How does Elliott wave theory work, and what are the rules for identifying impulse versus corrective waves?

Elliott Wave Theory proposes that market prices unfold in fractal patterns driven by collective investor psychology. A complete cycle consists of 5 impulse waves (trending) followed by 3 corrective waves (counter-trend), forming an 8-wave sequence that repeats at every timeframe.\n\nThe Basic Pattern:\n\n`mermaid\ngraph LR\n A[\"Wave 1
Initial impulse\"] --> B[\"Wave 2
Corrective pullback\"]\n B --> C[\"Wave 3
Strongest thrust\"]\n C --> D[\"Wave 4
Consolidation\"]\n D --> E[\"Wave 5
Final push\"]\n E --> F[\"Wave A
Counter-trend start\"]\n F --> G[\"Wave B
Counter-trend rally\"]\n G --> H[\"Wave C
Counter-trend completion\"]\n`\n\nThree Inviolable Rules:\n\n1. Wave 2 never retraces beyond the start of Wave 1. If it does, your wave count is wrong.\n2. Wave 3 is never the shortest impulse wave. It can be the longest, but it cannot be shorter than both Wave 1 and Wave 5.\n3. Wave 4 does not overlap with the price territory of Wave 1. The low of Wave 4 must stay above the high of Wave 1 (except in diagonal triangles).\n\nGuidelines (Tendencies, Not Rules):\n\n- Wave 2 typically retraces 50-61.8% of Wave 1 (Fibonacci ratios)\n- Wave 3 is usually the longest and most powerful impulse wave, often 1.618x Wave 1\n- Wave 4 often retraces 38.2% of Wave 3\n- Wave 5 can be approximately equal to Wave 1 in length\n- Alternation: if Wave 2 is sharp, Wave 4 tends to be sideways (and vice versa)\n\nWorked Example:\nAnalyst Brennan studies Palomar Semiconductors (PLS). From the March low of $42:\n\n- Wave 1: $42 to $58 (+$16)\n- Wave 2: $58 to $49 (retracement: $9/$16 = 56.3%, fits 50-61.8% guideline)\n- Wave 3: $49 to $84 (+$35, which is 2.19x Wave 1 -- longest wave, rule satisfied)\n- Wave 4: $84 to $74 (retracement: $10/$35 = 28.6%, does not overlap Wave 1 high of $58 -- rule satisfied)\n- Projected Wave 5: $74 + $16 (equal to Wave 1) = target $90\n\nAlternation check: Wave 2 was a sharp zigzag; Wave 4 was a sideways triangle -- alternation guideline holds.\n\nCorrective Wave Patterns:\n\nCorrective structures (A-B-C) take multiple forms:\n- Zigzag (5-3-5): Sharp correction, each leg is impulsive-corrective-impulsive\n- Flat (3-3-5): Sideways correction, Wave B retraces most of Wave A\n- Triangle (3-3-3-3-3): Contracting range with 5 overlapping waves\n\nWhy Analysts Disagree:\nElliott wave counting is inherently subjective because:\n- Waves nest fractally -- each wave contains sub-waves, creating multiple valid interpretations\n- The \"correct\" count is only confirmed in hindsight\n- Different timeframes can suggest conflicting counts\n- Corrective patterns are more complex and ambiguous than impulse waves\n\nCFA Exam Perspective:\nThe curriculum presents Elliott waves as part of the technical analysis toolkit, acknowledging the theory while noting its subjectivity. Candidates should understand the basic structure and rules without necessarily endorsing the predictive power.\n\nExplore technical analysis concepts in our CFA course.