To understand the Elliott Wave Theory, we need to delve into the principles of how price movements unfold in a market, according to the wave principle laid out by Ralph Nelson Elliott and later popularized by Robert Prechter.
The Elliott Wave Theory suggests that financial markets move in repetitive cycles, which are primarily driven by investor psychology. These cycles are broken down into "impulse waves" and "corrective waves":
Impulse Waves: These are five-wave patterns that move in the direction of the primary trend (labeled 1, 2, 3, 4, 5).
Corrective Waves: These are three-wave patterns that move against the trend (labeled A, B, C).
Basic Elliott Wave Structure
The basic structure consists of 5 impulse waves (1, 2, 3, 4, 5) and is followed by a corrective 3-wave pattern (A, B, C). Each of these waves has its own characteristics:
Wave 1: The initial move up.
Wave 2: A retracement of Wave 1.
Wave 3: Typically the strongest wave in the sequence and extends beyond Wave 1.
Wave 4: A corrective move against the trend.
Wave 5: The final move in the direction of the trend.
The corrective phase that follows includes:
Wave A: An initial move against the trend.
Wave B: A partial retracement of Wave A.
Wave C: A continuation of the move started by Wave A.
Fibonacci Retracement and Extensions in Elliott Waves
Retracements and extensions in Elliott Wave Theory are deeply tied to Fibonacci ratios. The retracement levels for Wave 2 are typically 0.382, 0.5, 0.618, 0.786, or even 0.91 of Wave 1. The retracement levels of Wave 2 will influence the extent of Waves 3 and 5.
Retracement and Extension Calculations
1. If Wave 2 Retraces 38.2% of Wave 1 (0.382)
Wave 3: When Wave 2 is a shallow retracement (38.2%), Wave 3 tends to be extended. It often moves 1.618 to 2.618 times the length of Wave 1. The most common target for Wave 3 in this case is 161.8% to 261.8% of Wave 1.
Wave 5: If Wave 3 is extended, Wave 5 is often equal to Wave 1 in length. However, Wave 5 can also extend, especially if Wave 1 was short. A common extension for Wave 5 would be 100% of Wave 1 or 61.8% of Wave 1 to Wave 3 combined.
2. If Wave 2 Retraces 50% of Wave 1 (0.5)
Wave 3: A 50% retracement still suggests a strong Wave 3, but the extension may not be as aggressive as in the 38.2% scenario. Typically, Wave 3 might move to 1.618 times the length of Wave 1.
Wave 5: After a 50% retracement in Wave 2, if Wave 3 is extended, Wave 5 will likely be equal to Wave 1 or potentially 0.618 times Wave 1 to Wave 3 combined.
3. If Wave 2 Retraces 61.8% of Wave 1 (0.618)
Wave 3: With a 61.8% retracement, Wave 3 is still expected to extend, although it is less certain to reach extreme extensions like 2.618 times the length of Wave 1. More conservatively, Wave 3 might move to 1.618 times the length of Wave 1.
Wave 5: If Wave 3 is still extended (but not as much as it would be in a scenario with a smaller retracement), Wave 5 might be equal to Wave 1 or 0.618 times the length from the start of Wave 1 to the end of Wave 3.
4. If Wave 2 Retraces 78.6% of Wave 1 (0.786)
Wave 3: A deeper retracement of 78.6% for Wave 2 suggests that Wave 3 might not be as extended. Typically, Wave 3 could be around 1.272 to 1.618 times Wave 1.
Wave 5: If Wave 3 is not significantly extended, Wave 5 may also not extend much. In such a scenario, Wave 5 might be around 61.8% to 100% of Wave 1.
5. If Wave 2 Retraces 91% of Wave 1 (0.91)
Wave 3: If Wave 2 retraces as much as 91% of Wave 1, this is considered a very deep correction, and the chances of a strong Wave 3 diminish. Here, Wave 3 might only extend to about 1.0 to 1.272 times Wave 1.
Wave 5: With a deep retracement and a limited Wave 3, Wave 5 could be equal to or less than the length of Wave 1. In some cases, Wave 5 may even truncate or fail to exceed the high of Wave 3.
Summary of Retracement and Extension Patterns
Key Notes for Practical Application
Wave 3 Never the Shortest: In Elliott Wave Theory, Wave 3 is never the shortest compared to Waves 1 and 5. A shallow Wave 2 usually results in a longer and more extended Wave 3.
Wave Alternation Principle: If Wave 2 is sharp (e.g., 0.786 or 0.91), expect Wave 4 to be a flat or sideways correction, and vice versa.
Confluence Zones: Use Fibonacci confluences to predict termination zones. For example, Wave 5 ending around a confluence of 100% of Wave 1 and 61.8% of Wave 1 to 3 can be a high-probability target.
Conclusion
The retracement of Wave 2 significantly influences the potential extensions of Waves 3 and 5 in the Elliott Wave structure. The relationship between these waves is not fixed, but understanding Fibonacci retracements and extensions can provide traders with a powerful tool to predict market movements and potential price targets.
By applying this approach with market observation and technical analysis tools, you can better estimate where each wave is likely to end and set appropriate stop-loss levels and profit targets accordingly.
