Special feature Ichimoku (3/4) – Wave theory in Ichimoku

Developed by Ralph Nelson Elliott in the late 1930s, Elliott wave theory is one of the foundations of stock market analysis. Several methods exploit this theory, allowing the market to be studied and financial movements to be better anticipated. The Ichimoku Kinko Hyo technique uses wave theory in particular in the structuring and interpretation of graphs. Explanations :

Basic principle of wave theory

Elliott’s wave theory is the theory that shows that markets go through cycles, which in turn follow waves. According to her, financial market movements evolve through series of successive waves, both in the very short and long term. In this sense, price movements are not disorderly, but follow a certain harmony, which is then easier to observe and anticipate.

The rules of this theory are inspired by Dow’s theory and are governed by Fibonacci numbers. Generally speaking, waves are broken down into subwaves, which determine the upward or downward trend of a cycle and then the markets.

Each wave has its own personality and rules that govern its behaviour. But in general, we can distinguish between impulse waves and correction waves. A pulse wave is the one that follows the main trend of the movement, while the direction of a corrective wave is the opposite of this trend.

Each wave is, in all cases, composed of subwaves, whose rules governing them make it possible to validate or not a movement. They are numbered and, depending on its rank, a wave may or may not be able to go below another wave. To go down or not lower than a peak, or to be the shortest wave.

If one of the rules is not respected, then another formation should be considered and a new count conducted. As a benchmark, Elliott modelled an “elementary cycle” composed of 8 main waves: 5 impulse waves and 3 correction waves.

However, the decomposition remains infinite and the whole forms a “complete cycle”.

The use of wave theory in Ichimoku

To complete his Ichimoku analysis method, Goichi Hosoda was inspired by Elliott’s wave theory. Its objective was to develop a tool to model movements, by studying the impulse and corrective structures of markets.

Thus, in a trend, the main movement can be broken down into 3 main waves: waves I, V and N, each of which can be downward or upward.

ichimoku wave IVN

Wave I is a pulse wave composed of a segment. Wave V consists of two segments, including an impulse wave (wave I) and a correction wave. The N wave, on the other hand, consists of three segments, including a V wave (an impulse wave and a correction wave), as well as a secondary impulse wave.

As with Elliott’s wave theory, this decomposition principle remains valid in both the short and very long term. It is also possible to use a wave independently, especially to detect complex movements. In this case, it is only necessary that the waves have identical duration in the movement.

For example, a 60-day movement can be divided by three and modelled by waves I, V and N independently. The first 20 days by wave I; the intermediate 20 days for wave N and the last 20 days by wave V. It should be noted, however, that in practice, current markets are much harder to break down into movements of the same duration.

The secondary waves P and Y specific to Ichimoku

In addition to these three main waves, Goichi Hosoda also added the secondary waves P and Y. Wave P includes an impulse wave and a consolidation wave of 5 elements, in the shape of a narrowed triangle. The composition of wave Y is also the same as that of wave P, with the exception of its consolidation phase, which takes the form of an enlargement bevel.

chartist pennant
The wave P corresponds to the figure chartist Fanion

It is the combination of waves that allows the movements to be structured and in-depth technical analyses to be carried out. The Ichimoku analysis method becomes even more precise with Elliot’s wave theory.