Content

• What are Elliott Waves?

• The Basic Elliott Wave Pattern

  • Impulse Waves

  • Corrective Waves

• Do Elliott Waves work?

• Conclusion

What are Elliott Waves?

Elliott Waves designate a theory (or principle) that investors or traders can adopt in technical analysis. This principle is based on the idea that financial markets tend to follow specific patterns, regardless of the time frame.

Basically, Elliott Wave Theory (EWT) suggests that market movements follow a natural sequence of mass psychology cycles. Patterns are created based on current market sentiment, which alternates between bearish and bullish.

The principle of Elliott Waves was proposed in the 1930s by Ralph Nelson Elliott - an American accountant and writer. However, the theory would not become popular until the 1970s, thanks to the efforts of Robert R. Prechter and A. J. Frost.

Initially, the TOE would be called the Wave Principle, and it would be a description of human behavior. Elliott's proposal was based on his exhaustive study of market data, with a focus on stock markets. His systematic research work would include data from at least 75 years.

As a technical analysis tool, TOE is used today in an attempt to identify market cycles and trends, and can be applied in a wide range of financial markets. Now, Elliott Waves are not an indicator or trading technique; but a theory that can help predict market behavior. As Prechter states in his book:

[...] the Wave Principle is not, primarily, a predictive instrument; but a detailed description of the behavior of the markets.

– Prechter, R. R. The Elliott Wave Principle (p.19).

The Basic Elliott Wave Pattern

Typically, the basic Elliott Wave pattern is identified as an eight-wave pattern. Of these, five are Impulse Waves (which move in favor of the main trend), and three are Corrective Waves (which move in the opposite direction).

Thus, a complete Elliott Wave cycle in a bull market would look like this:

Note that, in the first example, we have five Impulse Waves: three on the upward movement (1, 3 and 5), and two more on the downward movement (A and C). Simply put, any movement in line with the main trend can be considered an Impulse Wave. This means that 2, 4 and B are the three Corrective Waves.

But according to Elliott, financial markets create patterns that are fractal in nature. Therefore, if we expand the time frame, the movement from 1 to 5 could also be considered a single Impulse Wave (i), while the movement A-B-C can represent a single Corrective Wave (ii).

Likewise, if we reduce the time frame, a single Impulse Wave (such as Wave 3) could, in turn, be divided into five smaller waves - as illustrated in the next section.

In contrast, an Elliott Wave cycle in a bear market would look like this:

Impulse Waves

According to Prechter's definition, Impulse Waves always move in the same direction as the major trend.

As we just saw, Elliott described two types of wave development: Motive and Corrective Waves. The example above involves five impulses and three corrective waves. But, if we zoom in on a single impulse wave, it will consist of a smaller five-wave structure. Elliott called it the five-wave pattern, and created three rules to describe its formation:

• Wave 2 cannot lag more than 100% of the previous movement of wave 1.

• Wave 4 cannot lag more than 100% of the previous movement of wave 3.

• Among waves 1, 3, and 5, wave 3 may not be the shortest and is often the longest. Furthermore, wave 3 always passes the end of wave 1.

Corrective Waves

Unlike impulse waves, corrective waves are usually made of a three-wave structure. They are often formed by a smaller corrective wave that occurs between two smaller impulse waves. The three waves are often called A, B, and C.

Compared to impulse waves, corrective waves tend to be smaller because they move against the larger trend. In some cases, this counter-trend fight can also make corrective waves much more difficult to identify, as they can vary significantly in length and complexity.

According to Prechter, the most important rule to keep in mind regarding corrective waves is that they are never made up of five waves.

Do Elliott Waves work?

There is an ongoing debate about the efficiency of Elliott waves. Some say that the success rate of the Elliott Wave principle depends largely on the ability of traders to accurately divide market movements into trends and corrections.

In practice, waves can be drawn in various ways, without necessarily breaking Elliot's rules. This means that drawing waves correctly is far from a simple task. Not only because it requires practice, but also because of the high level of subjectivity involved.

Consequently, critics argue that the Elliott Wave theory is not a legitimate theory due to its highly subjective nature, and is based on a poorly defined set of rules. Still, there are thousands of successful investors and traders who have managed to apply Elliott's principles profitably.

Interestingly, there are a growing number of traders who combine Elliott Wave theory with technical indicators to increase their success rate and reduce risks. Fibonacci retracement and Fibonacci Extension indicators are perhaps the most popular examples.

In conclusion

According to Prechter, Elliott never speculated about why markets tend to exhibit a 5-3 wave structure. Instead, he simply analyzed the market data and came to this conclusion. The Elliott Principle is simply the result of inevitable market cycles created by human nature and collective psychology.

However, as mentioned, the Elliott Wave is not an AT indicator, but a theory. As such, there is no correct way to use it, and it is inherently subjective. Accurately predicting market movements with the TOE requires practice and skills because traders must figure out how to draw the wave count. This means that using it can be risky, especially for beginners.