What Is the Elliott Wave Theory?
Trading Analysis

What Is the Elliott Wave Theory?

1 year ago

Moving between optimism and pessimism, market psychology contributes significantly towards the price movement of an asset. Learn about one of the best techniques that's been helping traders with different asset classes for decades.

What Is the Elliott Wave Theory?

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The Elliott Wave theory was conceived in its entirety by Ralph Nelson Elliott who identified recurring fractal wave patterns to understand the relation between the market sentiments and trends. As a forced retiree, Elliott picked up a very unusual and unconventional hobby of analyzing 75 years' worth of yearly, monthly, weekly, and daily charts across various indexes.
At its core, the theory hypothesizes that the stock market functions in repetitive up-and-down movements and that these movements can be predicted because they relate to the psychology of the investor and the overall sentiment. The hypothesis defines two major waves known as impulsive and corrective waves. So, during the analysis, there are five sub-waves that are found to be making the impulsive wave, and three sub-waves constituting the corrective wave.

While the theory is quite effective, it is still - for the most part - a theory, which means that it can be interpreted differently by different traders. However, because of the sheer volume of data backing it, it has proven to be quite an effective method of analyzing financial markets at a much deeper level.

Let's understand what the two waves are and how they work.

What Are Impulse Waves?

An impulse wave pattern is the one in which an asset moves strongly in the direction that the asset, in general, is moving, thus denoting what can be interpreted as an "impulsive" move in the direction.
An impulsive wave consists of five sub-waves.
Image Source: www.investopedia.com

In the graph above, waves 1, 3, and 5 are impulse waves. These waves follow some unspoken rules that define their presence. These rules are unbreakable, which means that both must be followed to build an impulse wave pattern. We will look at these rules in the section below.

What Are Corrective Waves?

As the name suggests, corrective waves tend to move against the general direction of the impulse waves, and typically consist of three sub-waves. While they are extremely helpful in identifying a solid uptrend of an asset's price action, they are a bit difficult to spot as they can vary greatly in length.

How Do Elliott Waves Work?

The Elliott Wave theory analyzes psychological swings within people (from pessimistic to optimistic) about the market. If we can identify repeated patterns in prices, understand where we stand today, and then apply the Elliott Wave theory, then we can easily identify where the market is headed. The theory requires analysts to apply principles of probability to financial markets and the overall psychological sentiment of the investors who participate in it.

Technically, the waves work with simple patterns. Since there are five impulse and three corrective waves, they generally follow a 5-3 format. This 5-3 move forms a single cycle.

Image Source: www.ig.com

In this chart, we see waves 1, 3, and 5 as impulse waves. However, 2 and 4 are the corrective waves. Remember that as per the Elliott Wave theory, the corrective waves are nothing but fluctuations of market sentiment, which eventually push the asset's price action upwards. There are some rules that help to identify the Elliott Wave patterns.

Elliott Wave Theory Rules

  • The first rule is applicable to waves 1 and 2. It states that the second wave never retraces more than 100% of the first wave.
  • The second rule stipulates that the third wave will be the shortest of the three impulse waves.
  • The third rule states that the fourth wave cannot go lower than the high of the first wave.

How Can Elliott Waves Be Used in Trading?

You can simply follow the rules stated above to identify the patterns and apply the Elliott Wave theory properly. Since the principle relies mostly on market sentiments, you may also check out the Crypto Fear and Greed Index to see if there are similarities between the index and the asset that you are analyzing.
  • The best time to open a position using the Elliott Wave analysis would be during the presence/occurrence of the corrective wave - provided all the waves in general are following all the rules stated above.
  • Additionally, Fibonacci retracement tools can be of assistance when tracing these waves. You must take special note of key Fibonacci percentages - 38%, 50%, and 62%.
  • If any of the waves that you are tracing breaks either of the rules, then you need to "recount" the waves to identify a new pattern.

How Successful Is the Elliott Wave Theory?

The Elliott Wave theory is, indeed, a theory. Therefore, it is hard to tell how successful it can be because it is interpreted differently by different traders/users. The underlying aspect of subjectivity in applying the theory and identifying the impulse and/or corrective wave means that it means completely different things for different people. For some traders, it has proven to be an extremely powerful tool, but for some it has been challenging to identify the patterns.
While it might be hard to identify the waves, it indeed requires a significant amount of practice and exposure to deeper technical analysis. As a result, some seasoned traders/analysts often combine it with other technical indicators and tools to identify trends.
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