Elliott Wave Theory

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21 Aug, 2024

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Elliott wave theory is used in technical analysis to explain a security's price movement over time by identifying repeating eight-wave patterns in return data. According to the theory, the market or price action will be in cycles of five waves up, followed by the correction represented by three waves down.

The application of Elliott wave theory patterns helps in making stock market predictions. The theory suggests that price moves in waves, which can be recognized by studying historical stock market price data and long-term price patterns that are rhythmic, regular, and repetitive. The waves are categorized as impulse and corrective waves.

What is The Elliott Wave Theory?

Elliott wave theory explains how a security's price changes over time by identifying recurring eight-wave patterns in return data. The eight-wave pattern is usually five waves up and three waves down.
Ralph Nelson Elliott introduced it in the 1930s and was famous for predicting the 1935 stock market bottom after studying long indices and historical data.
The Elliott wave theory is a technical analysis tool that claims and predicts that stock price movements are primarily in waves rather than simple patterns. It is said to be quite similar to the Dow theory on the common grounds that price movements occur in waves and not just line patterns.
There are many books on Elliott wave theory that analysts can read and understand how to apply in prevailing market conditions to make sound investment decisions.

Elliott Wave Theory Explained

Elliott wave theory is used to predict price variations primarily in the stock market; the creator of Elliott wave theory is Ralph Nelson Elliott, an American accountant, and author; hence the theory is named after him. He introduced it in 1930. Typically, the wave theory suggests that the price movements are repetitive and historic, and when looked at from a broader perspective, they look like ocean waves in long patterns.

It is essential to identify where one wave segment finishes and another starts and analyze whether a significant correction is the completion of a wave or merely a deviation from the general trend. As a result, it is one of the most popular forms of technical analysis used by many portfolio managers globally.

Elliott believed that every action would give a reaction; he studied long-form and historical data patterns and introduced the wave theory based on this. It is often compared to the Dow theory. He proposed that the investors' sentiment and psychological behavior can make waves in price movements rather than just straight lines. When he studied long-form historical data, he concluded that these waves are repetitive.

Elliott wave theory trading is extremely popular among traders as it helps in predicting future price movements; based on that information, traders take a position in the market. Elliott wave theory with Fibonacci retracement is a typical example among traders and analysts. Though typically employed in the stock market, it can also be used in other financial markets.

Rules

Elliott wave theory patterns provide a comprehensive framework for understanding market cycles and predicting future price movements by applying a set of rules and guidelines to the observed wave patterns. Let us understand them through the discussion below.

Wave Structure: The theory identifies two types of waves—impulse waves and corrective waves. Impulse waves move in the direction of the main trend, while corrective waves move against it.
Wave Count: An Elliott wave sequence consists of impulsive and corrective waves, typically labeled as 5-3-5-3-5. This represents the rhythm of market price movements.
Wave Degrees: Elliott Wave Theory categorizes waves into different degrees, including Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, and Minuette, indicating the scale of the waves.
Wave Direction: Impulse waves (1, 3, and 5) follow the main trend and are labeled with numbers, while corrective waves (2 and 4) move against the trend and are labeled with letters.
Fibonacci Ratios: The theory incorporates Fibonacci ratios to determine potential reversal points and wave extensions, providing a quantitative basis for analyzing wave retracements and extensions.
Wave Equality: In certain patterns, particularly within corrective waves, there is a tendency for specific waves to achieve equality in terms of price or time, providing insights into potential turning points.
Wave Alternation: Elliott Wave Theory suggests that waves of similar degree do not usually exhibit the same pattern, promoting the idea of alternation in wave structures.
Channeling: Price movements often adhere to trend channels, and Elliott Wave analysts use trendlines to identify potential reversal or continuation points based on wave patterns.
Confirmation: Analysts use additional technical indicators and price confirmation to strengthen the validity of Elliott Wave analysis, enhancing the reliability of forecasted price movements.

Types

As discussed earlier, there are two types of waves under this concept. They are-

Impulse Waves: These consist of five waves, generally named Wave 1, Wave 2, Wave 3, Wave 4, and Wave 5. All these waves move in the primary trend direction, but Wave 2 and Wave 4 move in the opposite direction. It has often been sighted that the motive waves are only three and not five in a real-time market. There are three inevitable Elliott wave theory rules regarding motive waves.
Corrective Waves: The corrective waves, also called diagonal waves, move opposite to motive waves. These waves are more complex and elemental than motive waves, and thus, they are time-consuming to comprehend. The waves are in triangles, diagonals, and zig-zag. Generally, a motive wave is the upward trend in a bull market, and corrective waves alter the tendency. This same scenario is reversed, as in a bearish market, the corrective waves will show an upward trend in stock price, and the motive will decrease it.

Chart

Let us look at the CFDs on WTI Crude Oil chart below to better understand the concept of Elliot Wave Theory.

Source

As we can see above, the first five waves (1, 2, 3, 4, and 5) move in the main trend’s direction. On the other hand, the remaining 3 waves (A, B, and C) move in a correction. Hence, overall, it is a 5-3 move. The first five waves lead to the formation of an impulse, while the next three denote the corrective waves. From the chart, it is clear that this theory can help in the identification of trends in the market. Thus, utilizing this tool can help traders exit their trades at the right time and safeguard their profits.

If a person wants to look at more charts concerning Elliot the wave theory, they can consider observing more charts that involve this theory on TradingView.

Examples

Let us understand the practical applicability of Elliott wave theory trading through the examples below.

Example #1

Glenn, a financial analyst is applying Elliott Wave Theory to analyze a stock's price movements. The analyst identifies a bullish trend and observes a five-wave sequence representing an impulse wave, denoted as waves 1 through 5. Following this upward movement, the analyst identifies a corrective wave, labeled as wave A, which retraces a portion of the preceding impulse wave.

As the correction completes, he anticipates another impulsive move to the upside, forming waves B and C of the corrective sequence. The entire pattern, when visualized, reflects the classic 5-3-5-3-5 structure of this Theory. Additionally, Glenn may use Fibonacci ratios to pinpoint potential reversal levels or extensions within each wave, providing a quantitative dimension to the analysis.

Example #2

The analysis of the stock price movement of Gamestop starts from a significant low, which is at $2.57, seen on April 3 2020. The evaluation and interpretation based on the theory explain that wave 1 of the five waves of the bull cycle went from $2.57 to a peak of $159.18, seen on 25 January 2021.

It should be observed that wave 2 corrected wave 1, a 61.8% retracement, and the third wave reached 200% of wave 1. Again another wave, wave 4, brought a correction which presented another chance to buy, as the stock dropped to close to the 38.2% retracement of wave 3. Finally, wave 5 finished at $483.

Traders holding the company's shares should have intended to sell them when the price got closer to this objective. When the fifth wave finished, the chances of a correction rose, and given the already irrational swings that had occurred, the chances of traders trying to buy from a point beyond the wave 5 level may decrease. As expected, a correction quickly decreased the price to almost a 78.6% retracement of the bull cycle.

Is It Reliable?

While this theory is one of the most used technical analysis tools by portfolio managers, let us cross-check if it is actually as reliable through the points below.

The reliability of Elliott Wave Theory is influenced by the subjective nature of wave interpretation, allowing for different analysts to identify different wave counts.
The theory's complexity and the multitude of rules and guidelines can make it challenging for analysts to consistently apply and interpret correctly, affecting its reliability.
Its effectiveness may vary under different market conditions, and in highly unpredictable or chaotic markets, the application of Elliott Wave Theory can be less reliable.
Analysts often use additional technical indicators and price confirmation to enhance reliability, but these tools don't eliminate the inherent subjectivity of Elliott Wave analysis.
While it has demonstrated accuracy in specific historical patterns, its reliability remains a topic of debate among traders and analysts due to its sensitivity to interpretation and market dynamics.

Frequently Asked Questions (FAQs)

What is the difference between Dow's theory and Elliott Wave Theory?

The Elliott wave theory resembles the Dow theory; both studies theorize the same objective that prices in a market move in waves rather than just straight lines. However, the Elliott wave theory was a much better explanation and detailed the concept than the Dow theory. The main difference is that the Elliott theory breaks markets down into fractals.

How important is Elliott Wave Theory?

The theory's application is essential in predicting the trend and the correction following the trend. In other words, identifying trends and corrections that will probably take place soon will help the traders protect the profit or reduce the loss.

How to apply the Elliott wave theory?

It is a technical analysis, and the most common technique to apply is to spot an upward trend which is an impulse wave, move forward with it, and there is a high chance that it will reverse after five complete waves. Then, depending on the movement and strategy, the trader can decide on the entry or exit point.