Wave Theory by Robert Prechter: Studying Charts and Market Psychology

Over its nearly 90-year history, the Elliott Wave Theory has inspired a variety of interpretations, but only two have become foundational in technical analysis.

This article explains everything you need to know about Robert Prechter’s wave theory, highlighting what makes his work particularly remarkable. It also examines his ideas in detail and demonstrates how to apply wave theory in live trading.

The article covers the following subjects:

What Is Robert Prechter Famous For?

Source: robertprechter.com

Robert Prechter is a renowned stock market analyst and psychologist, best known as the originator of the Socionomic Theory of Finance, a theory of social causality. Frequently dubbed the financial Nostradamus by his contemporaries, Robert Prechter has a long record of remarkably accurate forecasts. In the 1980s, he anticipated both a decline in gold prices and a rally in the stock market, followed by the crash of 1987. His ideas were further validated in live trading when he participated in the US Trading Championship in 1984 and achieved a record 444% return.

Prechter achieved these remarkable results through his extensive study of Elliott’s work. He also refined the classic Wave Theory, revealing the patterns that link market fluctuations to shifts in public sentiment. In his view, fundamental economic indicators tend to lag behind waves of public sentiment, while technical analysis provides a way to interpret the signals generated by market behavior.

Wave Types and Functions

Bill Williams distinguished two primary wave types: impulse waves, which move with the trend, and corrective waves, which move against the trend. Robert Prechter, however, offers a more nuanced framework. He classifies waves by their formation style, identifying the following categories:

• Motive waves that subdivide into five smaller waves.
• Corrective waves that subdivide into three waves.

Based on wave function or relative direction, Robert Prechter distinguishes:

• Actionary waves that follow the trend.
• Reactionary or countertrend waves that move against the trend.

Many actionary patterns are motive waves, though some can also be corrective, made up of three sub-waves. At the same time, all countertrend patterns are corrective.

Motive Waves

Within motive waves, wave 2 never retraces more than 100% of wave 1, and wave 4 always retraces less than 100% of wave 3. Additionally, wave 3 always advances above the end of wave 1 and is often longer than waves 1 and 5.

Motive waves can be divided into two types:

Let’s explore each of these wave types.

Impulse Waves

An impulse is the most common type of motive wave. In an impulse, wave 4 never overlaps the price territory of wave 1, though in rare cases, minor overlaps may occur on short-term charts. Another key rule suggests that actionary sub-waves 1, 3, and 5 are themselves motive, and sub-wave 3 is always an impulse.

Extension

Some impulse waves have wave extensions, which are elongated formations with an extended wave structure. In these cases, it is clearer to represent the formation as a nine-wave structure instead of the usual five.

The BTCUSD chart above shows a nine-wave pattern. Since wave 3 of the five-wave pattern turned out to be extended, it was divided into segments for simplicity.

For new traders, spotting the extended wave can be tricky. The good news is that a nine-wave pattern holds the same technical weight as a standard five-wave structure.

However, spotting extended waves is still useful, since it can reveal how long the next move might run. For instance, when waves 1 and 3 are about the same size, wave 5 is usually the one that extends, while an extended wave 3 often means a shorter wave 5.

Truncation

Prechter describes wave 5 as truncated when it fails to rise above the peak of wave 3. A truncated wave often appears after a particularly strong surge in wave 3. To distinguish wave truncation from a continued correction, you can divide the wave into five parts. The example below illustrates how it works.

The 15-minute BTCUSD chart shows that the price is rapidly rising in waves (1) and (3). As a result, bullish forces prove insufficient to generate strong momentum in wave (5). In such cases, breaking wave (5) into five waves of a lesser degree can confirm the truncation.

Diagonals

A diagonal is a motive pattern, though it cannot be considered an impulse due to its corrective features. This pattern replaces an impulse in certain sections of wave formations.

Diagonals still follow the basic Elliott Wave rules: wave 2 cannot retrace beyond the start of wave 1, and wave 3 cannot be the shortest. The only exception is that in diagonals, wave 4 is allowed to overlap wave 1. In rare cases, a diagonal may also finish with a truncation.

Ending Diagonal

An ending diagonal often forms as wave 5, especially when wave 3 shows strong price acceleration. It can also appear as wave C in a simple correction A-B-C. In complex corrections, such as double or triple threes, the ending diagonal may occur as the final wave C.

A defining feature of an ending diagonal is its wedge-shaped structure, formed by two converging trendlines. Each of its sub-waves, whether actionary or reactionary, unfolds as a three-wave pattern.

The hourly BTCUSD chart shows an ending diagonal formed as wave (5). As is typical of this pattern, this five-wave wedge formation marked with blue lines converges between the crossing red lines.

The fifth sub-wave of the ending diagonal does not always end at the channel boundary. It may finish with a “throw-over,” where price breaks through the trendline, often on high trading volume. For this reason, the channel boundary should not be treated as a target or a signal that the wave is complete. Sometimes, the fifth sub-wave may end below the boundary.

A rising ending diagonal usually signals a trend reversal, often followed by a sharp decline (as shown by the red arrow). Conversely, a falling ending diagonal points to an impending price surge.

Leading Diagonal

A diagonal can also appear at the very start of a pattern, forming in the wave 1 position. In this case, it is called a leading diagonal. Unlike an ending diagonal, which has a 3-3-3-3-3 structure, a leading diagonal typically follows a 5-3-5-3-5 pattern. This formation usually signals a continuation of the bullish trend, whereas the three-wave sub-waves of an ending diagonal often precede a reversal. A common sign of a leading diagonal is a slowdown in sub-wave 5 compared to the stronger move in sub-wave 3.

The hourly BTCUSD chart displays a part of a five-wave pattern, where wave (1) is a leading diagonal. Let’s switch to a lower time frame to confirm this.

As you can see, the five-wave pattern can be broken down into sub-waves of a lesser degree. Sub-wave (1) forms as a five-wave structure, sub-wave (2) unfolds as three waves, sub-wave (3) develops in five waves, sub-wave (4) represents three waves, and sub-wave (5) has a five-wave structure (marked with the purple lines on the chart). Altogether, these sub-waves create a clear 5-3-5-3-5 pattern, which is a leading diagonal.

All of the patterns described above, except for the leading diagonal, typically signal a trend reversal. Sometimes, they may even appear together within the same formation, such as an ending diagonal followed by a truncated wave 5. In such cases, the move against the preceding trend often becomes especially strong.

Corrective Waves

In Prechter’s theory, there is only one absolute rule about corrections: they can never consist of five waves. Although a five-wave pullback against a wave of a larger degree can occur, it represents only part of the correction, not the entire corrective pattern.

Corrections usually come in two styles: sharp corrections, caused by intense price movement against a larger trend, and sideways corrections, which often return to the starting level, creating the appearance of sideways movement.

There are four types of corrective patterns, each of which falls into several categories:

• zigzags;
• flats;
• triangles;
• combinations.

Zigzags

Zigzags have a 5-3-5 structure and can be single, double, or triple. A single zigzag is the simplest pattern, which is usually labeled A-B-C. Williams refers to this pattern as a simple correction. Its key feature is that, in an uptrend, wave B ends below the start of wave A. In a downtrend, this pattern is called an inverted zigzag.

The hourly BTCUSD chart above shows a classic zigzag pattern. Notably, the top of wave (B) is lower than the start of wave (A).

In some cases, corrections can consist of two or even three zigzags separated by an intervening three. Such patterns are called double or triple zigzags. They usually occur when the first zigzag does not reach its target. Prechter labels double zigzags W-X-Y, where W is the first zigzag A-B-C and Y is the second one. X, in this case, is a linking wave. If there is an extended correction, it can be marked W-X-Y-X-Z, where Z is the third zigzag A-B-C.

The chart presents a triple zigzag. The red lines indicate three consecutive single zigzags, while the blue lines mark the corrective threes connecting them.

Flats

Flat corrections are divided into three types: regular, expanded, and running. Unlike zigzags, flats follow a 3-3-5 structure. Since the first actionary wave A does not have enough strength to form a full five-wave impulse, wave B reflects this lack of pressure and ends near the start of wave A. In most cases, wave C terminates just slightly beyond the starting point of wave A, whereas in a zigzag, wave C usually moves much further. In a bear market, the pattern unfolds in the opposite direction.

Flat corrections are usually weakened by strong waves of a higher degree and, therefore, almost always follow or precede extensions. The more powerful the main movement, the shorter the flat.

An expanded flat is the most common type of flat correction. Its highest point exceeds the extreme point of the previous impulse wave. In other words, the top of wave B is above (or below in a bear market) the beginning of wave A.

The chart shows an expanded flat marked with red lines. The top of wave (B) is above the end of wave (5) (the start of wave (A)). Besides, waves (A) and (B) of the expanded flat are three-wave structures, and wave (C) is a five-wave pattern. The waves of a lesser degree are marked with blue lines.

In a regular flat, shown on the chart above, the top of wave (B) is about the same level as the top of the last impulse, and wave (C) ends just below the extreme point of wave (A). Regular flats are less common than expanded flats. On the chart, a regular flat is marked with red lines, and the start and end levels of wave (A) are marked with horizontal purple lines.

A running flat is an even rarer type of correction. In this pattern, wave B concludes considerably above the top of the preceding impulse. However, in contrast to an expanded flat, wave C falls short of reaching the end of wave A, which means it is truncated. Such shifts occur when the underlying trend is so strong that a full correction does not have time to form and gives way to the primary trend.

When analyzing, it is crucial to confirm that a running flat still follows the 3–3–5 structure. If wave B consists of five sub-waves instead of three, then it is no longer a correction but the beginning of a new impulse. Another feature of running flats is the strong, rapid impulse that precedes them, which forms the shift.

Prechter warns that running flats have appeared only a few times in the entire history of the markets. Therefore, it is no wonder that I could not find a single similar pattern on the BTCUSD chart.

Triangles

Diagonals and triangles share a wedge-like appearance, but while diagonals develop in the direction of the trend, triangles form as sideways corrective patterns.

Triangles comprise five overlapping waves consisting of smaller threes. The pattern has a 3-3-3-3-3 structure, which is typically labelled A-B-C-D-E on a chart.

There are two basic types of triangles: contracting and expanding. Contracting triangles are more common and can be divided into three subtypes:

• Ascending triangles: in a bear market, the upper line is flat while the lower line is rising.
• Descending triangles: the upper line is declining, while the lower line is flat.
• Symmetrical triangles: the upper line is declining, while the lower line is rising.

The chart above shows a contracting triangle. Its waves are marked with red lines. The two blue lines connecting the extremes of the triangle gradually converge. Therefore, this is a symmetrical contracting triangle.

Expanding triangles are rarer and are not divided into subtypes.

The figure above shows an expanding triangle that formed in the second wave of the impulse. Its waves are marked in red, while its boundaries are drawn in blue. Unlike a contracting triangle, the initial waves are overlapped by the subsequent ones.

Sometimes, wave B of a contracting triangle exceeds the top of the previous impulse wave. In this case, similar to flats, the triangle will be running.

Furthermore, the 3-3-3-3-3 structure is not mandatory for triangles. Wave C often takes a more complex form, such as an expanded or regular flat, or a multiple zigzag. In rare cases, wave E may unfold in five sub-waves, becoming a triangle itself.

Triangles often appear just before the final actionary wave. When a triangle forms as wave 4, wave 5 is sometimes swift and brings a sharp price move roughly equal to the widest part of the triangle. If the price moves beyond that thrust, it often signals the development of an extended wave 5.

In rare cases, wave 2 of the impulse can become a triangle, as in the example above. Usually, such triangles are part of a larger corrective pattern or combination.

Combinations

Combinations can be made up not only of the same patterns, such as zigzags, but also of different ones, for example, a zigzag followed by a flat. These formations are called double or triple threes. Their structure and labeling are similar to multiple zigzags: the first simple pattern is followed by a corrective pattern, most often a zigzag. Then comes the second pattern, which is another correction, and finally the third pattern.

For the most part, double and triple threes are horizontal structures, so the first simple pattern most often sets the magnitude of the correction and can subsequently be used as a target. At the same time, combinations cannot contain more than one zigzag or more than one triangle.

Orthodox Top and Bottom

Usually, the end of a pattern coincides with the price extreme, but sometimes this is not the case. In such situations, the extreme price level is called the actual price high or low, while the end of the wave pattern is referred to as the orthodox top or bottom.

A prime example of such patterns is the truncated five-wave sequence. Let’s look at the chart below.

The top of wave (5) is below the top of wave (3). Thus, the actual high will be the end of wave (3), and the orthodox top will be the end of wave (5).

Actionary Corrective Waves

Earlier in this article, I have already described the styles of wave development and their functions. A closer look at the patterns shows that some actionary waves develop in the form of corrections. These include:

• waves 1, 3, and 5 in an ending diagonal;
• wave A in a flat correction;
• waves A, C, and E in a triangle;
• waves W and Y in double zigzags and double threes;
• wave Z in triple zigzags and triple threes.

These waves will be referred to as actionary corrective waves.

Wave Degrees

The highest wave level is the Grand Supercycle degree. Such waves can only be identified on very long-term charts, typically with twelve-month time frames. A single Grand Supercycle wave may take years or even decades to complete. Its sub-waves belong to the next lower level, the Supercycle degree, which in turn is divided into Cycle degree sub-waves, and so on. In total, Robert Prechter’s classical theory defines nine wave degrees:

1. Grand Supercycle;
2. Supercycle;
3. Cycle;
4. Primary degree;
5. Intermediate degree;
6. Minor degree;
7. Minute degree;
8. Minuette;
9. Subminuette.

Identifying wave levels is one of the hardest parts of wave theory because it is not based on exact data like price ranges or time frames. Fortunately, you do not need that kind of precision to make reliable forecasts. Even if you misjudge the level by one degree, it will not have a big impact on your predictions.

Moreover, Robert Prechter’s followers expanded the theory by defining six more levels:

1. Supermillennium;
2. Millennium;
3. Submillennium;
4. Grand Supercycle;
5. Supercycle;
6. Cycle;
7. Primary degree;
8. Intermediate degree;
9. Minor degree;
10. Minute degree;
11. Minuette;
12. Subminuette;
13. Micro;
14. Submicro;
15. Minuscule.

In this classification, the Minute degree is divided into the Minuette and then the Subminuette degree. Below Subminuette come the Micro, Submicro, and Minuscule degrees.

Judging by its name, the Supermillennium degree represents waves that span millennia, while the Minuscule degree reflects tick movements.

In terms of classical technical analysis, both wave degrees lack practical meaning. Thus, we will adhere to Robert Prechter’s canonical nine-degree wave framework.

There are several noteworthy guidelines that make it much easier to determine wave structure:

• Alternation;
• Depth of corrective waves;
• Channeling;
• Wave personality;
• Other guidelines.

The following section focuses on the first three types of guidelines.

Alternation

Most traders, especially beginners, believe that if the last market cycle followed certain rules, then the next one will behave in exactly the same way. Instead, wave behaviour tends to change constantly. On the one hand, this makes it difficult to recognize Elliott waves, as successive structures can mislead inexperienced traders. On the other hand, the guideline of alternation helps predict the characteristics of individual waves. For example, waves are unlikely to be the same length: if one wave is long, the others are likely to be short.

Alternation Within Impulse Waves

If wave 2 of a five-wave formation is a sharp correction with an intense downward movement, then wave 4 will most likely be a sideways movement. Conversely, if wave 2 is flat, then wave 4 will be a sharp correction.

Sharp corrections never form a new price extreme. That is, they do not have a price value that would be higher than the orthodox end of the preceding wave. In addition, such corrections almost always develop either as simple or multiple zigzags or as double threes that originate from a zigzag.

Sideways corrections, by contrast, often include a new price extreme. They usually take the form of flats, combinations, or diagonals. In rare cases, a regular triangle without a new extreme may develop in the fourth wave position, especially if a sideways pattern appeared earlier in wave 2.

There is a pattern that does not show alternation between waves 2 and 4. These are diagonals consisting of zigzags. Wave extensions, in contrast, tend to alternate. In most cases, if wave 1 is short, wave 3 will be extended, and wave 5 will also be short. Less frequently, extensions can occur in wave 1 or wave 5.

The chart shows a pattern in which wave (2) is a sideways correction, wave (3) is the shortest, and wave (5) is extended. The blue lines outline the five-wave structure of wave (5). Since wave (2) is a sideways correction, wave (4), according to the guideline of alternation, is a sharp correction, and short impulse wave (3) is followed by an extension in wave (5).

Alternation Within Corrective Waves

If wave A of a correction is a flat pattern with an a-b-c structure, then wave B will be an a-b-c zigzag and vice versa.

The figure above shows how the guideline of alternation within corrections works. Wave (a) forms as a zigzag, followed by wave (b), which is more like a flat.

Another common phenomenon is increasing wave complexity. For example, wave 1 forms as a standard zigzag, wave 2 unfolds as a complex double zigzag, and wave 3 may be even more complex, forming a triple zigzag or a combination of zigzags with other patterns. The reverse order of complexity, where waves become progressively simpler, is very rare.

The 5-minute BTCUSD chart above shows a three-wave correction with consecutive complexity. Wave (a) is a simple zigzag, wave (b) is a triple zigzag, and wave (c) is an even more complex structure consisting of three triangles. The major waves on the chart are marked with red lines, the sub-waves are blue, and the intermediate waves of complex patterns are marked with purple letters.

Depth of Corrective Waves

Few analytical tools can indicate when a bear market might end. Elliott Wave Theory is one of them. According to the guideline, a correction, especially when it forms as wave 4, usually pulls back into the area of the previous fourth wave of a lesser degree.

The green lines on the chart above mark the main five-wave pattern, while the blue lines indicate the pattern of a lesser degree. The purple horizontal line marks the end of wave (4) of the main impulse. As you can see, it coincides with the beginning of the correction of a lesser degree.

While analyzing various markets, Robert Prechter observed another regularity: when wave 1 of an impulse is extended, the correction following wave 5 usually holds above the low of wave 2.

However, these guidelines are not always followed. Sometimes, triangles and flat corrections, especially those that occur after extended waves, fail to reach the area of wave 4. This typically happens when strong market forces continue to push the price in the direction of the impulse.

Zigzags, on the contrary, may retrace into the area of wave 2 of a lesser degree due to their sharpness. Such situations most often occur when zigzags themselves form as second waves.

Corrections After Extended Fifth Waves

Prechter outlined another guideline of wave theory that is often observed. When wave 5 is extended, the following correction usually forms a support level around the end of sub-wave 2 of the extended wave 5. At this point, the decline may halt, or the first sub-wave of the correction may complete.

The chart above shows an impulse wave (green) with an extended fifth wave, followed by a correction (red). The extension of wave (5) within the main impulse is highlighted in blue. The low of its sub-wave 2 is marked by a horizontal purple line, which almost perfectly coincides with the end of wave (A), showing a clear support level.

Corrections that follow extended fifth waves are usually characterized by strong downward momentum. When such patterns appear, they can signal a sharp reversal toward a specific price level.

If a flat correction follows an extended fifth wave, then the correction usually ends below the second sub-wave of the extension. Wave A often terminates close to this level, and the subsequent five-wave structure develops within the larger bullish trend.

Channeling

When developing his theory, Prechter noticed that the upper and lower boundaries of impulse waves can often be contained within parallel trendlines. Let’s explore why this occurs.

Guideline of Wave Equality

One of the most common guidelines suggests that two motive waves in a sequence will be similar in length and magnitude. Most often, this rule applies to two non-extended waves, especially if they are waves 1 and 5, and wave 3 is extended. If perfect equality is lacking, the waves can be formed based on a 0.618 ratio. By the way, this principle can be combined with the guideline of wave alternation, which states that if one of the three motive waves is significantly different from the other two, then the remaining waves may be similar to each other.

The BTCUSD chart above shows waves (1) and (3), which are similar in three respects: their structure, their length, and their duration (wave (1) spans 12 candlesticks, while wave (3) spans 11).

To measure wave ratios more accurately, Robert Prechter recommends using arithmetic (linear) or percentage values for waves up to the intermediate degree. For larger waves, only percentage values should be applied, since arithmetic measurements become impractical. Market volatility can change dramatically over long periods. For example, in a calm market, a 100-point move may be seen as significant, but a few years later, the same move can be considered modest.

As an example, let’s look at the daily BTCUSD chart starting from April 2014. The red zones highlight periods of high volatility, while the other areas show low-volatility phases, where even small price moves had a significant impact.

Channeling Technique

Wave channels are used to forecast future trends. The ends of impulse waves often align with channel boundaries with remarkable precision, meaning that drawing channels early can help identify potential reversal points in advance.

The basic channeling technique requires at least three points. The upper boundary is drawn through the peaks of waves 1 and 3, while the lower boundary runs from the end of wave 2 and is set parallel to the upper line.

This technique helps estimate where the peak of wave 4 will be, but it should not be used to predict wave 5. Wave behavior does not always fit ideal conditions, so a channel drawn from only three points should not be considered final. Moreover, third waves often extend far enough that the peak of wave 1 falls outside the channel.

The chart above presents three completed channel waves and a fourth wave in progress. The tops define the channel’s upper boundary and direction, while the end of wave (2) represents the lower boundary. Based on these channel lines, wave (4) is expected to end in the 8400–8600 range. This initial forecast can be refined by analyzing the subsequent direction and structure of wave (4).

If wave (4) ends at the lower boundary, the initial channel should not be adjusted. However, wave (4) often falls short of the lower boundary or, conversely, breaks through it. This is normal, since the channel at this stage is only preliminary.

In such cases, Prechter recommends redrawing the channel to project the end of the fifth wave. First, connect the ends of waves 2 and 4. If the waves are regular, the upper boundary is then drawn through the top of wave 3, with its slope determined by the lower boundary.

If wave 3 is abnormally strong, meaning the price has risen sharply, the parallel line drawn through its peak may be set too high. This is often clearly visible on the chart. In such cases, it is more appropriate to draw a parallel to the lower boundary line through the top of wave 1.

In the example above, wave (3) is standard. Thus, we can draw the upper boundary through its peak. The green arrow on the chart indicates the projected end of wave (5), expected between 9600 and 9800.

Sometimes the wave structure is so complex that it is impossible to choose a single reliable method for calculating the upper boundary. Prechter advises against relying on chance and recommends drawing two upper lines instead. The lower line should be considered the conservative target, while the upper line represents the maximum potential.

Finally, wave (5) ends almost exactly at the channel boundary. Experience shows that the extreme of wave (4) is correctly identified only about half the time. Once the channel boundaries are adjusted, predicting the end of wave (5) becomes easier. A similar approach can also be used to set targets in contracting triangles.

Wave Personality

The concept of wave personality represents an inherent part of the wave theory. In the context of the Elliot rules, the idea of personality reflects mass psychology, which often exhibits similar patterns. The transition of emotions from pessimism to optimism and vice versa creates wave patterns that share a similar structure, allowing traders to predict the next sequence and correctly determine the market phase.

What Processes Stand Behind the Five-Wave Formation?

Firstly, we will review the processes that accompany the emergence and development of impulse waves. In most cases, the development of an ideal five-wave structure goes as follows:

Bottom (before the first wave). In the case of large wave degrees, the bottom is formed during a prolonged bearish trend due to a deep crisis, depression, military conflicts, or other devastating events. At intermediate wave degrees, the bottom is formed as a result of deep declines or limited crises. In small degree waves, the bottom is most often formed due to unfavorable news.

Rise (wave 1). As a rule, the price of an asset is undervalued at the bottom. The rise is a kind of response to the low value of the asset. In most cases, major players are already aware of the impending trend reversal.

Test of lows (wave 2). Most traders perceive the rise as a correction, after which a reversal will inevitably occur. It is usually accompanied by negative fundamental factors. Large players take advantage of the situation, luring small traders to sell their assets at low prices. Therefore, testing lower levels almost always does not lead to new swing lows.

Powerful wave (wave 3). At this point, most traders are aware of a trend reversal and enter the market under the new rules. Wave 3 is called powerful because it is characterized by great strength and a sustained movement in the direction of the main trend. By the end of the wave, the market often believes that the movement will continue for a long time.

Surprising disappointment (fourth wave). This wave does not enter the area of wave 1. Prechter called the correction that developed after wave 3 a surprising disappointment. Many traders who opened long positions on positive news are experiencing severe stress as they find themselves locked into their trades. However, the beginning of the correction signals that the best part of the formation, where the highest profits could be made, has come to an end.

Final advance (fifth wave). After a slight stress during wave 4, temporary relief sets in. The masses form an exaggerated assessment of the trend strength, which is actually coming to an end. During wave 5, fundamental factors improve, but they rarely allow this wave to reach the size of the third powerful wave.

First Waves

Essentially, the structure of almost every wave 1 is the result of processes that occur before its inception and at the very beginning of its formation. Unlike a correction, wave 1 of a five-wave pattern usually demonstrates a movement of medium intensity in the direction of the trend, with trading volume increasing slightly.

This can be explained by the fact that at the beginning of a trend, most market participants, due to their erroneous choice of market side, are commonly referred to as small players, and are confident in the stability of the bearish trend or bullish in a bearish pattern progression. They perceive the upward movement as an opportunity to profit from the subsequent decline and open short positions en masse. For this reason, the intensity of the upward movement is moderate, and a correction occurs in wave 2.

On the chart, wave (1) is unfolding much more slowly than wave (3) because many traders are not participating in the upward price movement and are waiting for what they consider to be the right moment to open short positions. For the same reason, trading volumes are growing only slightly.

Once wave (1) is complete, traders open sell positions en masse, dragging prices down. Marked by the red area on the chart, the pullback negated the growth of wave (1). The slight difference between the bottom and the extreme point of wave (2) is marked by the blue area.

The remaining half of wave (1) is formed either by a noticeable reduction in corrections, or by large bases formed by the preceding correction, or by a failed downward movement. Their main differences are small corrections and rapid growth.

An example of the wave described above is the structure marked with blue lines on the chart. The base of the correction is wave (3) of the main formation, which I have highlighted in green. The red area indicates the size of the correction (2), which is approximately 25% of wave (1).

Second Waves

The behavior of wave 2 is closely related to the characteristics of the first ones. Most of them perform such a price pullback that most of the movement of wave 1 is offset by the end of wave 2. At the same time, the movement in the opposite direction is often not accompanied by large volume, which points to waning selling pressure. From a market perspective, this behavior can be explained by the fact that some small players perceive the beginning of the wave as an onset of a new trend. Large investors, on the other hand, are aware of the beginning of a new bullish trend and obtain the asset at the lowest possible prices.

The chart shows wave (2), which retraces almost the entire wave (1). Notably, most candlesticks are accompanied by low trading volume. Only at the very end does the volume increase along with a sharp drop in price. This can be explained by the fact that by the time of the decline, most weak market players were convinced that the bear market was intact.

Following the surge bar, large players start to acquire the asset. Then, in wave (3), they push the price significantly higher, leaving the remaining bears trapped. You can read more about these processes in the materials on VSA analysis.

Third Waves

Waves 3 is particularly appealing as they are characterized by high duration and possess a steady movement that cannot be confused with anything else. By the time wave 3 forms, as a rule, more and more favorable news appears, confirming the prospects of taking profits without much risk. Wave 3 is usually accompanied by high volume and robust price movement, which often leads to an extension of its structure.

Other indications follow from this pattern. For example, sub-wave 3 of wave 3 is inconsistent in its intensity of movement: there may be sharp jumps, breaks through resistance levels, gaps, and an increase in trading volume. In fact, virtually all market participants are involved in the development of wave 3. Hence, the intensity of movement is high.

On the hourly chart of the BTCUSD, wave (3) and its corresponding trading volume are highlighted in green. As we can see, the strong growth is accompanied by elevated volume throughout wave (3). This indicates strong bullish sentiment in the market. The majority of market participants consider the price growth to be stable enough to open long positions.

Fourth Waves

Unlike wave 2, the shape and intensity of which sometimes are puzzling, wave 4 is more predictable. Suffice it to recall the guideline of alternation: a sharp decline in wave 2 is followed by a sideways movement in wave 4, and vice versa. As a rule, wave 1 is accompanied by a deep correction, which is why the bulk of wave 4 develops sideways, creating the conditions for a powerful surge in wave 5.

This behavior is easily explained by mass psychology. As you may recall, during the formation of wave 3, most traders are confident in the stability of the prevailing trend. Although they view wave 4 with caution, they still perceive it as a temporary deviation. Therefore, there is no significant increase in positions opened against the main trend, resulting in minor price fluctuations and relatively low trading volume.

The red areas on the chart mark the pullbacks in waves (2) and (4). As you can see, even if the pullback in wave (2) is not particularly sharp, it becomes even more subdued in wave (4). The decline is hampered by strong support from bulls. The second important point is that trading volume throughout wave (4) is low. The only exception is one bar, and that is only because it reflects the movement in the direction of the main trend.

Fifth Waves

Wave 5 almost always has a smaller size and demonstrates weaker price movement. However, extended wave 5 is the only exception. One of the sections of such structures, sub-wave 3, may be faster than wave 3 of the main impulse.

As for volume growth, here the picture is not so obvious. When it comes to higher degree waves, volume is usually high. However, at a level below the primary one, the increase in volume is comparable to wave 3, with a more intense increase occurring only when wave 5 is extended. So, one of the ways to recognize the impulse structure is to look for lesser volume as a rule in wave 5 as opposed to wave 3, but it should be greater compared to wave 4.

The blue areas on the chart show the volume of wave (3) and (5). Wave (5) displays less powerful price movement and way lower volume, but a slight increase in volume happens at the end of the wave.

From a mass psychology perspective, this can be explained by the fact that optimism hits its peak during wave (5). For example, positive news is released, a short-term downward movement has only resulted in a sideways correction, and most weak holders have finally assured that the trend is sustainable. It is not surprising that many traders open long positions on the wave of bullish sentiment.

Throw-Over

Although channeling can sometimes help predict the end of wave 5, I want to focus on cases when the end of wave 5 is far from the channel boundary. These cases are often preceded by indirect signals.

A decreasing trading volume may indicate that wave 5 will likely fail to reach the upper boundary of the channel.

On the chart above, an oval marks the area where wave (5) has ended. As you can see, the last candles of the formation were accompanied by low volume. However, during the downward movement, the volume rose sharply, signaling that the wave was coming to an end.

From a market perspective, wave 5 does not reach the upper boundary due to major players, most of whom are already aware of the inevitable end of the bullish trend. In the final phase of wave 5, they open short positions, thus hindering the upward movement. In addition, a sharp decline with an equally rapid increase in volume at the end of wave 5 gives another confirmation.

If the volume is increased and, moreover, is further rising as the price is approaching the channel boundary, it is likely to break through the channel. Another signal of a likely breakout is when wave 4 is trending sideways just below the channel’s upper boundary. Such a setup often indicates that the uptrend is strong, but the correction structure itself sets the stage for breaking through the channel at the final throw-over of the bullish trend.

Sometimes, an upward throw-over can be preceded by a sharp drop in wave 4 or wave 2 in the five-wave sequence that makes up the primary wave. Such throw-overs are usually followed by a sharp reversal in the opposite direction just below the channel line.

This example shows that the price has violated the channel’s resistance line within wave (5). The point of the breakout is marked by a blue oval. Notably, the volume rises as the price approaches the channel boundary, and it sharply jumps to a swing high when the price breaks through the boundary. Another signal suggesting the resistance breakout is wave (4) which is a flat structure marked by blue lines on the chart.

The increase in volume results from the joint actions of weak holders and professional traders. The uninformed traders are likely to be deeply convinced in the strong bull market, opening more and more long trades; the experienced traders do not set them back, trying to sell their assets at the highest price before the uptrend reverses. The sharp reversal immediately following wave (5) suggests that Bitcoin is overvalued at the peak of wave (5).

Personality of Corrective Waves

Top (start of wave A). At higher wave levels, the sentiment of the masses at the end of wave 5 is characterized by excessive self-confidence and overly high expectations. Many traders believe that growth will continue for a very long time. At the middle levels, traders are also enthusiastic and expect the trend to continue. As for the lower levels, there is generally no optimism, although the crowd expects favorable prospects against the backdrop of good news.

Technical breakdown (wave A). This wave does not represent a fundamental decline. Sometimes, the price may drop sharply, especially if wave 5 features strong price movement. At this point, experienced traders may consider opening long positions, while other traders believe that this reaction is just a pullback before a trend continuation.

Recovery or emotional advance (wave B). It is a manifestation of crowd sentiment. Usually, this wave is technically weak and does not last long. At the same time, most market participants become extremely excited, receiving a false signal about the possible continuation of the primary trend.

Capitulation (wave C). It is characterized by great strength and size. In this wave, most participants, following major market players, understand that prices will continue to fall.

Wave A

At the very beginning of wave A, most investors are convinced that the current price decline is a short-term pullback. Similar to wave 1 of the main impulse, the structure of wave A is the result of processes that occur before its inception. If the price soars in wave 5, then the first correction will be followed by a sharp pullback. However, most traders do not believe that the bullish trend is over: they perceive the downward movement as a response to the overvaluation of assets, which occurred in wave 5.

Optimistic sentiment boosted trading volume in wave A. High volume is sometimes observed only at the onset of a correction. In the second part of wave A, where traders do not believe in the strength of the bearish trend, the volume declines, pointing to a looming pullback.

In addition, wave A influences the subsequent wave B. If the first wave of correction consists of three sub-waves, then a horizontal triangle or flat pattern can be expected to form. If it consists of five sub-waves, then a zigzag pattern is most likely to emerge.

The hourly chart of the BTCUSD shows a three-wave correction, with the first wave accompanied by low volume even in areas where there is a relatively rapid decline marked by the blue area. In addition, take a look at the structure of wave (A). It consists of five sub-waves, which signal the appearance of a zigzag.

Wave B

Robert Prechter calls B waves phonies and large players and speculators’ paradise. At the end of the first correction, some traders no longer believe that the impulse will continue and are already planning to open long positions. However, with the beginning of wave B, they open short positions. For large players, this is an excellent opportunity to make a profit.

By their personality, wave B does not usually exhibit rapid price changes. They also rarely reach the peak of the last impulse wave, although this does occur, for example, in the case of an expanded flat.

As a rule, corrective wave 2 of the intermediate degree and below is accompanied by lower trading volume compared to those that accompanied the preceding bull market. At the same time, waves of the primary degree and higher may display an increase in volume. In the first case, due to the short duration of the correction, traders do not believe in the strength of the upward movement, so long positions are not opened en masse. In the second case, everything happens exactly the opposite. The protracted bullish movement attracts weak players, and they open new trades.

On the chart, the blue areas mark trading volume in wave (5) of the main impulse and correction (B). The second corrective wave is accompanied by low volume and a slight rise. If the initially low values on wave (5) are coupled with an increase in trading volume at the end of the wave, this does not happen in wave (B), even with intensified price movement. 

Notably, the very end of the wave has the lowest volume, signaling that the trend is fading and about to reverse, and a new trend will emerge soon.

Wave C

Waves C are devastating in their nature, destroying the hopes of traders who were counting on the upward movement to continue. The optimistic expectations that were initially fostered during the development of wave B have been superseded by feelings of fear and panic. Therefore, there may be some uncertainty in the structure of wave C.

In terms of their structure, C waves resemble the third sub-waves of an impulse. They are often very long and feature significant downward movement. Since market sentiment is rather turbulent and the wave is large, minor corrections can occur. Therefore, these waves should be approached with great caution. Upward corrections in complex patterns can sometimes be mistaken for the beginning of a new uptrend, which is facilitated by their five-wave structure.

At the same time, trading volume in C waves can vary greatly. If there is intense struggle between market forces, volume can change from high to low values.

The blue areas on the chart indicate the volume values corresponding to waves (A) and (C). In the third wave (C), the bearish movement develops more rapidly, with volumes slightly higher than in wave (A).

Wave D

D waves are structural units of complex patterns. In all triangles except expanding ones, they are accompanied by increased volume. This feature is explained by the fact that in non-expanding triangles, D waves are peculiar hybrids that are partially corrected but still possess most of the characteristics of wave 1. At the same time, they follow powerful wave 3 and are often not fully retraced by the subsequent wave.

In essence, D waves act as phonies in the same way as B waves. The long-awaited price reversal occurs, and traders open long positions. Professional speculators take advantage of this by selling their assets at the most favorable prices.

The blue areas on the chart show the volume values of waves (B) and (D). When the latter is formed, volume increases significantly: weak holders open trades, inspired by the growth in wave (B). This was followed by a weak pullback in wave (C), which could well be interpreted as a correction. As a result, the upward movement in wave (4) of the triangle prompted traders to open long positions, which triggered an increase in volume.

Wave E

E waves come as a surprise to many market participants. They are almost always accompanied by negative news releases, creating a bear trap for traders who are expecting the downtrend to continue. Against the news and falling prices, traders open short positions, while the bearish trend is coming to an end. In some cases, the bearish sentiment is further reinforced by a false breakout through the lower boundary of the triangle on the chart.

In this regard, E waves are similar to wave 5 of the main impulse. The same is true for the increase in volume. At the primary level, when the downward movement continues for a long time, stable bearish sentiment forms in the market. As a result, traders open a lot of short positions, which trigger an increase in trade volume.

At lesser degrees, the volume in E waves is usually lower compared to the third corrective wave. In both cases, volume often increases during the last phase of wave development. At the same time, the price tries to break through the lower boundary, which further assures weak holders that the bearish trend is strong.

The blue areas on the chart indicate the volume values corresponding to waves (C) and (E). The third corrective wave is relatively short, but its volume is greater than that of wave (E). As the fifth wave approaches the lower boundary of the triangle, trade volume surges as bears begin to open positions.

Additional Guidelines

In his book “Elliott Wave Principle: Key to Market Behavior,” Robert Prechter provided additional guidelines that help analysts avoid mistakes in wave interpretation. 

Scaling

As I noted earlier, waves of a higher degree are best measured in percentage terms, since the same price advance or decline may have completely different significance on different time frames. Elliott also pointed out that as the degree of the waves increases, the need for semi-logarithmic scaling increases, too. It’s an excellent idea; however, for some waves, the accuracy of the channeling technique declines when you switch time frames.

Above is one of the channels we examined earlier, drawn on a linear scale. Note how the strong surge in wave (5) broke through the upper boundary several times. After the first breakout, we could already expect that wave (5) would end outside the channel. The breakout also indirectly signaled that a sharp decline could follow the completion of wave (5).

And that’s the same wave plotted on a semi-logarithmic scale, with the price axis expressed in percentages and the time axis plotted linearly. In this case, wave (5) does not reach the upper boundary. As a result, we would not have been able to anticipate the strong final surge of the wave or the subsequent sharp retracement. And this, despite the fact that volume increased at the peaks of the lower-degree five-wave sequence, which indirectly indicated market strength.

According to Prechter, the need for logarithmic scaling arises when analyzing waves that accelerate due to crowd psychology. That is why, at higher degrees, the log scale is preferable: over long periods, the crowd’s perception of price formation shifts repeatedly in cycles. In other cases, the linear scale provides a more accurate picture.

The best approach in uncertain situations is to draw channels on both scales, so that you can choose the representation that conveys the most information.

How Volume Behaves at Different Degrees 

Robert Prechter actively used volume data to confirm his wave counts and to identify the precise boundaries of extensions. Those who have studied my lessons on Volume Spread Analysis can use this guideline to identify wave boundaries more effectively and anticipate reversal points.

In a bull market, pressure builds as trading volume increases. The greatest expansion is usually seen in wave (3), when it becomes clear to nearly all traders that a bull trend is underway and that long positions should be opened. Similarly, in a bear market, selling pressure grows along with the bears’ activity, driving prices lower. Volume is often at its lowest near the end of waves, which can serve as a warning of an upcoming reversal. 

On the chart above, the orange zones highlight the areas prior to a trend reversal. As you can see, in every case, volume declines compared with the areas of strong directional movement.

Prechter also noted several guidelines regarding fifth waves of an impulse. As I mentioned earlier, in a standard fifth wave below the primary degree, volume is lower than in the third wave. If volume in wave (5) matches or exceeds that of wave (3), the fifth wave is likely to be extended. This guideline is particularly useful when wave (3) is extended and wave (5) also develops as an extension.

The chart shows a standard third wave and an extended fifth wave. The purple areas on the lower indicator mark these waves. The third wave shows average volume, while an extended fifth wave is accompanied by high volume. The strongest volume spikes occur in sub-wave (3) of wave (5), which is also extended and, consistent with crowd psychology, drives the majority of traders to open long positions. Despite this excitement, volume typically contracts by the end of wave (5) as major players exit the market.

At the primary degree and above, volume often peaks at the end of wave (5), because a long advance naturally attracts more traders. This surge in volume usually happens near the upper channel line, during the last upward push, or in the final stage of a diagonal triangle.

Wave Length Ratios in Corrective and Impulse Waves. Retracement, Alternate, and Same-Directional Wave Ratios

This section covers ratio analysis based on Fibonacci geometry. This method should not be viewed as a standalone forecasting tool, but it perfectly complements the rules of the Elliott Wave Theory discussed earlier. Combined with other methods, Fibonacci ratios can also be used to identify support and resistance levels where reversals occur.

Introduction to Fibonacci Geometry

The Fibonacci sequence 0, 1, 1, 2, 3, 5, 8…was discovered by Leonardo of Pisa, later known as Fibonacci, a great thirteenth-century mathematician. Originally, the sequence was the answer to the problem of how many rabbits can be produced in a single year from one pair of rabbits placed in an enclosed area. Later, it turned out that the great mathematician discovered a universal sequence that occurs in many natural objects and processes.

In the Fibonacci sequence, each next number is the sum of the two preceding numbers. Another important property is that, after the first several numbers, the ratio of any number to the next higher is about 0.618, while its ratio to the preceding number is about 1.618. This number, known as φ (phi), is the golden ratio.

Any length can be divided so that the smaller part is about 0.618 of the larger part. In nature, this ratio can be seen in many places, from atomic structures and DNA spirals to planetary systems and galaxies. The golden ratio is used in architecture, painting, and music.

One of the figures based on the φ number is the golden rectangle, whose sides are in the ratio of about 1.618 to 1. To construct it, draw a square with sides of 2 units, and inside it a right triangle with legs of 2 and 1 units. Then extend the shorter leg by a length equal to the square root of 5 (≈ 2.236 units), so that its total length becomes 1 + √5 (≈ 3.236 units).

An even more complex figure is the golden spiral, constructed on the basis of the golden rectangle. The principle of construction is to divide the rectangle into smaller squares and rectangles according to the golden ratio. The spiral inscribed in these shapes becomes the golden spiral.

According to Elliott and his disciples, a financial market has the same mathematical base as natural phenomena. A perfect or nearly perfect real wave can be fitted into a spiral and analyzed using the ratios discovered by the Italian mathematician. In practice, we will not calculate proportions or draw Fibonacci shapes by hand, measuring segments and rectangles. 

Ratio Analysis

Ratio analysis is the assessment of the proportional relationship between waves, in both time and length. If you are familiar with my training articles explaining the approach of Bill Williams (Part 1 and Part 2), you may recall that I discussed the ratios between the lengths of different waves.

Unlike Williams, Prechter divides ratios into two categories:

Retracement Ratios

A correction often retraces a Fibonacci percentage of the preceding wave. Williams analyzed the size of the retracement depending on its position. For example, the second wave most commonly retraces 38.2%–61.8% of the first wave’s length, while the fourth wave most commonly retraces 38.2%–50% of the third wave.

Prechter, however, relates the length of the correction to the retracement type. For instance, sharp corrections tend to retrace 61.8% or 50% of the previous wave. Prechter agrees with Williams that sharp corrections most often occur as the second wave. Corrective waves also often occur as sub-wave B of a zigzag and as sub-wave X of a multiple zigzag.

The BTCUSD chart displays an example of a five-wave structure. Wave (2) is a sharp correction. This wave retraces 61.8% of wave (1) (blue area around 10,800 USD on the chart).

Sideways corrections are usually much smaller and typically retrace 38.2% of the preceding impulse wave, particularly when they occur as wave (4).

The chart above shows an example of a flat (sideways) correction as wave (4). The retracement within this wave is relatively shallow, ranging between 23.6% and 38.2% of wave (3), around the 10,640 USD level. As you can see from the two examples above, retracement ratios show some deviation in accuracy, but they still allow us to define approximate boundaries and the structure of the move. It is important to view these targets as tendencies and consider the deviations from the actual move.

Nonetheless, this method is popular because it is easy to apply and calculate. However, ratios between same-directional waves or alternate waves provide more reliable data.

Multiples of Motive Waves

In previous articles, I noted that when the third wave is extended, the other waves tend towards equality or a 0.618 ratio. The same principle applies to all motive waves within an impulse: their lengths are interconnected through Fibonacci ratios such as 1.618 or 2.618, or the inverse values 0.618 and 0.382.

The chart above shows the relationship between waves (1) and (5) in comparison to the length of wave (3). The colored areas mark Fibonacci levels relative to the length of wave (3). As you can see, the length of wave (1) is almost equal to that of wave (3), while wave (5) relates to it by the ratio of 0.618.

If wave (1) is not extended, wave (4) will most likely divide the price range according to the golden ratio. In other words, the distance from the start of wave (1) to the end of wave (4) equals 61.8% of the total impulse length, while the length of wave (5) is 38.2%.

The example above illustrates a standard motive-wave formation. Wave (4) ends precisely at the turquoise line marked 0.618.

In the case of an extended fifth wave, the ratio is reversed. The distance from the start of wave (1) to the end of wave (4) equals 38.2% of the total impulse length, while the length of wave (5) is 61.8%.

On the 15-minute BTCUSD chart, you can see a five-wave sequence with an extended fifth wave. The end of wave (4) is located in the yellow area, meaning the distance from wave (1) to wave (4) is slightly less than 38.2% of the entire wave structure. Accordingly, the length of wave (5) makes up 61.8% of the five-wave sequence.

Thus, this guideline is quite flexible when it comes to spotting the point within wave (4) that represents the golden ratio of the five-wave impulse. This point can be the start, the end, or the extreme of the retracement. Therefore, when forecasting the end of wave (5) using ratios, we can determine its approximate area, consisting of several closely located target levels.

In rare cases, when wave (1) is extended, the lengths of waves (3) and (5) are likely to equal 0.382 or 0.618 of the length of wave (1), measured from the end of wave (2).

On the hourly BTCUSD chart above, you can see a five-wave sequence where wave (1) is extended. The Fibonacci levels are marked with colored areas. The chart shows that the lengths of waves (3) and (5) are approximately 61.8% of the length of wave (1).

Multiples of Corrective Waves

In a zigzag, the most common ratio is equality between the lengths of waves A and C. Ratios of 0.618 and 1.618 are also quite frequent.

The chart shows a classic zigzag. Wave C of the corrective pattern nearly reaches 61.8% of the projection of wave A.

The same ratio applies to multiple zigzags, where simple zigzags are compared.

The chart above displays a double zigzag, in which the length of zigzag (W) is approximately equal to the length of zigzag (Y). The end of the second zigzag slightly exceeds the projection of the first and enters the purple zone, which starts below 100% of the first zigzag’s length.

As you already know, the waves of a standard flat correction are approximately equal to one another. In an expanded flat, however, wave C reaches 168.2% of the length of wave A.

The chart above illustrates an expanded flat correction. Its wave C ends in the purple zone, falling slightly short of the 1.618 level. This can be explained by the fact that wave B only slightly exceeded the end of wave (5) of the impulse, which gave the following retracement insufficient support from the bears.

In expanded flats, wave B typically equals 1.236 or 1.382 of the length of wave A. In rare cases, exceptions are possible, as in the example above.

Triangles always contain at least one pair of alternate waves related to each other by the ratio of 0.618. In contracting triangles, the following ratios are usually observed:

• wave E is 0.618 of wave C;
• wave C is 0.618 of wave A;
• wave D is 0.618 of wave B.

The chart shows a complex correction consisting of a triangle and an expanded flat. The colored areas mark the Fibonacci ratios of other waves relative to the length of wave A, with multiples ranging from 0 to 4.236. As you can see, the length of wave C is 61.8% of the length of wave A.

In expanding patterns, the multiples of waves are usually 1.618. In rare cases, adjacent waves may also be related by these ratios.

As for complex corrections, one simple pattern may sometimes have a length equal to that of another pattern, or be related to it by the ratio of 0.618. In rare cases, other ratios are also possible. The probability of such an event increases if one of the simple patterns is a triangle.

Multiple Ratios 

The ratios I have described can be used for two purposes. First, this tool helps confirm whether the interpretation of a developing pattern and our position within it are correct. Second, the ratios can be used for forecasting: if a reversal occurs at one of the Fibonacci levels, the significance of that point is much higher.

It is important to remember: forecasts based on several Fibonacci levels at once are usually more accurate. For example, by using the Fibonacci ratios of waves (1) and (5) relative to an extended wave (3) (0.382 or 0.618 of wave (3)), you can anticipate the likely ending point of wave (5). Another potential point can be identified by calculating the overall length of the pattern based on the length of waves (1) through (4), which should amount to 61.8% of the total length. Let us consider an example. 

Wave (3) is extended, so it can be assumed that the length of wave (5) will range from 38.2% to 100% of its length (marked with the bright green area). The most probable ratio is 61.8% of the length of wave (3) (marked with the blue arrow).

Now, without removing the projected completion area of wave (5) from the chart, let’s calculate the total length of the five-wave sequence by measuring waves (1) through (4). Taking the start of wave (1) as 0 and the end of wave (4) as 1, the projected completion of the pattern is at the 1.618 level (red arrow on the chart).

By combining the most probable reversal point obtained from the previous ratio calculations with the current one, we get a fairly narrow zone (the blue circle). In this area, a reversal is highly likely, especially if other signs of trend weakening appear as the price approaches the resistance level.

As it turned out later, the reversal occurred just above the projected area. This is quite a good result, given that only ratio analysis was used. By the time the price approached the assumed reversal point, it was also clear that wave (5) would have a complex structure with sharp upward spikes. Therefore, a slightly higher-than-projected resistance level was a natural outcome.

I should note that in everyday trading, I do not recommend relying solely on ratio analysis. It allows for many variations and cannot give a definitive answer as to where exactly a reversal will occur. Ideally, Fibonacci ratios should be used together with other indicators, the latter serving as the primary signals, while Fibonacci levels provide additional confirmation of resistance at the projected point.

What If the Ratios Don’t Work?

In practice, you will often come across situations where the market ignores Fibonacci levels. If the price suddenly moves through one of the projected levels, it should not undermine confidence in the tool. On the contrary, such an event carries additional, highly important information.

A breakout suggests that the reversal will likely occur at the next level. In most cases, these are considerable distances that can yield extra profit.

On the other hand, if the projected points are not reached or are surpassed significantly, it is worth reconsidering the wave interpretation. Traders usually keep several alternative interpretations of the trend and stick to one of them until it either plays out or the market evolves into another pattern.

The chart above shows an unusual five-wave pattern with excessively sharp retracements. Wave (2) easily breaks below the 0.618 level. In the absence of other reversal signals, this should not discourage the trader. In this case, the new support level is at 0.786. As you can see, the reversal did occur when the price approached this boundary.

It is also important to remember that wave (2) must end above the starting point of wave (1). If the price had moved further down and broken through the 0.786 level, it would have been a reason to reconsider the interpretation of the market situation.

That wraps up the overview of Robert Prechter’s wave theory. By mastering this branch of wave analysis, along with Bill Williams’ theory, you can combine the most effective tools from both approaches and build your own trading strategy based on Elliott waves.

Good luck and profitable trading! 

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