What is Elliott Wave theory?

Summary - Elliott Wave Theory is a form of technical analysis that is named after the American accountant and author Ralph Nelson Elliott. By using the Dow Theory and his own observations about nature, Elliott theorized that individual investors could predict the movement of the stock market by identifying a repetitive pattern of waves. 

Elliott Wave Theory is similar to the Dow Theory in that it theorizes that price movement is based on waves. However, Elliott took his observations an additional step further and discovered that within a large wave structure there was a repeating pattern of sub-waves that repeated in the same pattern. Pointing out this fractal nature of waves set the Elliott Wave Theory apart from the Dow Theory and was made popular in Elliott’s 1938 book, The Wave Principle.

The basic wave principle states that markets move in a 5-3 pattern where the initial five waves show price movement in line with a trend. These are known as impulse (or motive) waves. The next three waves will be corrective waves and will have a net movement against the prevailing trend. In a bull market, the impulse trend is upwards. Conversely, in a bear market, the impulse trend is downward.

Traders looking to create an investment strategy based on the Elliott Wave Theory will look to identify the end of a wave cycle. When they see the end of an impulse wave cycle in an uptrend, it provides an opportunity for them to take a short position (or sell) because the anticipated price movement will be against the trend. Likewise, when they see the end of a corrective cycle in a downtrend, they can take a long position (or buy) because the anticipated price movement will be higher.

In recent years, the Elliott Wave Theory has evolved to move away from its strict adherence to a 5-3 wave structure to account for the wide-ranging price movements found in the forex, commodities, and bond markets. These markets were not considered when the Elliott Wave Theory was first introduced. This evolution of the theory has fostered critics who are uncomfortable with the subjectivity found in identifying wave patterns. However, adherents to the Elliott Wave Theory find it to be an extremely accurate predictor, particularly because of its relationship to key Fibonacci ratios.

Introduction

Markets don’t move in the same way all the time, and they don’t announce their next move. Investors who engage in technical analysis find meaning in patterns. When traders see predictable movements in asset prices (forex, stocks, commodities, etc.), it can give them more assurance of the direction a trade is likely to go.

Finding patterns in market movements is the principle behind the Elliott Wave theory. Similar to the Dow Theory, the Elliott Wave theory is based on finding predictable wave patterns in the movement of stock prices. In this article, we will take a closer look at the Elliott Wave Theory. In addition to defining the theory and providing a little history behind it, we will explore the fractal nature of the wave principle that sets it apart from the Dow Theory. We will also go into some detail about how the Elliott Wave Theory shows a strong correlation to key Fibonacci retracement levels, review some primary rules that can help traders identify a wave structure. We’ll conclude by reviewing how the Elliott Wave Theory has evolved based on markets such as the forex market – which were not originally covered by the theory.

What is Elliott Wave theory?

Elliott Wave Theory is a market forecasting tool that was developed in the 1930s by Ralph Nelson Elliott. At that time stock markets, coming off the crash of 1929 were seen to behave randomly and chaotically. Elliott challenged that notion, by discovering that markets moved in very repetitive patterns. Furthermore, these waves were tied into the predominant, or trending, the psychology of investors. This meant a large swing in investor psychology (what might be called today “investor sentiment”) would result in a corresponding, and recurring, wave pattern in the markets.

The Elliott Wave Theory was a relatively obscure theory until the 1970s and the publication of Elliott Wave Principle: Key to Market Behavior by A.J. Frost and Robert Prechter. This book, using Elliott Wave Theory, accurately predicted the bull market of the 1980s. Prechter garnered further credibility by issuing a sell recommendation just days before the market crash of 1987.

This wave principle (i.e. market prices move in waves) is similar to the Dow Theory. The classic definition of the wave principle in Elliott Wave theory is that the price of an asset will move in the direction of the trend in five waves (called impulse waves) and move in opposition to the trend in three waves (known as corrective waves). The five trend-setting waves are labeled 1, 2, 3, 4 and 5 respectively. The subsequent three-wave corrective wave pattern is labeled a, b and c.

In its simplest form, the Elliott Wave Theory is a form of trading based on market trends. In this case, identifying an impulse wave creates an ideal set-up for trading. When traders identify an impulse wave that is showing upward price movement, they can take a long position. When they see the five wave pattern (signifying a market rally) coming to an end (signifying a pullback), they can then take a short position in anticipation of the imminent reversal.

Elliott waves have a fractal nature

We mentioned above that the Elliott Wave Theory has its origins in, and is very similar to, the Dow Theory. However, within a 5-3 Elliott Wave structure, Elliott noted that there are many sub-wave patterns that display five waves. This next pattern can repeat itself, theoretically, to infinity at increasingly smaller scales. This "wave within a wave" structure is known as a fractal pattern and is where the Elliott Wave Theory departs from the Dow Theory.

The fractal nature of Elliott Waves is a visual indicator of what traders inherently know. That is, prices don't move in the same way all the time. A stock may be riding a bullish wave upwards, but still, have periods where the price is dropping. However, for the stock to follow the Elliott Wave principle there will be evidence of higher highs and higher lows. Similarly, in a bearish wave, there will be moments where the price of a stock or security rises.

Inside of an impulse wave, a sub-wave shows a five-wave pattern in which the first, third, and fifth waves follow the trend and the second and fourth are corrective. These waves are labeled i, ii, iii, iv, v. These five sub-waves make up the larger impulse wave.

In the same way, inside a corrective wave, a sub-wave will show a three-wave pattern labeled A, B, C. Sub-waves A, and C follow the corrective trend, and sub-wave B will move counter to the trend. The three sub-waves make up a larger corrective wave.

The link between Elliott Wave Theory and Fibonacci ratios

In addition to their fractal nature, Elliott Wave price movements frequently have a strong correlation to Fibonacci ratios at Fibonacci extension and retracement levels. This correlation between Elliott wave patterns and the Fibonacci summation series (i.e. the Fibonacci numbers) give traders extra assurance when looking for predictive patterns for trading opportunities that optimize their risk/reward ratios.

The Fibonacci numbers (i.e. the Fibonacci Summation Series) is created by starting with the numbers 0 and 1 and then continuing the series by adding the previous two numbers together. The Fibonacci sequence then is: 0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 … and so on until infinity.  Furthermore, when one Fibonacci number is divided with a previous number in the Fibonacci series, the resulting number is at or near 1.618 – which is also called the Golden Ratio – a concept found in architecture and biology.

When this number is expressed as a ratio, it is approximately 61.8%. Technical analysts have since expanded the golden ratio to create the Fibonacci ratios. These ratios are found by dividing two numbers in the series in a specific pattern. For example, dividing any number in the Fibonacci sequence by the number three places to its right creates a ratio of 23.6%. Dividing any number in the sequence by the number two places to its right creates a ratio of 38.2%. Continuing on creates what is called the key Fibonacci retracement ratios of:

23.6%, 38.2%, 50%, 61.8% and 100%

Fibonacci retracement is an anticipated market correction that occurs at a point of support or resistance as defined by key Fibonacci ratios. The theory is that once this correction occurs, the market will take its next move in the direction of the initial trend. Fibonacci extension refers to a period of price movement where the market moves into a support or resistance level at one of the key Fibonacci ratios.

The Fibonacci ratios have been shown to have a high correlation with the movement of a wave within an Elliott Wave structure. Here are some correlations for an impulse wave:

• The second wave (Wave 2) is typically 50%, 61.8%, 76.4%, or 85.4% of Wave 1
• The third wave (Wave 3) is typically 161.8% of Wave 1
• The fourth wave (Wave 4) is typically 14.6%, 23.6%, or 38.2% of Wave 3
• The fifth wave (Wave 5) is typically 61.8%, 100% or 123.6% of Wave 1

The primary rules of Elliott Wave theory

Finding an Elliott Wave structure can be very subjective. However, there are some primary rules that help traders predict future price action based on Elliott Wave movement.

1. Within an impulse wave, the third wave can never by the shortest wave.
2. The second wave can never go beyond the start of the first wave.
3. The fourth wave can never make a cross over into the same price area as the first wave.

Beyond these three primary rules, there are additional guidelines that are strong tendencies but do not always occur. These guidelines include:

1. In some cases, movement between the fifth and third wave will be truncated. This is a condition where the fifth wave (the end of an impulse wave) does not move beyond the end of the third wave.
2. The fifth wave most often breaks through the trend line which is drawn off the third wave and is parallel to the start of the third and fifth waves.
3. The third wave is usually very long, rises sharply and is extended.
4. The second and fourth waves will find support and will bounce off Fibonacci retracement levels.

Waves are broken down into degrees

The Elliott Wave principle can be seen over both large and small time periods making it applicable to every investment strategy even the short term trading patterns used by day traders. To that end, Elliott Wave Theory identifies nine wave degrees which are assigned different periods of time. They are as follows:

• Grand Supercycle (multi-century)
• Supercycle (approximately 40-70 years)
• Cycle (one year to several years)
• Primary (a few months to a couple of years)
• Intermediate (weeks to months)
• Minor (weeks)
• Minute (days)
• Minuette (hours)
• Sub-Minuette (minutes)

One way to visualize how all these waves fit together is to consider the example of the Russian nesting doll. A Grand Supercycle wave would contain Supercycle waves. These waves would contain Cycle waves, which would contain Primary waves … and so on.

The evolution of the Elliott Wave Theory

The 5-3 wave principle behind the classic Elliott Wave Theory worked well to define trends and counter-trends in the stock market. However, today’s investors are looking at other market classifications that include the forex market, commodities, and bonds. These markets tend to have more wide-ranging price movements than other markets and changes in a trend tend to happen over shorter cycles. This means that a three-wave structure is more common than a five-wave structure, which has changed the classical definition of a trend. According to modern Elliott Wave Theory, the market can now trend in a 3-3 structure.

Corrective waves will always move in a three-wave pattern. However, there can be one of five corrective patterns:

• Zig-zag (5-3-5)
• Flat (3-3-5)
• Triangle (3-3-3-3-3) – this is usually associated with decreasing volume and volatility
• Double three: A combination of any two patterns
• Triple three: A combination of all three corrective patterns

Each of these patterns has different correlations with Fibonacci ratios that go beyond the scope of this article.

This has opened up the Elliott Wave Theory to criticism because, by moving away from its strict 5-3 orthodoxy, the patterns can give the appearance of the wave movement being even less predictable. Detractors of the Elliott Wave Theory would say this randomness makes it easy for advocates to blame a mistimed trade on their reading of the chart as compared to a flaw in the theory itself. However, despite some detractors, practitioners of the Elliott Wave Theory find it to be among the most compelling of all technical indicators, particularly with its relationship to Fibonacci numbers.

The final word on Elliott Wave theory

Elliott Wave Theory is an off-shoot of the Dow Theory. Both theories show how the price movement of stocks can be predicted by identifying wave patterns. According to Elliott Wave theory, a trending market will move in a 5-3 wave pattern. The first five waves, known as the impulse wave will have a net positive movement. The second 3-wave pattern will have a net negative movement and is called a corrective wave.

However, the Elliott Wave Theory takes the Dow Theory one step further by identifying a subset of waves within a larger wave structure. These waves make up what is called the fractal nature of an Elliott Wave sequence. This means that every wave is divided into many smaller sub-waves, each bearing a similarity to the overall wave pattern.

Lending credibility to Elliott Wave Theory is its strong correlation to key Fibonacci ratios and retracement levels.

In its simplest form, traders can use an identified wave pattern to go long or short on a trade depending on the anticipated end of a wave cycle.