Elliott Wave Theory breaks down the price fluctuations of financial markets into cycles, each comprising of eight "waves" with specific characteristics.
To this day, price fluctuations in the financial market still pose somewhat of a conundrum for the scientific community. However, in the early 1900s, theorists were already trying to link the markets’ behaviour with nature, an innovative concept known as “biomimicry” and the basis for the Elliott Wave Theory.
Just like the Dow Theory, the Elliott Wave Theory was also developed in the 1930s. Ralph Nelson Elliott was inspired by the natural waves of the sea, and his theory attempts to break down the fluctuations of the financial markets into a series of repetitive patterns, formed by a succession of "waves".
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.
Elliott Wave principle
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.
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.
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, social and economic events, but rather human reactions to these events.
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 aren’t 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 which 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’s 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.
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 analysed 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 start counting Elliott Wave
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.
Where to start an Elliott wave count will depend on your trading objectives and where you stand with analysis. According to the Elliott Wave principle, motive waves are followed by corrective waves and vice-versa. You may get the best results by starting the count at the beginning of a market turning point, rather than in the middle of a rally or decline. In other words, if you want to count the sub-waves of a correction, you could start your count from the end of the previous wave.
Following identification of the movements, it is possible to open a long position when creating the wave. At that point, the stop-loss order 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.
Elliott Wave theory rules
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:
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.
