Content
What is Elliott Wave?
Basics of the Elliott Wave Pattern
Moving waves
Corrective waves
Do Elliott waves work?
Summary
What is Elliott Wave?
The Elliott Wave is a type of principle that investors and traders can use in technical analysis. This principle is based on the idea that financial markets tend to follow certain behavioral patterns, regardless of the time frame.
Essentially, Elliott Wave Theory (EWT) suggests that market movements follow the natural cycles of crowd psychology. Patterns are created in accordance with the current market sentiment, which alternates between bearish and bullish.
This theory was created in the 1930s by Ralph Nelson Elliott, an American accountant and writer. However, the theory only gained popularity in the 70s, thanks to the efforts of Robert R. Prechter and A. J. Frost.
EWT was originally simply referred to as the wave principle, which is a reflection of human behavior. Elliott's work is based on comprehensive research into market data with a focus on equity markets. His systematic analysis includes at least 75 years of information.
Nowadays, EWT as a technical analysis tool is used to identify market cycles and trends and can also be applied to various financial markets. However, the Elliott wave is not an indicator or trading method. However, this theory can help you predict future market behavior, as Prechter writes in his book:
[...] the wave principle is not primarily a forecasting tool; it is a detailed description of how markets behave.
– Prechter R.R. Elliott Wave Principle (p. 19).
Basics of the Elliott Wave Pattern
The basic Elliott wave pattern can be identified by an eight-wave pattern that contains five driving waves (they move in the direction of the main trend) and three corrective waves (they move in the opposite direction).
Thus, the Elliott wave cycle in a bull market looks like this:
Notice that in the first example we have five driving waves: three on the up move (1, 3 and 5) and two on the down move (A and C). Simply put, any movement that follows the underlying trend can be considered a moving wave. This means that 2, 4 and B are three corrective waves.
According to Elliott's theory, financial markets create fractal patterns. Thus, if we zoom in to longer time frames, a move from 1 to 5 can also be considered one driving wave (i), while an A-B-C move can represent one corrective wave (ii).
If we zoom out to lower time frames, a single driving wave (such as 3) can be further divided into five smaller waves, as shown in the next section.
In turn, the Elliott wave cycle in a bear market looks like this:
Moving waves
According to Prechter's definition, driving waves always move in one direction, like a strong trend.
Taking into account the above information, Elliott described two types of wave development: driving and corrective. The previous example included five driving and three corrective waves. But if we zoom out to a single driving wave, it consists of a smaller five-wave structure. Elliott called this the five-wave pattern, and he created three rules to describe how it forms:
Wave 2 cannot recover more than 100% of the previous movement of wave 1.
Wave 4 cannot recover more than 100% of the previous wave 3 move.
Among waves 1, 3 and 5, the third wave may not be the shortest; it is often the longest. In addition, this wave always passes by the end of the first wave.
Corrective waves
Unlike driving ones, correctional waves mainly consist of a three-wave structure. They are often formed by a smaller corrective wave that occurs between two driving waves of a similar format. The three waves are usually referred to as A, B and C.
Compared to driving waves, corrective waves are usually smaller in size because they move against the main trend. In some cases, such counter-trend fighting can also make corrective waves difficult to identify due to the fact that 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 never consist of five waves.
Do Elliott waves work?
Discussions on the effectiveness of Elliott waves continue to this day. Some say that the level of success of the wave principle depends heavily on traders' ability to accurately separate market movements into trends and corrections.
In practice, waves can be depicted in various ways without violating Elliott's rules. This means that mapping waves correctly is no easy task, not only because it requires practice, but also because it is highly subjective.
Critics argue that the Elliott wave theory is not real due to its high level of subjectivity and reliance on a loose set of rules. However, there are thousands of successful investors and traders who have been able to profitably apply Elliott's principles.
It is worth noting that the number of traders who combine the Elliott wave theory with various technical indicators in order to increase the success of the forecast and reduce possible risks is regularly increasing. Fibonacci retracements and Fibonacci extensions are perhaps the most popular examples of additional tools.
Summary
According to Prechter, Elliott never thought about why the market produces a 5-3 wave structure. Instead, he simply analyzed market data and came to this conclusion. The Elliott Principle is the result of inevitable market cycles created by human nature and crowd psychology.
As we have already said, the Elliott wave is not an indicator of TA, but just a theory. There is no most correct way to use this theory, and is essentially purely subjective. Accurately predicting market movements using Elliott waves requires practice and skill, as the trader is tasked with correctly determining the number and sequence of waves. This means that using this method can be extremely risky, especially for novice traders.
