Table of contents

• What are Elliott Waves?

• The basic pattern of Elliott Wave

  • Driving Wave

  • Corrective Wave

• Do Elliott Waves work?

• Summarize

What are Elliott Waves?

Elliott Waves is a theory (or principle) used by investors and traders in technical analysis. The principle is based on the idea that financial markets tend to follow certain patterns regardless of time periods.

The Elliott Wave Theory (EWT) essentially states that market movements follow the natural sequence of cycles in mass psychology. Patterns are established based on current market sentiment, alternating between bearish and bullish.

The Elliott Wave Principle was developed by American accountant and author Ralph Nelson Elliott in the 1930s. It was not until the 1970s that the theory became popular among the general public, thanks to the efforts of Robert R. Prechter and A. J. Frost.

Originally, the Elliott Wave Theory (EWT) was called the Wave Principle, a description of human behavior. Elliott based his creation on his extensive study of market data, especially the stock market. His systematic research covered at least 75 years of rich information.

Today, traders use the Elliott Wave Theory (EWT) as a technical analysis tool to identify market cycles and trends, and it is widely used in many areas of financial markets. However, Elliott Wave is not a trading indicator or technique, but a theory that helps predict market behavior. As Prechter said in his book:

[...] The Wave Principle is not a forecasting tool per se, but rather a detailed description of market behavior.

– Robert R. Pratchett, The Elliott Wave Principle (page 19).

The basic pattern of Elliott Wave

Typically, Elliott Waves are divided into eight different basic patterns, which include five motive waves (waves that follow the primary trend) and three corrective waves (waves that go against the trend).

Therefore, in a bullish market, a complete Elliott Wave cycle looks like this:

Notice that in the first example, we see five motive waves: three moving up (1, 3, and 5) and two moving down (A and C). In short, any move in the direction of the primary trend is considered a motive wave, which means that 2, 4, and B are all corrective waves.

According to Elliott, financial market patterns have a fractal nature. Therefore, if zoomed in on a longer time frame, the move from 1 to 5 can also be seen as a single motive wave (i), while the move A-B-C represents a single corrective wave (ii).

If we zoom out to a more specific time frame, a single motive wave (e.g. 3) can be further divided into five smaller waves, as shown in the next section.

Conversely, an Elliott Wave cycle in a bearish market would look like this:

Driving Wave

As defined by Prechter, motive waves always move in the same direction as the more dominant trend.

As we have just seen, Elliott described two types of wave trends: motive waves and corrective waves. The previous example involved five motive waves and three corrective waves. However, if we look at a motive wave in isolation, it is made up of smaller five-wave structures. Elliott called this a "five-wave pattern" and created three rules to describe this structure:

• Wave 2 will not retrace 100% of the preceding wave 1.

• Wave 4 will not retrace 100% of the preceding wave 3.

• Wave 3 is not the shortest of waves 1, 3, and 5, but is usually the longest. Also, wave 3 always crosses the end of wave 1.

Corrective Wave

Unlike motive waves, correction waves usually consist of three waves. A common structure is a smaller correction wave between two smaller motive waves. These three waves are usually called A, B and C.

Corrections tend to be weaker than motive waves because they move against the larger trend. In some cases, this counter-trend opposition can make corrective waves more difficult to identify because their length and complexity can vary greatly.

The key rule to remember, according to Prechter, is that a correction never has five waves.

Do Elliott Waves work?

There is a lot of debate about the role of Elliott Waves. Some people believe that the success of the Elliott Wave Principle depends largely on whether traders can accurately divide market trends into driving and corrections.

In fact, there are several ways to draw these waves, and they don’t necessarily break the rules set by Elliott. This means that drawing waves correctly is not easy at all. It requires not only specific practice, but also may involve a strong degree of personal subjectivity.

Critics argue that the Elliott Wave Principle is not a sound theory because it is highly subjective and relies on poorly defined rules. Despite this, tens of thousands of investors and traders have successfully used the Elliott Principle to trade profitably.

Interestingly, more and more traders are combining the Elliott Wave Principle with technical indicators to improve their trading success rate and reduce trading risks. Fibonacci retracements and Fibonacci extension indicators are perhaps the most popular choices.

Summarize

According to Prechter, Elliott didn't actually predict why the market tended to exhibit a 5-3 wave structure. He simply analyzed market data to come to this conclusion. Human nature and mass psychology dictate inevitable market cycles, and all of this led to the birth of the Elliott Principle.

However, as mentioned above, Elliott Waves is not a technical analysis indicator, but a theory. Elliott Wave Theory is subjective in nature, so there is no right way to use it. If traders want to accurately predict market trends through Elliott Wave Theory, they need practice and skills, and first understand how to draw wave counts. This means that Elliott Wave Theory is risky and beginners need to be very careful.