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The Elliot Wave Theory and Fibonacci Analysis

It was Ralph Nelson Elliott that developed a theory based on three central aspects of movement of price which later became known as the Elliot Wave Theory (EWT). The three important elements are:

Pattern
Ratio
Time

The Pattern aspect is in reference to the formations – or wave patterns - , whilst ratio is the correlation between numbers and is used to measure the waves. When putting this theory into effect, a trader ascertains the most important wave, also known as a supercycle, trades long and then shorts or sells a position once it becomes evident that the pattern is coming to an end and reversal is soon going to happen.

The EWT in its simplest form dictates that all movements in the markets pursue a recurring regularity of 5 waves in the same way that the key trend is pursued by 3 waves, called corrective waves. This is deemed a 5-3 move.

Wave Cycles

Once the 3 wave move back is finished, another 5 wave move forward commences until such time a reversal is triggered. Once this occurs, it’s possible to view that every 5 wave move forward is identifiable as a singular advance wave. Also, when looking at it from a bigger viewpoint, every wave can be deconstructed into much lesser waves.

The EWT determines waves as per the length of the cycle, anything from a few hours to decades (called a grand supercycle).

Fibonacci Analysis

The Elliott Wave Theory is made possible by the Fibonacci numbers forming the mathematical cornerstone for the EWT. The Fibonacci numbers, named after Leonardo of Pisa (otherwise called Fibonacci) are calculated by beginning the number sequence at 1 and adding the previous number to obtain the new number:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on

The Fibonacci ratios are used for different technical indicators but their primary is the measuring of correction waves within technical analysis and contains some significant properties.

Within the sequence, the ratio of any number in relation to the next number, after the initial four numbers, is 61.8% or 0.618. This is called the Golden Ratio.

Any number has a ratio of 38.2% or 0.382 to the number that is 2 places along the sequence (to the right)

Any number has a ratio of 23.6% or 0.236 to the number that is 3 places along the sequence (to the right)

The ratios and the inter-relationships within the sequences are used to calculate price extensions and price retracements in a trend.

Price Extensions

These are used to calculate points in the trend to take profits, either in an uptrend or a down trend. They are charted as horizontal lines below/above the prior trend movement. 61.8%, 100%, 138.2% and 161.8% are the most used extension levels.

Price Retracements

This is a price movement which retraces a part of the prior price movement. Normally, an asset will retrace at 1 out of three regular Fibonacci levels. 38.2%, 50.00% and 61.8%. The retracements are calculated from a previous low to high movement to predict support levels when the market moves back from an elevated position.

The price retracements can also be used to identify resistance levels when the market rallies from a low position. This is achieved by reversing the low to high swing to a high to low movement.

Getting the best out of Fibonacci

When put into practice, the Elliot Wave Theory is difficult to apply and prices and their movements do not behave always as per the pattern. With this is in mind it is recommended that a trader use the Fibonnacci ratios along with and not instead of other forms of technical analysis.

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