List of contents

• What are Elliot Waves?

• Elliot Wave basic pattern

  • Motive Wave

  • Correction Wave

• Are Elliot Waves useful?

• Closing

What are Elliot Waves?

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

In essence, Elliott Wave Theory (EWT) shows that market movements follow the natural sequence of psychological cycles. Patterns form based on current market sentiment, which always alternates between bearish and bullish.

The Elliot Wave Principle was created in the 30s by Ralph Nelson Elliot – an American accountant and writer, but this theory only became popular in the 70s, thanks to the hard work of Robert R. Prechter and A. J. Frost.

Initially, EWT was called the Wave Principle, which was a description of human behavior. Elliot's principle was discovered based on his ongoing study of market data, focusing on stock markets. His systematic research is worth at least 75 years of information.

As a technical analysis tool, EWT is now used to try to spot market cycles and trends. This can be applied in various financial markets. However, Elliot Waves are not an indicator or trading technique, but rather a theory that can help predict market behavior. As Prechter states in his book:

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

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

Elliot Wave basic pattern

Usually the basic Elliot Wave pattern can be recognized by an eight-wave pattern, consisting of five Motive Waves (which move in support of the main trend), and three Correctional Waves (which move in the opposite direction).

So, a complete Elliot Wave cycle in a  bull market would look like this:

Please note that in the first example, we have five Motive Waves: three moving up (1, 3, and 5), and two moving down (A and C). In short, any movement that supports the main trend can be considered a Motive Wave. This means that 2, 4, and B are three Correction Waves.

But according to Elliot, financial markets form fractal patterns. So, if we zoom out to a longer time frame, the move from 1 to 5 can also be considered a Motive Wave (i), while the A-B-C move constitutes one Correction Wave (ii).

Likewise, if we zoom in to a shorter time frame, one Motive Wave (example: 3) can be divided into 5 smaller waves, as illustrated in the next session.

Conversely, an Elliot Wave cycle in a bear market would look like this:

Motive Wave

As defined by Prechter, Motive Waves always move in the same direction as the larger trend.

As we just saw, Elliot describes two types of wave development: Motive and Correctional Waves. The previous example shows five Motive Waves and three Corrective Waves. However, if we zoom in on one Motive Wave, we will see a structure of five smaller waves. Elliot called it the Five Wave Pattern, and he created three rules to describe this information:

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

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

• Among waves 1, 3, and 5, wave 3 is unlikely to be the shortest wave, in fact it is more often the longest. Also, wave 3 always moves past the end of wave 1.

Correction Wave

Unlike Motive Waves, Correction Waves usually consist of a three-wave structure. Formed by one smaller Correction Wave appearing between two smaller Motive Waves. These three waves are often called A, B, and C.

When compared to Motive Waves, Correctional Waves tend to be smaller because they move against the main trend. In some cases, such counter-trend moves can also make Correction Waves much more difficult to recognize, as they can vary greatly in length and complexity.

According to Prechter, the most important rule to remember is that a Correction Wave is never formed by five waves.

Are Elliot Waves useful?

There is still debate today regarding the efficiency of Elliot Waves. Some people argue that the level of success of the Elliot Wave principle depends largely on the trader's ability to precisely divide market movements into trends and corrections.

In practice, waves can be drawn in several ways without violating Elliot's rules. This means that drawing waves correctly is not a simple task. Not only does it require practice, but it also involves a very high level of subjectivity.

Therefore, critics argue that Elliot's Wave Theory is not a valid theory because it is highly subjective, and relies on a loosely defined set of rules. However, there are also thousands of successful investors and traders who have managed to apply Elliott's principles in a profitable way.

Interestingly, there are quite a number of traders who combine Elliot's Wave Theory with technical indicators to increase their chances of success and reduce risks. The Fibonacci Retracement and Fibonacci Extension indicators are perhaps the most popular examples.

Closing

According to Prechter, Elliot never actually predicted how the market would tend to form a 5-3 wave structure. Instead he just analyzed the market data and came to that conclusion. Elliott's principle is simply the result of inevitable market cycles created by human nature and psychology.

As mentioned previously, Elliot Waves are not a TA indicator. As such, there is no right way to use it, and it is inherently subjective. Accurately predicting market movements with EWT requires practice and skill, as traders need to figure out how to draw wave counts. This means that their use can be risky – especially for beginners.