In the 1930s, Ralph Nelson Elliott created what is now known as the Elliott Wave Theory. 1 Elliott was of the opinion that the stock markets, which are often assumed to operate in a way that is somewhat haphazard and chaotic, really moved in predictable patterns.
In this post, we’ll examine the background of Elliott Wave Theory as well as how it might be applied to the world of trading.
KEY TAKEAWAYS
- The Elliott Wave Theory is a school of thought within the field of technical analysis that searches for repeating patterns of long-term prices that are tied to ongoing shifts in the emotions and psychology of investors.
- The theory distinguishes between impulse waves, which establish a pattern, and corrective waves, which move in the opposite direction of the overall trend.
- A fractal method of trading is based on the idea that each set of waves is stacked inside a bigger set of waves that follow the same urge or remedial pattern.
Waves
Elliott hypothesized that the prevalent psychological assumptions of investors were to blame for prevailing price movements in the financial markets. He discovered that shifts in the collective psyche always manifested themselves in the same recurrent fractal patterns, often known as “waves,” in the stock market.
Both the Dow theory and Elliott’s theory acknowledge that there are waves in the movement of stock values. This is one similarity between the two theories. But, since Elliott also understood the “fractal” structure of markets, he was able to dissect and study them at a far deeper level of depth. Mathematical structures known as fractals are those that endlessly replicate themselves on a size that is ever-increasingly smaller. Elliott found that the patterns of stock index prices were built in the same manner again and over again. After that, he started looking into how these recurring patterns might be utilized as predictive predictors of future market swings and how they could be utilized.
Elliott Wave Theory.
Market Predictions Based on Wave Patterns
Elliott was able to accurately forecast the stock market by analyzing the wave patterns for trustworthy traits and basing his forecasts on those characteristics. There are always five waves visible in the pattern of an impulse wave, and this wave type always goes in the same direction as the bigger trend. A corrective wave, on the other hand, is characterized by its overall movement in the opposite direction of the primary trend. On a more minute scale, you’ll find five waves included inside each of the impulsive waves itself.
The following pattern is one that will continue to recur indefinitely on ever-narrower scales. In the 1930s, Elliott discovered a fractal pattern in the financial markets; nevertheless, it would not be until the 1960s that scientists would come to identify fractals and quantitatively verify their existence.
In the financial markets, we know that “what goes up, must come down,” since a price movement up or down is always followed by a counter-movement. Price activity is separated into trends and corrections. Trends represent the general direction of pricing, whereas corrections go against the trend.
Elliott Wave Theory Interpretation
According to one interpretation, the Elliott Wave Theory goes as follows:
- First, there are five waves that move in the direction of the primary trend, and then there are three waves that go in the direction of a correction (totaling a 5-3 move). After that, these 5-3 moves form two subdivisions of the higher wave move that follows after them.
- While the length of time between each wave may change, the fundamental 5-3 pattern that underlies everything stays the same.
Let’s examine the chart below, which consists of eight waves (five net upward and three net downward) designated 1, 2, 3, 4, 5, A, B, and C.
An impulse is formed by waves 1, 2, 3, 4, and 5, whereas a correction is formed by waves A, B, and C. The five-wave impulse ultimately results in the formation of wave 1 at the next-largest degree, whereas the three-wave correction ultimately results in the formation of wave 2 at the same degree.
Typically, the corrective wave will consist of three separate price movements: two in the same direction as the primary correction (A and C), and one in the opposite direction (B). Both Wave 2 and Wave 4 in the image above represent adjustments. The following is an example of the usual structure of these waves:
Take note that waves A and C advance in the direction of the trend at a one-larger degree than the previous wave, and as a result, they are impulsive and comprised of five waves in this illustration. Wave B, on the other hand, is moving in the opposite direction of the trend and is thus corrective. It consists of three waves.
An Elliott wave degree, which consists of trends and countertrends, is formed by an impulse-wave formation, which is then followed by a corrective-wave formation.
Five waves do not always move net upward or downward, as seen in the patterns above. Likewise, three waves do not always travel net upward or downward. For example, the five-wave sequence is down when the trend with a higher degree is down.
Wave Degrees
Elliott discovered nine different degrees of waves, which he categorized as follows, going from most significant to least significant:
- Grand Super Cycle
- Super Cycle
- Cycle
- Primary
- Intermediate
- Minor
- Minute
- Minuette
- Sub-Minuette
Elliott waves are a kind of fractal, and as such, the wave degrees may potentially extend both further big and further tiny than those that are shown above.
To put this theory into practice in day-to-day trading, a trader may look for an impulse wave that is moving in an upward direction, enter a long position, and then sell or short the position after the pattern has completed five waves and a reversal is about to become likely.
Elliott Wave Theory’s Popularity
The contributions of A.J. Frost and Robert Prechter in the 1970s helped propel the Elliott Wave idea to the forefront of the financial analysis world. The authors of the now-iconic book The Elliott Wave Principle: Key to Market Behavior accurately forecast the bull market that would occur in the 1980s in that book. Later on, 2 Prechter would advise investors to liquidate their stocks only days before the market meltdown of 1987.
The Bottom Line
Practitioners of the Elliott Wave underline that the fact that the market is a fractal does not automatically make it simple to forecast how the market will behave. Although if a tree is considered a fractal by scientists, this does not indicate that anybody can accurately anticipate the route that each of its branches will take. When it comes to its use in the real world, the Elliott Wave Principle is much like any other kind of analytical approach in that it has both supporters and critics.
One of the major flaws is that practitioners can always attribute their interpretation of the charts instead of flaws in the theory. In its absence, there is an open-ended interpretation of the duration of a wave. However, speculators who adhere to the Elliott Wave Theory vigorously defend it.
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