Elliott Wave theory explained

Elliott Wave theory is one key method of forming market predictions, with a host of rules and complimentary theories providing a key tool for technical analysts.

Chart
Source: Bloomberg

Elliott Wave theory was established in the 1920s and 1930s by stock market analyst, Ralph Nelson Elliott, who believed that there was a more common structure to markets than the chaotic form seen by most other analysts at that time. His work on cycles and waves remains one of the most popular methods with which technical analysts can view financial markets, despite there being a range of views over the efficacy of his techniques.

Cycles and waves

The psychological element of trading can often provide waves rather than simple straight lines, and these waves form one of the biggest features of Elliott’s theory. To a large extent this is a reflection of Elliott’s studies of Charles Dow’s work, with Dow Theory stating that stock prices typically move in waves. He also relies on cycles, which accounts for the restitutive nature of the patterns. The theory refers mainly to waves as the key form seen throughout markets, with the fractal nature of his waves proving that the same patterns can be seen in both short-term and longer-term charts. Given that Elliott observed the same patterns over and over again, he suggested this to be a potential tool to predict future price movements.

Elliott’s waves

Elliott saw that there is typically an impulsive wave which moves with the trend, followed by a corrective wave which is counter-trend. He saw that there is typically five waves that make up one larger impulsive wave, before a three-wave corrective phase. The ability to see the first five waves as one impulsive move highlights the fractal nature, given that you are expected to see the same patterns on a smaller and larger timeframe.

The theory

Elliott believed that every action is followed by a reaction. Thus, for every impulsive move, there will be a corrective one.

The first five waves form the impulsive move, moving in the direction of the main trend. The subsequent three waves provide the corrective waves. In total we will have seen one five-wave impulse move, followed by a three-wave corrective move (a 5-3 move). We label the waves within the impulsive wave as 1-5, while the three corrective waves are titled A, B and C.

Once the 5-3 move is complete, we have completed a single cycle.

However, those two moves (5 and 3) can then be taken to form the part of a wider 5-3 wave.

Elliott Wave

Taking the moves in isolation, the first impulsive move includes 5 waves: 3 with the trend and 2 against it. Meanwhile, the corrective move includes three waves: 2 against the trend and 1 with the trend.

Interestingly, the fact that the corrective wave has three legs can have implications for the wider use of highs and lows for the perception of trends. Thus, while the creation of higher highs and higher lows will typically signal an uptrend, Elliott Wave theory highlights that you can often see the creation of a lower high and lower low as a short-term correction from that trend. This does not necessarily negate the trend, but instead highlights a period of retracement that is stronger than the previous corrections seen within the impulsive move.

Rules

Wave 2 never retraces more than 100% of wave 1.

Elliott Wave

The image above shows a break below the start point of the wave sequence, thus negating the notion that it is wave 1.

Wave 3 cannot be the shortest of the three impulse waves.

Elliott Wave

The image above highlights the instance when we see a third wave that is too short, thus negating the possibility that this is a correct wave count. Therefore, the subsequent waves remain part of the third wave rather than forming 4 and 5.

Wave 4 does not cross the final point of wave 1.

Elliott Wave

The break below the wave 1 point clearly negates the classification of the fourth wave, instead remaining within wave 3.

Cycles

Elliott assigned a series of categories to the waves, which highlight the fact that you will see the same patterns within both long-term and shorter-term charts. The categories are as follows.

  •       •   Grand supercycle: multi-century
  •       •   Supercycle: multi-decade (about 40 to 70 years)
  •       •   Cycle: one year to several years (or even several decades under an Elliott Extension)
  •       •   Primary: a few months to a couple of years
  •       •   Intermediate: weeks to months
  •       •   Minor: weeks
  •       •   Minute: days
  •       •   Minuette: hours
  •       •   Sub-minuette: minutes

Fibonacci within waves

The use of corrective waves highlights the potential cross-study of Fibonacci retracements. Elliott didn’t specifically utilise Fibonacci levels, yet traders have applied them as a way to add greater complexity to the traditional theory.

The rules previously specified highlight which Fibonacci retracement levels could be used at different points in the trend. Given rule three, a trader would be looking for a fourth wave to be relatively shallow, with the 23.6%-50% levels of particular interest. We can also look for the correct A, B, C move to be a 50%-61.8% retracement of the entire 1-5 impulse move.

Conclusion

Elliott Wave theory is something that continues to provide a sense of structure to markets for a lot of people worldwide. The ability to constantly shift the theory when a rule is broken can hinder the use of the theory as a means to place trades. However, it also adds a significant degree of clarity to the art of trend recognition. How much complexity a trader wishes to add to Elliott’s initial rules is up to them, yet it is certainly a method that many choose to place front and centre in their market strategies.

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