fits within this general cycle structure.

Fractal Nature

If we incorporate our expanded motive and corrective waves together, we will see that they make a more detailed general Elliott structure. We can see five advancing waves in the motive wave that make up Wave I, as well as three declining waves in the corrective wave that make up Wave II. However, notice that in Waves 1 and 2 of Wave I, the general Elliott structure forms. This structure forms on both a larger scale and a smaller scale within the same picture.

This is an example of the fractal nature of the Elliott Wave patterns. A fractal is a curve or geometric figure, each part of which has the same statistical character as the whole, and anything that resembles this type of formation is said to be fractal. Within the Elliott Wave structure, this is evidenced by the expanding and contracting similarity of wave structures. Wave I is the next higher degree of trend for Wave 1, but within Wave 1 and 2 is the 5-3 pattern of the full Elliott Wave cycle. The 5-3 pattern then repeats for Waves 3 and 4, and for waves A and B as well (except in the declining direction).

There are actually three degrees of trend shown in the chart above. Waves I and II form the larger degree cycle. The next degree down are the waves that are labeled 1, 2, 3, 4, 5, A, B, and C. And the next degree down are the waves labeled i, ii, iii, iv, v, a, b, and c. In theory, this pattern expands to infinity and shrinks to infinity and constitutes what is known as a fractal, an infinitely contracting and expanding pattern.

Elliott discovered, by observation, that the markets were fractal in nature. No matter how big or small the wave degree, motive waves take on a 5-wave sequence and corrective waves usually take on a 3-wave sequence. He classified patterns that showed up in higher degrees of trend and saw that those same types of patterns repeated on lower degrees of trends.

The chart above shows the same picture in a declining market. See if you can spot the different degrees of trend.

Elliott Wave is not a trading technique. There are no specific rules of entry or exit, nor is there one “right” way to use it in trading. As a result, the use of Elliott Wave has been avoided by many traders and technical analysts, not due to a lack of understanding but because of the apparently subjective nature of how it may be applied. Nonetheless, there are those who have successfully used Elliott Wave patterns in their trading. The Theory continues to attract a wide following, both with individual investors as well as professional traders. Advocates tend to apply various indicators to help them in trading specific Elliott Wave patterns, although those techniques are unique to the people who developed them.

If you are going to perform Elliott Wave analysis, you will be making “wave-counts.” This simply means that you will be labeling the waves to see how they conform to the Elliott Wave pattern, allowing you to anticipate market movement. The next section will give you some guidelines on labeling the wave-counts.

Next Article in this Series: Identifying Elliott Wave Patterns

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