Introduction to Elliott wave theory refers to a theory (or principles) that investors and traders can adopt in technical analysis. This principle is based on the idea that financial markets tend to follow certain patterns regardless of time frame.
Basically, Elliot wave theory (EWT) suggests that market movements follow the natural sequence of mass psychology cycles. These patterns are made according to the current market trend which alternates between bearish and bullish.
The Elliott Wave Principle was created in the 1930’s by Ralph Nelson Elliott – American writer and accountant. Nonetheless, the theory gained popularity in the 1970s, thanks to the efforts of Robert R Prechter and AJFrost.
Originally, the EWT was called the Elliott Wave Theory Wave Principle and it is a description of human behavior. Elliot’s idea is based on his comprehensive study of market data with a focus on the stock market. His systematic research covers at least 75 years of information.
As a technical analysis tool, EWT is now used in an attempt to determine market cycles and trends, and can be applied to a wide variety of financial markets. However, Elliott waves are neither an indicator nor a trading method. Rather, it is a theory that can help predict market behavior. As Prechter states in his book:
The wave principle is not a predictor by nature; This is a detailed description of market behavior.
Prechter, R. R, The Elliot Wave Principle (p. 19).
Basic Elliott wave pattern
Typically, a basic Elliott wave pattern can be identified by an eight-wave pattern consisting of five impulse waves (which move in support of the main trend), and three corrective waves (which move in the opposite direction).
So, a complete Elliott wave cycle in a bullish market would look like this:
Notice that in the first example, we Elliott Wave Theory have five motive waves: three moving upwards (1, 3, and 5), plus two downward waves (A and C). In simple terms, any movement that corresponds to the main trend can be considered as an impulse wave. This means that 2, 4 and B are three corrective waves.
However, according to Elliott, financial markets create patterns that are fractal in nature. Therefore, if we shrink the long time frame, the move from 1 to 5 can be considered as a single motive wave (i), while the movement ABC can represent one corrective wave (2).
Also, if we zoom in on the time frame, a single impulse wave (such as No. 3) can be divided into five smaller waves, as shown in the next section.
Conversely, an Elliott wave cycle in a bear market could be as follows:
motivation wave
As Prechter knew, impulse waves always move in the direction of the greater direction.
As we have seen, Elliott describes two types of development: impulse and corrective waves. The previous examples include five motive waves and three corrective waves. However, if we magnify a single impulse wave, it will consist of a smaller five-wave structure. Elliot called this the five wave pattern, and coined three rules to describe its composition:
• Wave 2 cannot track more than 100% of the previous move of wave 1.
• Wave 4 can’t track more than 100% of the previous move of wave 3.
• Out of waves 1, 3 and 5, wave 3 can be the shortest and often the longest. Also, wave 3 always moves Elliott Wave Theory past the end of wave 1.
Corrective waves
Unlike impulse waves, corrective waves have a three-wave structure. Usually formed by a smaller corrective wave that occurs between two minor motive waves. The three waves are usually called A, B, and C.
When compared to impulse waves, corrective waves tend to be smaller because they move against the direction of the larger trend. In some cases, suffering from the opposite direction can make the corrective waves difficult to distinguish because their length and complexity change significantly.
According to Prechter, the most important rule to consider regarding corrective waves is that they cannot consist of five waves.
Do Elliot waves work?
There is an ongoing debate about the efficacy of Elliott waves. Some say that the success rate of the Elliott Wave Principle depends heavily on a trader’s ability to accurately divide market movements into trends and corrections.
In practice, waves can be drawn in a number of ways without breaking Elliott’s rule. This means Elliott Wave Theory that drawing waves correctly is not an easy task. Not only because it requires practice but also because of the high level of subjectivity.