Elliot wave theory: explained

The Elliott Wave theory was developed in the 1930s by Ralph Nelson Elliott, who was inspired by the natural waves of the sea to describe price movements within the financial markets. This theory attempts to break down the fluctuations of the financial markets into a series of repetitive patterns, formed by a succession of “waves”. Traders can identify waves in stock price movements and in consumer behavior as well.

The Elliott Wave theory gained popularity in 1935 when Elliot made a prediction of a stock market bottom.

To this day, price fluctuations in the financial markets still pose somewhat of a conundrum for the scientific community. However, in the early 1900s, theorists were already trying to link the markets’ behavior with nature, an innovative concept known as “biomimicry” and the basis for the Elliott Wave theory.

Elliott Wave principle

Ralph Nelson Elliott is still considered by many the only worth successor to Charles Dow in analysing market movements. In fact, he not only confirmed Dow’s studies, but also introduced a series of more precise definitions for each market phase. In particular, he added a series of forecasting elements that no longer merely identified market trends (upward or downward), but also calculated achievable price levels. In a similar way to Dow’s theory, Elliott’s wave theory distinguishes price movements in terms of waves.

Overall, Elliot’s approach aimed at finding a synthesis of the laws that govern natural phenomena, of which the stock market is simply an aspect. Elliott placed great importance on the systematic observation of nature in order to grasp its most significant cycles.

Since the movement of the market prices is the product of human activity and therefore subject to natural rules, it tends to express recurring sequences of bullish and bearish waves, which can be traced back to a general model.

The Elliott Wave principle is based on the assumption that each market represents a phenomenon fuelled by economic flows, induced by psychological currents and governed by natural laws. If these were missing, it would not be possible to achieve any balance and the prices would lead to convulsive disorganised fluctuations. The market must be considered a phenomenon created and fed by men and therefore permeated by irrational attitudes that characterise people’s daily lives.

Elliott Wave Theory relates these wave patterns to the mass psychology of investors. Their mood swings and confidence in the market create these price movement patterns, alternating between optimism and pessimism.

The market does not record political, economic, and social events, but rather human reactions to these events.

How to use Elliott Wave correctly

Elliott Wave represents the most famous and historically significant technical analysis tool used for trading forex and other financial markets. Understanding Elliott Wave theory and its numerous variations is an asset for traders, since it is still one of the most effective technical analysis tools discovered to date.

In his theory, Elliott defined two types of waves: the impulsive wave (which has a structure consisting of 5 waves) and the corrective wave (which has a structure consisting of 3 waves). The basic cycle consists of 8 waves: the first 5 waves create an upward “impulse” movement, whereas 3 sub-waves create a corrective wave. This cycle is endless: each wave can consist of one or more cycles of shorter duration. The complete cycle consists of 34 waves, where each wave can be divided based on the basic cycle. According to Elliott’s theory, waves that move in tune with the trend are called impulse waves, while those that move against the trend are called corrective waves.

Impulse waves

The Elliott Wave principle states that the market moves in a 5-3 wave pattern. Whether bullish or bearish, the repetitive patterns described by this theory all comprise eight waves. The first five waves are called ‘impulse waves’, which move in the direction of the main trend, and the last three waves are ‘corrective waves’, which move against the trend.

In this example, waves 1, 3 and 5 go with the prevailing trend, whereas waves 2 and 4 dip back in the opposite direction. Although waves 2 and 4 are not going in the direction of the trend, they must not be confused with the corrective waves, A, B and C.

Impulse waves have large price moves whereas the corrective waves tend to be smaller. There will, however, always be one impulse wave that is longer than the other two – usually the third wave, as the masses drive up the price.

• Wave 1 is the initial price moving upwards as a small group of people buy when the price is low
• Wave 2 slightly reverses, and the price goes down slightly as people take profits
• Wave 3 involves the mass public deciding to trade, driving the price even higher
• Wave 4 incurs more traders taking profits due to the expensive price of the instrument
• Wave 5 is a small group of bullish traders buying the overpriced stock

Corrective waves

The three corrective waves, labelled A, B and C, follow after the first five impulse waves, and when looked at in combination, go in the opposite direction to the impulse waves. This will either be downwards or upwards, depending on whether it is a bull or bear market. These three corrective waves can be grouped as part of three types of chart formations, although they tend to be less easily identifiable than the impulse waves. Corrective waves fall into three different categories: zigzag, flat, and triangle.

Zigzag

If the corrective waves are in a zigzag formation, wave B tends to be the shortest compared with A and C. This depicts steep moves in price, going against the initial trend, and can occur numerous times.

Flat

The flat formation is simpler, as typically the waves are all the same length. A sideways pattern will occur, correcting the impulse waves.

Triangle

Triangle formations are made up of 5 sub-waves, with each side subdivided further into 3 waves, hence forming a 3-3-3-3-3 structure. This may be a combination of complex corrections, including both zigzags and flat formations, and are either converging or diverging trend lines moving sideways. Triangle formations are associated with decreasing volatility and volume, and when the price momentum consolidates, the top and bottom trend lines culminate in a single point.

Correction waves are a lot more unpredictable in the pattern formation compared with the two above, as they can be descending, ascending, expanding or symmetrical.

Elliott Wave fractals

Each wave, both impulsive and corrective, can be considered an independent repetitive pattern, which when analyzed can be further broken down into a series of eight smaller "sub-waves" – or fractals. The ability to observe the same pattern at different time periods is what makes the theory fractal, and why it can also be said to mimic nature.

In this theory, depending on the time period during which a wave is observed, the wave is referred to as:

• grand super-cycle (multi-century)
• super-cycle (a few decades)
• cycle (a few years)
• primary wave (about a year)
• intermediate wave (a few months)
• minor wave (a few weeks)
• minute wave (a few days)
• minuette (hours)
• subminuette (minutes)

How to use Elliott Wave in trading

The advantage offered by the Elliott Wave theory is not limited to identifying the direction and maturity of a trend, but it also includes recognising the ranges of movement within which the trend will develop, thus allowing controlled management of gains and losses.

Following identification of the movements, it is possible to open a long position when creating the wave. At that point, the stop loss can be positioned at the origin of the movement, whereas the objective of the gain, resulting from the correction made by the movement itself, will be to increase to movement 3 or 5 inside the macro-wave.

By operating in this manner, an Elliott Wave trader will be able to gain control of the price range within which the trader must stay in order to comply with the theory, while also managing to optimise the exit point. Likewise, the Elliott Waves correction phase is an opportunity to open sell positions, identify the maximum points reached by the wave or from the wave, or for a new buy position, at the exact moment when the corrective waves will have ended and the main trend will have resumed.

How to use Elliott Wave correctly?

There are three rules which must be adhered to in an Elliott Wave pattern:

• Wave 2 cannot retrace more than the beginning of wave 1
• Wave 3 cannot be the shortest of the three impulse waves
• Wave 4 cannot overlap the price territory of wave 1

While there are further guidelines to this principle, these are not as strict and can be broken. For example:

• Waves 2 and 4 may frequently bounce off Fibonacci retracement levels
• Wave 5 doesn’t reach beyond the end of wave 3

Defenders and detractors of the Elliott Wave Theory

Elliott found that financial markets primarily respond to swings in mass psychology. Since human psychology is a constant factor over time, the profound nature of price movements should also remain constant over time, and its theory should, therefore, continue to be proven year after year. Although appealing on paper, the Elliott Wave Theory is often confronted with the reality of financial markets, and it’s not always easy to count the waves without breaking the rules of the theory’s very strict principles. Therefore, some followers of this analysis method opt for a more flexible approach and a freer interpretation of price movements.

When the book "Elliott Wave Principle: Key to Stock Market Profits" by AJ Frost and Robert Prechter was published, the authors had predicted the rise of the market in the 1970s and its crash in 1987. Whether this was down to genuine ability or just pure luck, it’s difficult to say.

Summary

Elliott Wave Theory relates the optimistic and pessimistic sentiment that investors hold to the waves seen in price charts. These waves are separated into five ‘impulse waves’, travelling in the direction of the trend, and three ‘corrective waves’ which go in the opposite direction.

When setting a stop-loss, the Elliott Wave Theory is a useful framework or set of guidelines by which a trader can estimate whether a price will rise or fall, and to what extent. It can also be used to identify market entry and exit. Furthermore, you can integrate Elliott Wave theory as one element of your holistic trading strategy, utilising other technical and fundamental analysis techniques to inform your trading decisions.

Source: CMC Markets UK