Elliott Wave and Behavioral Finance

Let’s dive deep in to the idea that market behavior is influenced by social or crowd behavior by exploring the connection between Elliott Wave and behavioral finance. This particular field of TA is arguably among the complex trading models but being able to master the art of counting waves will surely increase your winning odds in the market.

Elliot Wave Introduction

The Elliott Wave Principle is a tool for analyzing stock market behavior developed by Ralph Nelson Elliott. It is based on the idea that social or crowd behavior trends and reverses in recognizable patterns, which can be used to predict future market trends.

Elliott identified thirteen patterns of movement or “waves” that recur in market price data, and these structures link together to form larger versions of those same patterns.

The Wave Principle is primarily a description of how markets behave, providing a context for market analysis and a perspective on the market’s general position and outlook.

Elliott’s genius consisted of a disciplined mental process that enabled him to construct a network of principles that covered all market action known up to the mid-1940s. The patterns described in the Wave Principle have stood the test of time, and uncertainties can be avoided by following the rules and guidelines as laid down in this content.

Basic Tenets of Elliot Wave

The Elliott Wave Principle suggests that the behavior of the stock market follows a predictable pattern, just like the patterns found in nature. Every transaction in the market is like a link in a chain that creates a feedback loop, which is governed by the social nature of people. This process creates patterns that repeat over time and can help predict future market movements.

The market is not always influenced by outside events, and it has its own set of rules that don’t follow a linear or cyclical pattern. Instead, it follows a structured progression that unfolds in waves. Waves are patterns of directional movement that naturally occur under the Wave Principle and can be used to analyze the market.

By understanding and recognizing these patterns, investors can make informed decisions about when to buy or sell their investments.

Fig-1. Basic 53535 Elliot Wave Structure (Impulse Wave and ABC Correction)

Basic principles of the Elliot Wave Principle

1. The market moves in a series of five waves in the direction of the main trend, followed by three corrective waves against the trend.
2. Waves 1, 3, and 5 are the impulse waves and move in the direction of the trend, while waves 2 and 4 are corrective waves.
3. Waves 2 and 4 will never move beyond the start of wave 1.
4. Wave 3 is usually the longest and most powerful wave, and it is never the shortest.
5. Wave 2 will usually retrace between 50% and 61.8% of wave 1, while wave 4 will typically retrace between 38.2% and 50% of wave 3.
6. Waves 1, 3, and 5 are made up of smaller waves, usually three or five waves themselves.
7. Waves A and C of the corrective waves (waves 2 and 4) are made up of three waves, while wave B is made up of two waves.
8. Elliott Waves can form at all degrees of trend, from the smallest time frame to the largest.

Fig-2. Basic 53535 Elliot Wave Structure (Impulse Wave and ABC Correction) with Fibonacci Relationships

These principles are the basis of the Elliott Wave theory and are used by analysts to identify and predict market trends.

Motive Waves

Motive waves are a type of wave that move in the same direction as the trend of the larger pattern. They are made up of five smaller waves that are easy to identify. These waves have specific rules, such as wave 2 never going beyond 100% of wave 1, and wave 3 always being longer than wave 1. The purpose of a motive wave is to show progress, and these rules help ensure that happens. Wave 3 is often the longest among the actionary waves (1, 3, and 5) and as long as it moves more than waves 1 or 5, the rule is met.

Two Types of Motive Waves

There are two types of motive waves: impulses and diagonal triangles.

Complete Wave Cycle (Impulse and Corrective)

Impulse Waves

An impulse wave is a specific pattern in Elliott Wave Theory that consists of five waves that move in the same direction as the overall trend. The first, third, and fifth waves are called “actionary waves” and represent the main trend, while the second and fourth waves are “corrective waves” that move against the trend. In an impulse wave, wave 3 is typically the strongest and the longest of the three actionary waves, and it always extends beyond the start of wave 1. Additionally, wave 4 should not overlap with the price range of wave 1. Impulse waves are important to Elliott Wave Theory because they provide clues about the direction and strength of the trend.

Impulse Wave Extensions

Most impulses also contain an extension, which is an elongated impulse with exaggerated subdivisions. Extensions are usually found in one and only one of the three actionary subwaves of an impulse, and they can sometimes make it difficult to distinguish between a count of nine waves and a count of five waves. However, both counts have the same technical significance in the Elliott system.

Types Impulse Wave of Extensions

Truncation

Truncation is a term used to describe a situation where the fifth wave of an Elliott Wave sequence fails to exceed the high or low of the preceding third wave. In other words, the fifth wave is shorter than the third wave and does not make a new high or low.

Truncation is a sign of weakness in the Elliott Wave pattern and is considered to be a bearish signal in an upward trend and a bullish signal in a downward trend. It suggests that the market is unable to sustain the momentum of the previous move and is likely to experience a reversal in the near future.

Truncation/Failure/Incomplete Elliot Wave Pattern

Elliott used the word “failure” to describe a situation in which the fifth wave does not move beyond the end of the third. It is sometimes referred to as a “failed” fifth wave or an “incomplete” Elliott Wave pattern.

It is important to note, however, that not all fifth waves are truncated, and not all truncated waves lead to a reversal. Truncation should always be analyzed in the context of other technical indicators and market conditions before making any trading decisions.

Diagonal Triangles

A diagonal triangle is a pattern that has five waves, just like impulse waves, but it is not an impulse wave because it has one or two corrective characteristics. Diagonal triangles are found in specific locations within the wave structure. The third subwave in diagonal triangles is never the shortest, and no reactionary subwave fully retraces the preceding actionary subwave. Unlike impulse waves, wave four in diagonal triangles almost always moves into the price territory of wave one.

Ending Diagonal

Ending Diagonal

An ending diagonal is a special type of wave that occurs mainly in the fifth wave position when the preceding move has gone too far too fast. It is found at the termination points of larger patterns, indicating exhaustion of the larger movement. Ending diagonals take a wedge shape within two converging lines, with each subwave, including waves 1, 3, and 5, subdividing into a “three.”

In double or triple threes, they appear only as the final “C” wave.

Leading Diagonal

Leading Diagonal

A leading diagonal is a variation of the diagonal triangle pattern that can appear in the wave 1 position of impulses and in the wave A position of zigzags. It has a 5–3–5–3–5 pattern and overlaps between waves 1 and 4, converging into a wedge shape. This structure implies continuation of the larger trend, unlike the ending diagonal triangle which implies termination. It is important for analysts to recognize this pattern to avoid mistaking it for a series of first and second waves, and a key indicator is the slowing of price change in the fifth subwave relative to the third. In contrast, developing first and second waves often show short term speed increase and broader market participation.

Corrective Waves

Corrective waves, by classic definition, refer to waves that move in the opposite direction of the trend of a higher degree. These waves are less easily identifiable than impulse waves and display a greater variety. It can be challenging to identify corrective patterns until they have completed. Nevertheless, as we have previously explained, both trend and counter-trend movements can occur in corrective patterns in today’s market. It is more appropriate to define corrective waves as waves that move in three, as opposed to five, as only motive waves consist of five.

There are five types of corrective patterns:

1. Zigzag (5–3–5)

2. Flat (3–3–5)

3. Triangle (3–3–3–3–3)

4. Double three: A combination of two corrective patterns above

5. Triple three: A combination of three corrective patterns above

Zigzag (5–3–5)

Zigzag Correction

Guidelines

1. Zigzag is a corrective 3 waves structure labelled as ABC
2. Subdivision of wave A and C is 5 waves, either impulse or diagonal
3. Wave B can be any corrective structure
4. Zigzag is a 5–3–5 structure

Fibonacci Ratio Relationship

1. Wave B = 50%, 61.8%, 76.4% or 85.4% of wave A
2. Wave C = 61.8%, 100%, or 123.6% of wave A
3. If wave C = 161.8% of wave A, wave C can be a wave 3 of a 5 waves impulse. Thus, one way to label between ABC and impulse is whether the third swing has extension or not

Flat (3–3–5)

A flat correction is a type of corrective move consisting of three waves labeled as ABC. While the labeling is the same, flats and zigzags differ in the way the A wave is subdivided. Zigzags follow a 5–3–5 structure, whereas flats follow a 3–3–5 structure. There are three types of flats: regular, irregular/expanded, and running flats.

Regular Flat (3–3–5)

Guidelines

1. A corrective 3 waves move labelled as ABC
2. Subdivision of wave A and B is in 3 waves
3. Subdivision of wave C is in 5 waves impulse / diagonal
4. Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
5. Wave B terminates near the start of wave A
6. Wave C generally terminates slightly beyond the end of wave A
7. Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

1. Wave B = 90% of wave A
2. Wave C = 61.8%, 100%, or 123.6% of wave AB

Expanded Flat (3–3–5)

Guidelines

1. A corrective 3 waves move labelled as ABC
2. Subdivision of wave A and B is in 3 waves
3. Subdivision of wave C is in 5 waves impulse / diagonal
4. Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
5. Wave B of the 3–3–5 pattern terminates beyond the starting level of wave A
6. Wave C ends substantially beyond the ending level of wave A
7. Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

1. Wave B = 123.6% of wave A
2. Wave C = 123.6% — 161.8% of wave AB

Running Flat (3–3–5)

Guidelines

1. A corrective 3 waves move labelled as ABC
2. Subdivision of wave A and B is in 3 waves
3. Subdivision of wave C is in 5 waves impulse / diagonal
4. Subdivision of wave A and B can be in any corrective 3 waves structure including zigzag, flat, double three, triple three
5. Wave B of the 3–3–5 pattern terminates substantially beyond the starting level of wave A as in an expanded flat
6. Wave C fails travel the full distance, falling short of the level where wave A ended
7. Wave C needs to have momentum divergence

Fibonacci Ratio Relationship

1. Wave B = 123.6% of wave A
2. Wave C = 61.8% — 100% of wave AB

Triangle (3–3–3–3–3)

A triangle is a sideways movement in the market characterized by declining volume and volatility. Triangles consist of five sides, with each side subdivided into three waves, resulting in a 3–3–3–3–3 structure. In Elliott Wave Theory, there are four types of triangles: ascending, descending, contracting, and expanding. The graphic below provides an illustration of these four types.

Triangle

Guidelines

1. Wave B = 123.6% of wave A
2. Corrective structure labelled as ABCDE
3. Usually happens in wave B or wave 4
4. Subdivided into three (3–3–3–3–3)
5. RSI also needs to support the triangle in every time frame
6. Subdivision of ABCDE can be either abc, wxy, or flat

Double three: A combination of two corrective patterns above

Double three is a sideways combination of two corrective patterns. We’ve already looked at several corrective patterns including zigzag, flat, and triangle. When two of these corrective patterns are combined together, we get a double three. In addition,

Guidelines

1. Wave B = 123.6% of wave A
2. A combination of two corrective structures labelled as WXY
3. Wave W and wave Y subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree
4. Wave X can be any corrective structure
5. WXY is a 7 swing structure

Fibonacci Ratio Relationship

1. Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W
2. Wave Y = 61.8%, 100%, or 123.6% of wave W
3. Wave Y can not pass 161.8% of wave W

Triple three: A combination of three corrective patterns above

Triple three is a sideways combination of three corrective patterns in Elliott Wave Theory

Guidelines

1. A combination of three corrective structures labelled as WXYXZ
2. Wave W, wave Y, and wave Z subdivision can be zigzag, flat, double three of smaller degree, or triple three of smaller degree
3. Wave X can be any corrective structure
4. WXYZ is an 11 swing structure

Fibonacci Ratio Relationship

1. Wave X = 50%, 61.8%, 76.4%, or 85.4% of wave W
2. Wave Z = 61.8%, 100%, or 123.6% of wave W
3. Wave Y can not pass 161.8% of wave W or it can become an impulsive wave 3