The Elliott Wave Theory
The Elliott Wave Theory is a powerful tool for technical analysis. It provides a structured framework to understand market behavior and predict price movements. In this article, we explore the key principles of the theory, its historical background, and application in trading.
Definition of Elliot Wave Theory
Ralph Nelson Elliott, an American accountant and author, introduced the Elliott Wave Theory in the 1930s, revolutionizing the field of technical analysis. Elliott was the first to foresee a stock market bottom in 1935 after studying data from the stock market over multiple years across several indices. Since then, the theory has evolved into a trustworthy resource for many different portfolio managers worldwide.
Historical Background of the Theory
Ralph Nelson Elliott was a mad genius and certified public accountant back in the 1920s and 1930s. Elliott, born on July 28th, 1871, in Marysville, Kansas, accomplished his greatest feat in his latter years after taking a detour.
R.N. Elliott had a successful career in accounting and business, but an illness he developed while living in Central America pushed him into an unwelcome retirement at the age of 58. He focused his complete attention to researching the behavior of the stock market since he needed something to keep his mind busy while he was recovering. Elliott looked at 75 years’ worth of stock market behavior on yearly, monthly, weekly, daily, hourly, and half-hourly charts for the various indices.
By November 1934, R.N. Elliott had grown confident in his theories regarding what is sometimes referred to as the Wave Theory and he decided to share them with Charles J. Collins of Investment Counsel, Inc. in Detroit.
The next day, Thursday, March 14, 1935, was the Dow Industrials’ closing low for the year. After the 13-month “correction,” the market made an immediate upward turn. Collins decided to work with another author on a book about the Wave Theory two months later, and the book was released on August 31, 1938, as the market continued to rise.
Early in the 1940s, the Wave Theory kept evolving. Elliott connected the “golden” ratio to societal behavioral patterns. Then Elliott completed what he saw as his magnum opus, Nature’s Law, which is the Secret of the Universe. Almost all of his ideas for his Wave Theory are contained in this book. Due to Elliott’s groundbreaking research, thousands of institutional portfolio managers, traders, and private investors now use the Wave Theory.
Overview of the Theory’s Main Principles
Prices on the market tend to move in repeating patterns of bullish and bearish waves that may be linked to a general model since they are the result of human activity and as such are governed by natural laws.
These wave patterns are related to the general psychology of investors according to Elliott Wave Theory. These price movement patterns, which alternate between optimism and pessimism, are produced by their mood swings and market confidence.
The Elliott Wave principle is based on the idea that markets are influenced by economic factors, psychological factors, and natural laws, which together shape their behavior. Without these, achieving any kind of balance would be impossible, and the prices would experience convulsive, chaotic changes.
The Five Waves of the Elliott Wave Theory
Technical analysis uses Elliott waves to forecast price changes. Elliott’s Wave Theory divides waves into Motive (impulse) waves and Corrective waves. The first five waves are known as ‘Impulse Waves,’ and they move in the direction of the main trend, while the latter three waves are known as ‘Corrective Waves,’ and they move against the trend.
Explanation of the Five Waves
Five waves make up a motive or Impulse Waves which consists of three Impulse Waves and two retrace waves. Impulse Waves are the name for the initial 5-wave pattern. Waves 1, 3, and 5 in this pattern are motive or follow the general trend, but Waves 2 and 4 are corrective. Let’s first take a look at the 5-Wave Impulse pattern.
- Wave 1
The initial price increases as a select few buyers take advantage of the low price. At first, it may be challenging to spot this wave because the market will likely still be depressed if the prior trend was bearish.
- Wave 2
Marginally reverses, and when investors take profits, the price slightly declines. Enough participants in the initial wave now believe the stock is overpriced and are taking profits. Wave 2 can never go beyond the height of Wave 1 in general.
- Wave 3
This wave involves the general public making a trading decision, which raises the price even further. The majority of market participants will become aware that the prior trend is over during Wave 3 and will start to follow the new trend. Moreover, during Wave 3 the price climbs quickly in a positive market. The reverse happens in a bearish market.
- Wave 4
Because the instrument is pricey, this wave sees more traders take profits. Wave 4 is challenging to count and may take a while to develop, but it shouldn’t last longer than Wave 3 did.
- Wave 5
This wave is the final buying flurry before a new trend begins. Ultimately, purchasers run out of steam, and the price loses steam. A few bullish investors purchasing the expensive stock. The asset is at its most overvalued at this point.
Understanding the Impulse Wave
Price changes in Impulse Wave are typically large, whereas those in correction waves are typically lesser. The Impulse Wave is the sort of wave that has been used so far to demonstrate how the Elliott Wave structure is put together. It is the most prevalent and straightforward to identify in a market. As do all motive waves, five sub-waves consist of three motive waves and two corrective waves.
The Elliott Wave Theory’s variants on Impulse Wave have the fascinating property of not being constrained to a specific period of time. This makes it possible for some waves to linger for many hours, years, or decades.
However, the creation of an impulse wave is constrained by three unchangeable laws. If one of these guidelines is broken, the structure is not an impulse wave, and the suspected impulse wave needs to be re-labeled. They are as follows:
- Wave 3 is always longer than waves 1, 3, and 5.
- Wave 1 and Wave 4 cannot cross over.
- Wave 2 cannot retrace Wave 1 by more than 100%.
Understanding the Corrective Wave
Corrective waves move by one more degree in the opposite direction of the trend. Corrective waves are much more varied and less easily recognized than impulse waves. Corrective waves are most likely better described as never moving in five directions at once. The only fives are motive waves. Corrective patterns are classified into four types:
Wave B tends to be shorter than waves A and C when the corrective waves are arranged in a zigzag pattern.
The flat formation is easier to understand because the waves are often of uniform length. A sideways pattern will correct the impulse waves.
Triangle formations have a 3-3-3-3-3 structure because each side of a triangle is further divided into 3 waves, making a total of 5 sub-waves in a triangle.
- Double and Triple Threes
A double or triple three comprises flats, triangles, zigzags, and other less complex sorts of repairs.
Applying Elliot Wave Theory to Trading
Using the Theory for Trend Analysis
According to this idea, studying historical stock market price data and long-term price patterns that are rhythmic, regular, and repeated can help identify price waves. The theory is applied to assess and forecast price changes in the stock market. Furthermore, the five waves can be quickly identified on market trends.
Determining Market Trends With the Theory
Based on trustworthy traits he found in the wave patterns, Elliott’s theory provided precise stock market predictions. Trends and corrections are two categories of price activity. Prices often move in a trend, while corrections buck the trend. He specifically introduced several forecasting components that determined achievable price levels and identified market trends. The Elliott Wave theory distinguishes between price fluctuations in terms of waves.
Identifying Potential Entry and Exit Points Using the Theory
The most popular strategy is to identify an upward trend, an impulse wave, and follow it. There is a good likelihood that it will turn around after five full waves. The trader can then choose an entry or exit position based on movement and strategy.
Criticisms of the Elliot Wave Theory
Limitations of the Theory
According to some theory practitioners today, the criticisms of Elliott Wave Theory are misinformed. In actuality, Elliot Wave Theory is rather complicated. The issue with complex systems is that practically any claim can be made by picking the data that support it and ignoring the ones that refute it.
Most traders find the complexity of the theory to be a serious problem. Developing and fully understanding the technique takes time, research, and extensive experience. Even if they would not like to acknowledge it, most traders today lack patience and think that delaying pleasure is a thing of the past.
One common criticism of the Elliott Wave theory comes from academics and scientists who argue that the unpredictable nature of financial markets makes it impossible for any forecasting strategy to yield positive results consistently. These criticisms are usually presented in complex technical terms, but it’s important to remember that markets are not always rational.
Challenges in Applying the Theory to Real-World Markets
Applying the Elliott Wave theory needs to map out this wave counts on different timeframes, despite facing the challenges. The idea should be broken down frequently by traders to fully grasp how to apply it to real-world markets. Markets experience cycles, including moments of clarity when the pattern is evident and usable and periods of ambiguity when the pattern is unclear.
Accepting that Elliott wave analysis is only feasible approximately half the time is the only practical method to avoid this. In other words, a straightforward wave count will only appear on the charts you look at or will only be successful around half the time when you focus on one market.
Alternative Approaches to Market Analysis
This theory will provide high-probability setups to the trader if they are alert enough to recognize the setups. When used correctly, this price action strategy for forex trading is one of the most successful and consistent. But it turns out that this skill calls for a lot of focus and repetition.
Ralph Nelson Elliott, a stock market analyst, developed the Elliott Wave theory in the 1920s and 1930s because he thought that markets had a more regular structure than the chaotic appearance observed by most other analysts at the time.
The Eliott Wave Theory can also be used to categorize fresh prospects together with additional technical study. By examining Impulse Waves and Corrective Wave patterns, the theory attempts to gauge the evolution of consumer values. Corrective Waves consist of three smaller degree waves flowing in the opposite direction. In contrast, Impulse Waves comprise five distinct smaller-degree waves traveling in the form of a larger pattern.
For many people worldwide, the Elliott Wave theory gives markets a sense of structure. When a rule is broken, the capacity to constantly adjust the theory can make it more challenging to use the theory as a trading tool.