The Elliott Wave Theory in technical analysis describes price movements in the financial market. Developed by Ralph Nelson Elliott, it observes recurring fractal wave patterns identified in stock price movements and consumer behavior. Investors who profit from a market trend are described as riding a wave.
Key Takeaways
- The Elliott Wave theory is a technical analysis of price patterns related to changes in investor sentiment and psychology.
- The theory identifies impulse waves that establish a pattern and corrective waves that oppose the larger trend.
- Each set of waves is within another set of waves, adhering to the same impulse or corrective pattern, described as a fractal approach to investing.
Deep Dive into the Elliott Wave Theory
The Elliott Wave theory was developed by Ralph Nelson Elliott in the 1930s. He studied 75 years’ worth of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across various indexes. His theory gained notoriety in 1935 when Elliott made an uncanny prediction of a stock market bottom and has become a staple for thousands of portfolio managers, traders, and private investors.
Elliott defined rules to identify, predict, and capitalize on wave patterns in books, articles, and letters summarized in R.N. Elliott’s Masterworks, published in 1994. These patterns do not provide any certainty about future price movements but help order probabilities for future market actions. They can be used with other forms of technical analysis, including technical indicators.
How Elliott Waves Work
Some technical analysts profit from wave patterns in the stock market using the Elliott Wave Theory. The theory assumes that stock price movements can be predicted because they move in repeating up-and-down patterns called waves created by investor psychology or sentiment.
The theory is subjective and identifies two different types of waves: motive or impulse waves, and corrective waves. Wave analysis offers insights into trend dynamics and helps investors understand price movements.
Impulse and corrective waves are nested in a self-similar fractal to create larger patterns. For example, a one-year chart may be in the midst of a corrective wave, but a 30-day chart may show a developing impulse wave. A trader with this Elliott wave interpretation may have a long-term bearish outlook with a short-term bullish outlook.
Impulse Waves
Impulse waves consist of five sub-waves that make net movement in the same direction as the trend of the next-largest degree. This pattern is the most common motive wave and the easiest to spot in a market. It consists of five sub-waves, three of which are motive waves and two are corrective waves.
- Wave 2 can’t retrace more than the beginning of Wave 1
- Wave 3 cannot be the shortest wave of Waves 1, 3, and 5
- Wave 4 does not overlap with the price territory of Wave 1
- Wave 5 needs to end with momentum divergence
If one rule is violated, the structure is not an impulse wave. The trader would need to re-label the suspected impulse wave.
Corrective Waves
Corrective waves, also known as diagonal waves, consist of three, or a combination of three sub-waves that make net movement in the direction opposite to the trend of the next-largest degree. Its goal is to move the market in the direction of the trend.
- The corrective wave consists of 5 sub-waves.
- The diagonal looks like either an expanding or contracting wedge.
- The sub-waves of the diagonal may not have a count of five, depending on the type of observed diagonal.
- Each sub-wave of the diagonal never fully retraces the previous sub-wave, and sub-wave 3 of the diagonal may not be the shortest wave.
Elliott Wave Theory vs. Other Indicators
Elliott recognized that the Fibonacci sequence denotes the number of waves in impulses and corrections. Wave relationships in price and time commonly exhibit Fibonacci ratios, such as 38% and 62%. For example, a corrective wave may retrace 38% of the preceding impulse.
Other analysts have developed indicators inspired by the Elliott Wave principle, including the Elliott Wave Oscillator Chart. The oscillator provides a computerized method of predicting future price direction based on the difference between a five-period moving average and a 34-period moving average. Elliott Wave International’s artificial intelligence system, EWAVES, applies all Elliott wave rules and guidelines to data to generate automated Elliott wave analysis.
Trading with the Elliott Wave Theory
To trade using the Elliott Wave Theory, a trader identifies an impulse wave and may go long until the wave completes its fifth sub-wave. Anticipating a corrective phase, the trader may then go short. Underlying this trading theory is the idea that fractal patterns recur in financial markets, repeating themselves on an infinite scale.
The Bottom Line
The Elliott Wave Theory, developed by Ralph Nelson Elliott, provides a technical analysis of price patterns related to investor sentiment and psychology. The theory identifies impulse waves that establish a pattern and corrective waves that oppose the larger trend. It assumes stock price movements can be predicted because they move in repeating up-and-down patterns.
Related Terms: market analysis, Fibonacci ratios, financial forecasting, impulse waves, corrective waves.
References
- Elliot Wave International. “Introduction to the Wave Principle”.
- Elliott Wave Forecast. “Elliott Wave Theory: Rules, Guidelines, and Basic Structures”.
- Qualitative Analytics. “Introducing EWAVES”.
