Contents
What is Elliott wave?
The basic Elliott wave pattern
Impulse waves
Corrective waves
Is Elliott Wave useful?
Concluding thoughts
What is Elliott wave?
Elliott Wave refers to a theory (or principle) that investors and traders can follow in technical analysis. This principle is based on the idea that financial markets typically follow certain patterns, regardless of the time frame.
Essentially, Elliott Wave Theory states that market movements follow a natural sequence of crowd psychology cycles. Patterns arise according to current market trends, which alternate between bearish and bullish directions.
The Elliott Wave Principle was invented in the 1930s by Ralph Nelson Elliott – an American accountant and writer. But the theory did not gain widespread popularity until the 1970s, thanks to the efforts of Robert R. Prector and A. J. Frost.
Initially, Elliott Wave Theory was called the Wave Principle, a description of human behavior. Elliott's innovation was based on his extensive study of market data with an emphasis on stock markets. His systematic research included information collected over at least 75 years.
As a technical analysis tool, Elliott Wave Theory is currently used to attempt to identify market cycles and trends, and can be applied to a wide range of financial markets. But Elliott Wave is not an indicator or a trading mechanism. Rather, it is a theory that helps predict market behavior. Prector states in his book:
[...] The wave principle is not primarily a forecasting tool, but rather a detailed description of the behavior of markets.
-Brecter, R.R. Elliott Wave Principle (p. 19).
The basic Elliott wave pattern
The basic Elliott wave pattern can usually be identified by an eight-wave pattern that includes five impulsive waves (moving with the main trend), and three corrective waves (moving in the opposite direction).
So, a complete Elliott wave cycle in a bear market would look like this:
Notice that, in the first example, there are five impulse waves: three on the upside (1, 3, and 5), and two on the downside (A and C). Simply put, any movement that matches the main trend can be considered an impulse wave. This means that waves 2, 4, and B are the three corrective waves.
But according to Elliott, financial markets create patterns that are fragmented in nature. So, if we zoom out to longer time frames, the move from 1 to 5 can also be considered a single impulse wave (i), while the A-B-C move can represent a single corrective wave (ii).
If we zoom into smaller time frames, one impulse wave (such as 3) can be divided into five smaller waves, as shown in the next section.
In contrast, an Elliott wave cycle in a bull market would look like this:
Impulse waves
According to Prector's definition, impulse waves always move in the same direction as the larger market trend.
As we saw above, Elliott described two types of wave development: impulse and corrective waves. The previous example included five impulse waves and three corrective waves. But if we magnify one impulse wave, we find that it consists of five smaller waves. Elliott called it the five-wave pattern, and established three rules to describe its formation:
Wave 2 cannot rebound more than 100% of the movement of wave 1 preceding it.
Wave 4 cannot rebound more than 100% of the movement of wave 3 preceding it.
Among waves 1, 3 and 5, wave 3 cannot be the shortest, and is often the longest. Wave 3 also always moves past the end of wave 1.
Corrective waves
Unlike impulse waves, corrective waves usually consist of three waves. They are often formed by a smaller corrective wave that forms between two smaller impulse waves. The three waves are usually called A, B, and C.
When compared to impulse waves, corrective waves are usually smaller because they move against the larger market trend. In some cases, this counter-trend conflict can also create corrective waves that are more difficult to recognize because they can vary greatly in length and complexity.
According to Prector, the most important rule to always remember about corrective waves is that they never consist of five waves.
Is Elliot Wave useful?
There is an ongoing debate regarding the efficiency of Elliott waves. Some say that the success rate of the Elliott Wave principle depends heavily on the ability of traders to accurately divide market movements into trends and corrections.
In practice, waves can be drawn in many ways without necessarily breaking Elliott's rules. This means that drawing waves correctly is far from easy. This is not only because it requires practice, but also because it involves a large degree of subjectivity.
Therefore, critics argue that Elliott Wave Theory is not a reliable theory due to its highly subjective nature, as well as its reliance on an ill-defined set of rules. Despite this, there are thousands of successful investors and traders who have been able to apply Elliott's principles profitably.
Interestingly, an increasing number of traders are combining Elliott Wave theory with technical indicators to increase their success rates and reduce risks. The most common examples are the Fibonacci Retracement and Fibonacci Extension indicators.
Concluding thoughts
According to Prector, Elliott never actually predicted why markets tend to present a 5 to 3 wave structure. He only analyzed market data and came to this conclusion. The Elliott Principle is simply the result of the inevitable market cycles created by human nature and crowd psychology.
But, as mentioned, Elliott Wave is not an indicator for technical analysis, but a theory. Hence, there is no right way to use it, and it is inherently subjective. Accurately forecasting market movements using Elliott Wave Theory requires practice and skills because traders need to know how to plot wave numbers. This means that using them can be risky – especially for beginners.
