Last Updated on September 20, 2023
The Elliott Wave Theory is a technical analysis methodology for analyzing financial market cycles and predicting trends based on behavioral and psychological patterns in market participants.
This theory has provided a unique perspective on market dynamics since its inception.
Whether you are an experienced trader looking for a new market perspective or a complete beginner, this article will provide a comprehensive breakdown of the Elliott Waves Theory and its significance in forecasting market trends.
The Basics of the Elliott Wave Theory
The theory suggests that the market’s behavior isn’t rational. Instead, it moves between bullish and bearish sentiments in waves that form repetitive patterns.
The Elliott Wave Principle was considered a pivotal theory since it put significant emphasis on the psychological motivations of market participants.
It was invented by the accountant/analyst Ralph Nelson Elliott and released in his book The Wave Principle in 1938.
However, Elliott’s book didn’t immediately make the theory popular.
Instead, in the 1970s, two analysts named Frost and Prechter published their own book on the matter called Elliott Wave Principle: Key to Stock Market Profits.
Their work garnered massive interest and made the Elliott Wave Theory go mainstream.
How the Elliott Wave Theory Works
The foundation of the theory is that market cycles and patterns will inevitably re-appear at some point. To track that, Elliott suggests using a series of waves.
The Five-Wave Pattern
The first and most important part of the sequence is a set of five waves.
Waves 1, 3, and 5 are upward, while waves 2 and 4 are downward.
Together, these five waves form a strong bullish trend that resembles a lightning bolt. Elliott named the upward waves in this set impulsive waves.
The second part of the sequence in the Elliott wave principle is a set of three waves (A, B, C on the diagram). They form a trend that follows a similar lightning bolt pattern, except it is smaller and has a downward direction.
The first and third waves of the sequence are going down, with a mild upward move from the second wave. Elliott called the downward waves in this set corrective waves.
This 5&3 pattern forms the basis of Elliott waves. However, there is more to it – a second level of detail, which is identical to the first. In other words, each single upward impulsive wave is actually a set of 5 waves, as described at the start of this section. Alternatively, if you zoom into each single wave, you will find the same setup discussed above.
This is because waves are comprised of fractals, and the same shapes repeat on smaller and smaller levels.
Cycles
Elliott categorized the waves into different groups to illustrate his observation that identical patterns can emerge within both long-term and shorter-term charts.
The groups include:
- Grand Supercycle: Spanning centuries
- Supercycle: Spanning over several decades (6 or more decades)
- Cycle: From one year to several years
- Primary: A few months to a couple of years
- Intermediate: Ranging from weeks to months
- Minor: Spanning weeks
- Minute: Days
- Minuette: Hours
- Sub-Minuette: Minutes
How to Trade With the Elliott Wave Theory?
To trade with this theory, you have to identify an upward trending impulse wave and initiate a long position. Then you either sell or short the position as the pattern completes the five-wave sequence, which signals an impending reversal.
What Is the Best Time Frame to Utilize Elliott Wave Theory in Trading?
There is no definitive best timeframe for applying the Elliott Wave Strategy in trading. Instead, it largely depends on your trading technique and personality.
If you are a day trader, you may opt for intraday time frames such as hourly or 15-minute periods.
Limitations of the Elliott Wave Theory
Many consider the Elliott Wave Theory to be on the line between being an art and a science.
As a result, its efficiency can’t always be guaranteed. Traders who apply it often note that it is hard to distinguish if you failed at identifying the waves or if the principle is ineffective as a whole.
Furthermore, note that the Elliott Wave principle is the most useful when the overall trend in the market is crystal clear.
Read also: The Fibonacci Sequence
Takeaway: The Elliott Wave Theory Is an Interesting, Yet Imperfect Principle
The Elliott Wave Theory is a valuable tool to uncover market cycles and predict market trends by focusing on behavioral and psychological factors.
The categorization of waves into cycles equips traders with unique ways to identify patterns within short-term and long-term charts.
However, it is crucial to remember that the times when Elliott formulated this principle were different, and the markets have evolved significantly since then. As a result, the modern savviness of traders combined with automated trading is said to have undermined a large chunk of the psychological basis the theory was based on.
