This article will cover the origins of the ‘Elliott Wave Theory’, how it works, and the various components related to it.
What does it mean? What are its origins?
During the 1930s, Ralph Nelson Elliott developed an innovative concept called the ‘Elliott Wave Theory’. Following an involuntary retirement, he began to study 75 years worth of charts. These were yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across multiple indexes.
Starting in 1935, the theory would go on to garner substantial notoriety. This was when Elliott made an unusual guess concerning a stock market bottom. Since then, it is an essential component for thousands of portfolio managers, traders, and private investors.
Elliott describes certain rules about the identification, prediction, and capitalization of these wave patterns. In 1994, these books, articles, and letters would go on to be covered in the publication of R.N. Elliott’s Masterworks. The general consensus is that Elliott Wave International is the largest independent financial analysis and market forecasting firm. The market analysis and forecasting from this firm draw heavily from Elliott’s model.
Elliott was of the belief that stock markets trade in patterns that are repetitious. This is in stark contrast to the common belief that they function in a more erratic manner. The Elliott theory is a distinct form of technical analysis that describes price movements in financial markets. With this concept, he was able to observe and identify persisting, fractal wave patterns.
Elliott points out that these patterns do not necessarily supply any particular kind of inevitability regarding future price movement. Instead, it helps in ordering future market action probabilities. They are useful accordingly with a variety of other forms of technical analysis. These include technical indicators, which helps in identifying specific opportunities. Traders tend to have conflicting perceptions of a market’s overall Elliott Wave structure at any period of time.
Before we get into how the theory works, let’s provide context as to what ‘waves’ are. A wave is the general price behavior pattern in a security, marking it by routine increases and decreases.
One can identify waves in stock price movements, as well as the behavior of the consumer. Investors that are aiming to make a profit from a market trend are essentially “riding a wave.” A considerably strong movement by homeowners to replace their existing mortgages with new and better ones is “refinancing wave.”
The idea of wave analysis does not technically relate to a regular blueprint formation. With those, you simply follow the instructions, unlike a majority of other price formations. Wave analysis provides insight into trend dynamics and enhances an understanding of price movements in a deeper manner.
Elliott’s theory shares some similarities with the Dow theory in that both concepts recognize that stock prices move in waves. Elliott made an additional discovery concerning the “fractal” nature of markets. However, he was also able to break down and examine them in much greater detail. To elaborate on the subject, fractals are a type of mathematical structure. When they exist on a smaller scale, they have a tendency to repeat themselves.
Elliott would come to the realization that stock index price patterns’ structures were similar in design. He began looking into how these repeating patterns can be functional as predictive indicators of future movements in the market.
How the waves work
There are some technical analysts who use the Elliott Wave Theory to profit from wave patterns in the stock market. This rationale claims that stock price movements are predictable because they move in repeating patterns. These are waves whose creation is all thanks to investor psychology.
The theory pinpoints an array of wave types, which include motive waves, impulse waves, and corrective waves. It is entirely subjective; not all traders have the same interpretation, nor do they agree that it’s a successful strategy.
Impulse & Corrective
At its core, the Elliott Wave principle consists of two wave types: impulse and corrective.
- Impulse Waves – These waves consist of five sub-waves. They carry out net movement in the exact same direction as the trend of the next-largest degree. This specific pattern is arguably the most common motive wave and is the easiest to notice in a market. It consists of five sub-waves, not unlike motive waves. Three of these waves are also motive waves, and two are corrective waves. The label for this structure is 5-3-5-3-5. It has three core rules that properly outline its formation and these are unbreakable rules. Should one of these rules experience a violation, then the structure is not an impulse wave. Moreover, one would have to re-label the questionable impulse wave. The three rules are the following: 1) wave 2 cannot retrace more than 100% of wave 1, 2) wave 3 can never be the shortest of waves 1, 3, and 5, and 3) wave 4 doesn’t overlap with the price territory of wave 1, except in a diagonal triangle formation.
- Corrective Waves – These waves (alternatively ‘Diagonal waves’) consist of three sub-waves. These make net movement in a direction opposite to the trend of the next-largest degree. As is the case with all motive waves, its goal is to move the market in the trend direction. Furthermore, it consists of a total of five sub-waves. However, the diagonal resembles either an expanding or contracting wedge. The sub-waves of the diagonal might not have five; it largely depends on what diagonal type is under observation. Similar to the motive wave, each sub-wave of the diagonal never fully retraces the previous sub-wave. What’s more, sub-wave 3 of the diagonal likely isn’t the shortest wave.
An additional guideline
A prevalent guideline by the name of “alternation” makes an observation concerning a five-wave pattern. In it, waves 2 and 4 typically take alternate forms. For example, a basic sharp move in wave 2 indicates an intricate mild move in wave 4.
Corrective wave patterns unravel in forms that are either zigzags, flats, or triangles. In turn, these corrective patterns are able to join in order to form comparatively more complex corrections. Likewise, the formation of a triangular corrective pattern is often in wave 4, though very rarely in wave 2. Moreover, it is indicative of a correction’s conclusion.
Both the impulse and corrective waves are embedded in a self-similar fractal in order to construct larger patterns. For example, a one-year chart may hypothetically be in the middle of a corrective wave. However, a 30-day chart may present a flourishing impulse wave. A trader with this specific Elliott wave perception will likely have a long-term bearish outlook with a short-term bullish perspective.
Elliott was able to recognize that the Fibonacci sequence designates the number of waves in both impulses and corrections. Additionally, wave relationships in price and time frequently display Fibonacci ratios, such as ~38% and 62%. For instance, a corrective wave in all likelihood may have a retrace of 38% of the prior impulse.
Nine degrees of waves
Elliott would eventually identify a total of nine degrees of waves. From the largest to the smallest, he assigned the following labels to each degree:
- Grand Supercycle
Generally speaking, Elliott waves are a fractal. Because of this, wave degrees, in a sense, expand ever-larger and ever-smaller beyond the above nine.
To properly utilize the theory in conventional trading, a trader might determine an upward-trending impulse wave. Moreover, they may go long and then sell or short the position as the pattern proceeds to complete five waves. With all of this in mind, a reversal is only inevitable.
Elliott Wave specialists have an important note that they make sure to emphasize. Just because the market is a fractal does not necessarily mean that the market is easily foreseeable. Scientists identify a tree as a fractal, but that doesn’t equate to anyone being able to predict each branch’s path. Regarding practical application, the Elliott Wave principle has its fair share of supporters and detractors like any other analysis method.
A key weakness is that the practitioners tend to blame their chart readings rather than any flaws concerning the theory. Failing that, there is the unrestricted interpretation of how long a wave completion takes. With that in mind, the traders who commit to the Elliott Wave Theory continue to defend it with great intensity.