Gian
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7 min
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June 23, 2025
Ever wondered how traders predict market trends with precision? Discover the secrets behind Elliott Wave Theory and learn how to identify market cycles. In this guide, I’ll break down the basics of this powerful technical analysis tool, helping you to make more informed trading decisions.
Introduction
Elliott Wave Theory, a cornerstone of technical analysis that helps traders decode the seemingly chaotic movements of financial markets. Developed by Ralph Nelson Elliott in the 1930s, this theory is based on the idea that market prices move in repetitive cycles, or "waves," driven by the collective psychology of investors. These waves reflect shifts between optimism and pessimism, creating patterns that can be used to predict future price movements.
Basic Wave Patterns
At its core, Elliott Wave Theory identifies two primary types of wave patterns:
Impulse Waves: These waves move in the direction of the larger market trend and consist of five sub-waves, labeled 1, 2, 3, 4, and 5. Waves 1, 3, and 5 push the trend forward (motive waves), while Waves 2 and 4 are temporary pullbacks (corrective waves).
Corrective Waves: These waves move against the larger trend and typically consist of three sub-waves, labeled A, B, and C. Wave A and Wave C move opposite the trend, while Wave B is a smaller counter-move.
Imagine these patterns as the heartbeat of the market - impulse waves are the strong beats driving the rhythm, while corrective waves are the rests that keep it balanced.
Key Rules for Impulse Waves
To ensure a wave pattern qualifies as an impulse wave, it must follow three strict rules:
Rule 1: Wave 2 cannot retrace more than 100% of Wave 1. If it does, the pattern’s invalid.
Rule 2: Wave 3 cannot be the shortest among Waves 1, 3, and 5, it’s often the longest
Rule 3: Wave 4 cannot overlap with the price territory of Wave 1 (except in rare cases like diagonals). This keeps the waves distinct.
These rules are your checklist to confirm you’re reading the market’s story correctly.
Fibonacci Relationships
Elliott Wave Theory pairs with Fibonacci ratios, derived from a sequence where each number is the sum of the two before it (e.g., 0, 1, 1, 2, 3, 5, 8, 13, 21…). These ratios help predict wave lengths and turning points, with the golden ratio (approximately 1.618) playing a central role.
Understanding the Golden Ratio and Key Levels
The golden ratio (1.618) emerges when you divide a Fibonacci number by the previous one (e.g., 55 ÷ 34 ≈ 1.618). Its inverse, 0.618 (61.8%), is a key retracement level. Other levels, like 38.2%, are calculated as follows:
61.8% (0.618): Divide a number by the next one in the sequence (e.g., 34 ÷ 55 ≈ 0.618). This is the golden ratio’s inverse and a common retracement or extension point.
38.2% (0.382): Divide a number by the one two places ahead (e.g., 21 ÷ 55 ≈ 0.382). This is derived from 1 - 0.618, making it a complementary level to 61.8%.
50% (0.5): A psychological midpoint, not a true Fibonacci ratio, but widely observed in markets.
161.8% (1.618): The golden ratio itself, used for wave extensions (e.g., Wave 3 extending 161.8% of Wave 1).
Applying Fibonacci to Waves
These ratios estimate how far waves retrace or extend:
Wave 2: Often retraces 50% or 61.8% of Wave 1.
Wave 3: Might extend 161.8% or 261.8% of Wave 1.
Wave 4: Typically pulls back 38.2% of Wave 3.
Wave 5: May match Wave 1’s length or extend to 161.8% of Wave 1.
For example, if Wave 1 rises 100 points, Wave 2 might fall 61.8 points (61.8%), while Wave 3 could reach 161.8 points from Wave 2’s low (161.8% of Wave 1).
Practical Application
So, how do traders use this? Imagine you’re watching a stock like Apple. You spot a sharp rise (Wave 3) after a small dip (Wave 2). Knowing a pullback (Wave 4) is likely next, you might hold off selling until Wave 5 peaks.
In practice, combine Elliott Waves with tools like moving averages or RSI to confirm your counts. A real-world chart of the S&P 500 could reveal a five-wave rally followed by a three-wave dip, offering a textbook entry or exit point.
Common Mistakes to Avoid
Elliott Wave Theory isn’t perfect - its subjectivity trips up even seasoned traders. Watch out for:
Mislabeling Waves: Get the count wrong, and your prediction’s toast. Start simple.
Breaking Rules: Skip the impulse rules, and you’re guessing, not analyzing.
Overcomplicating: Don’t force every wiggle into a wave - keep it clear.
Practice on historical charts to sharpen your skills, and don’t rely on waves alone - blend them with other indicators.
Conclusion
Elliott Wave Theory is like a map for navigating market cycles. Understand its basics - impulse and corrective waves, the three rules, and Fibonacci magic with the golden ratio - and you’ll start seeing patterns where others see noise. It takes practice, but the payoff is worth it.
Elliott Wave Theory is the cornerstone of our analysis at Valbura - every chart we look at first gets analyzed through this lens, and then we proceed to place trades. It serves as a guide, not a standalone strategy for entering and exiting trades. Use it to get a feel for the market trend, combining it with indicators, fundamentals, and other tools to build a comprehensive approach. This method helps us anticipate potential moves while keeping risks in check, ensuring a balanced perspective on market behavior.
Disclaimer: The content provided in this blog post is for informational and educational purposes only and does not constitute financial, investment, or other professional advice. All data, figures, and examples are illustrative and should not be interpreted as guarantees of future performance or recommendations for specific investment actions. While we strive to ensure the accuracy of the information presented, we make no representations or warranties as to its completeness, reliability, or suitability for your individual financial situation. Always consult with a qualified financial advisor or professional before making any investment decisions. The author disclaims any liability for actions taken based on the information provided herein.