Elliott Wave Theory

Introduction

You must have seen how the prices move within stock markets. A lot of it appears to have these wave-like patterns, and sometimes those patterns can have predictive qualities. This is what the Elliott Wave Theory is all about.

Definition of Elliott Wave Theory

So, the Elliott Wave Theory assumes that price movements may be reasonably predicted through studying price history as markets tend to move in wave-like patterns. Investors who benefit from market trends are described as riding waves.

Brief history and development by Ralph Nelson Elliott

The Elliott Wave Theory saw its initial development way back during the 1930s. Its founder, Ralph Nelson Elliott, studied around 75 years’ worth of monthly, weekly, daily, yearly, and self-made 30-minute and hourly charts throughout various indexes.

But it was during 1935 that the theory gained popularity when Elliott uncannily predicted a stock market bottom, eventually leading to it becoming a staple for countless portfolio managers, private investors, or traders.

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Fundamentals of Elliott Wave Theory

Let’s dive a bit more into this theory’s fundamentals so that you know what you’re dealing with.

The basic principle of wave patterns

Some technical analysts within the stock market benefit from wave patterns using this theory, which assumes that the price movements of stocks may be predicted due to them moving in repeating up-and-down patterns known as waves that investor sentiment or psychology creates.

Impulse and corrective waves

According to Elliott’s theory, markets tend to move in two phases. One’s where it’s impulsive, with prices moving in the direction of the primary trends, and then the other phase is corrective, with prices moving against the trend.

The concept of fractals in market movements

Those wave patterns that we discussed earlier, the theory relies on them being fractal in nature, which just means that they repeat throughout various time frames and can discern what prices might do next. Thus, the application of this wave principle happens to be a type of pattern recognition.

The Structure of Elliott Waves

Here, we’ll dive a bit more into what the structure of those Elliot waves is, as there’s a lot more to them than what we’ve already discussed.

Impulse Waves

The interesting thing regarding these impulse wave patterns with regards to the Elliott Wave Theory is that they’re not limited to certain time periods. One wave could last for a couple of hours, years, or even decades.

Five-wave pattern in the direction of the main trend

Impulse waves are a five-wave pattern that form the dominant trend or go generally within the main trend’s direction.

Characteristics of each wave (1-5)

However, these waves have three rules that cannot be broken, which are that wave two may not retrace over 100% of the first wave, wave three should never be the shortest among waves one, five, and three, and finally, wave four may not overlap the first wave.

As to what these waves even are besides those rules, well, the first wave represents a new beginning for a bull market, the second wave corrects the first wave, the third wave is the strongest and largest in the entire trend, the fourth wave corrects the third, and finally the fifth and last wave is the final leg within the dominant trend’s direction.

Corrective Waves

Corrections are usually more difficult to find when compared to their impulsive counterparts.

Three-wave pattern against the main trend

Corrective waves represent a move against the main trend, or a reversal of sorts, from bullish to bearish.

Types of corrective waves (A-B-C)

The first wave, aka the A wave, is subtle, and many just assume it to be a correction within a still-active bull market, whereas during the B wave, prices tend to reverse higher, and many see the trend as a continuation of a now-long-gone bullish market. 

And finally, within the last wave, i.e., wave C, prices will move impulsively lower within five waves. Volume will pick up, and once the third leg of this wave picks up, nearly everyone will be aware that a bear market has been firmly entrenched.

Wave Degrees

Each wave degree comprises one entire cycle of corrective and motive waves.

Grand Supercycle to Subminuette waves

Although exact time spans might vary, the usual order of degrees can go from the grand supercycle, which can span multiple centuries, to subminuette, which spans mere minutes.

Importance of understanding wave hierarchy

By understanding the wave hierarchy, you’re essentially getting clues about where trends may be going next.

Fibonacci Relationships in Elliott Waves

Elliot’s analysis regarding the mathematical properties of patterns and waves eventually resulted in him making the conclusion that “The Fibonacci Summation Series is the basis of the Wave Principle.” Within those Elliott wave structures, numbers from that Fibonacci sequence repeatedly surface.

The role of Fibonacci numbers in wave analysis

So, the Fibonacci sequence offers the mathematical basis for the wave principle, which is why Elliott wave traders calculate the Fibonacci price levels so that possible ending points and target zones for wave patterns may be identified.

Common Fibonacci ratios used in wave measurements

The Fibonacci ratios more commonly used within Elliot wave measurements include 23.6%, 50%, 38.2%, 78.6%, and 61.8%.

Applying Elliott Wave Theory to Trading

Applying the Elliott Wave Theory within trading can take many shapes or forms.

Identifying potential entry and exit points

If you’ve identified the wave pattern, and if you truly believe in it, then finding your entry and exit points shouldn’t be that difficult.

Wave counting techniques

As you may have noticed by now, the theory is based on this 5-3 pattern, with five waves moving in the main trend’s direction, followed by a correction consisting of three waves. But to count them correctly, you have to adhere to the rules we went over earlier.

Combining Elliott Wave with other technical indicators

Like with any other tool or principle within the trading landscape, using the Elliott Wave in a vacuum may not lead to the best results, which is why using other indicators to confirm things may be better.

Advanced Elliott Wave Concepts

Let’s dive into some of the more advanced Elliott Wave concepts out there.

Complex corrections

Complex corrections comprise one or more intervening waves known as the X wave, which can link two or more simple corrections.

Extensions and truncations

Sometimes you may get a fifth wave that’s weak, ending up without touching the third wave’s end. This situation is known as a “truncation.” 

As for extensions, they’re just elongated impulses with these exaggerated subdivisions, which may occur within one of those three actionary impulse subwaves: one, two, or five.

Diagonal triangles

Then there are diagonal triangles as well, which are these narrowing price moves comprising two converging trend lines representing a fifth wave extension pattern.

Elliott Wave in Different Markets

The Elliott Wave Theory is not confined to any one market; it can be used within cryptocurrency, stocks, forex, and even commodities.

Application in stock markets

It probably has the most application within stock markets considering how their inception is tied with it, due to Elliott studying stock market prices mostly during his research or studies.

Forex market analysis using Elliott Waves

The Elliott Wave Theory, despite its connection with the stock sector, may be used just as well within Forex trading to examine all sorts of price movements to anticipate what future price movements may look like.

Commodity markets and Elliott Wave patterns

Commodity markets are often considered the most volatile of the bunch, which is why any sort of tool or indicator that can give any semblance of order within that chaos would be welcome, and that includes the Elliott Wave Theory.

Psychological Aspects of Elliott Wave Theory

The Elliott Wave Theory has much to do with human psychology, though it may be a more subtle aspect of it.

Market psychology and wave patterns

The theory posits that there is this collective trader psychology, or a type of crowd or market psychology, that shifts between pessimism and optimism in these repeating sequences of duration and intensity, and this is where those psychological aspects come into play.

Crowd behavior reflected in waves

So due to this sort of psychological underpinning, you’ll see that crowd behavior reflected in the waves.

Advantages and Limitations of Elliott Wave Theory

Applying any theory or tool within the stock or FX landscape will have its own set of benefits and limitations, and with the Elliott Wave Theory, it has managed some of its own too.

Benefits of using Elliott Wave analysis

If used properly, then it could provide some decent reversal signals, as well as entry and exit points and identifying trends.

Criticisms and potential drawbacks

The tool isn’t exactly what you’d call foolproof, and it needs quite the skill, patience, and discipline for efficient application.

Combining Elliott Wave with Other Analysis Methods

The Elliott Wave Theory may be combined with other analytical methods for maximum efficiency. Outlined below are a few of them.

Integrating with fundamental analysis

Fundamental analysis has everything to do with the factors affecting volume and price rather than the price and volume themselves, so using the Elliott Wave Theory for solely covering that technical analysis makes sense.

Using Elliott Wave with other technical indicators

Other indicators like the RSI or many of those moving averages would suffice if you want to improve the accuracy of your analysis with those Elliott waves.

Common Mistakes in Elliott Wave Analysis

But as with any indicator that you’ll see traders more commonly using, there’ll be a couple of common pitfalls that need to be avoided.

Forced wave counts

You don’t want to force a wave count when it’s not really there. Just stick to the rules, and you should be fine.

Ignoring larger market context

Ignoring the larger context by not incorporating higher time frames is a common mistake. Sometimes, within the short term, things aren’t as visible or apparent when you look at things in the long term.

Over-reliance on Elliott Wave alone

You don’t want to over rely on the Elliott Wave too and leave out other, just as viable, options for analyzing the market.

The Future of Elliott Wave Theory

The future of the Elliott Wave Theory sure does look interesting when you factor in the evolution that it has already undergone over the years.

Modern adaptations and refinements

Among such refinements that come to mind are the Harmonic Elliott Wave and the introduction of the Fibonacci sequence to the theory.

The role of AI and machine learning in wave analysis

 Machine learning and AI will undoubtedly play a major role within this theory considering how hard it can be to identify or count all those waves.

Conclusion

The enduring relevance of Elliott Wave Theory

It was quite the buzz when it initially came out, and even today, you’ll see many traders employing it within their analysis, which shows that it is still quite relevant today, despite whatever criticisms it might have faced.

Balancing Elliott Wave analysis with other market approaches

But once more, you want to balance things out by using other indicators in conjunction with the Elliott Wave Theory, as you may not find what you’re looking for all that often.