Elliott Wave Theory
The Elliott Wave Theory was created in the beginning of the twentieth century by Ralph Nelson Elliott. It assumes that financial markets move according to certain regularities, and are based on the mass psychology of market participants.
The key elements of this principle are the two types of movements, known as “waves.” They describe the various stages that a particular equity’s price goes through over time. No single market movement lasts forever. There are always periods of consolidation. The waves can be subdivided into:
1. Impulse or moving waves – numbered as 1, 3 and 5;
2. Corrective waves – numbered as 2 and 4.
Here is a visual example:
Now let’s talk about the logic of the waves. This logic is valid for any kind of financial instrument. It might be easier to understand it if you imagine that we are talking about the shares of a particular company. In our specific example, we analyze the situation when the market is in an uptrend, but the same logic is valid when the market is in a downturn.
During wave number 1, only a few market participants enter long positions. Gradually, their numbers increase, and this boosts up the price. However, this movement remains mostly unreported by analysts and the media.
Specialized sources start to mention the price movement. Some traders enter short positions, believing that the price surge is without any reason. Others begin exiting their long positions. This logically leads to a price drop.
During the third phase, there are enough buyers to stabilize the price movement, above the level it had reached during wave number 1. These buyers see something positive in the company (or currency pair) – for example, they might be telling themselves that “since the price surged during wave number 1, there’s no reason why it shouldn’t continue to rise.” Some of them even believe that there’s some kind of a “discount”, compared to the price peak of the first wave. Mass buying results, and traders who are in short positions and haven’t covered them, add extra strength to the movement. Thus wave number 3 is longer than wave 1.
At the beginning of wave number 4, the participants who acted as buyers during the third wave, and those who held on to their positions from the beginning of the first wave, start gradually taking profits. They believe that the price has moved beyond its “real value.” However, this stage lasts only a short time. Most traders remember what happened before (i.e. the beginning of wave number 2) and start buying, thereby not allowing the price to fall much.
By the start of the fifth wave, everyone’s aware how fantastic this company is, or how reasonable it is for the currency pair to continue going in that direction. A mass hysteria develops. Even people with zero market experience start buying the equity. You might even hear what a great investment this is, from the mainstream media.
It’s logical that the end of wave number 5 comes when the most disoriented participants enter the market, while all the “smart money” leaves it. At this stage, we enter into a period of correction, in which the price starts gradually falling.
It is important to remember that there are two kinds of waves – impulse and corrective. The impulse waves are longer than the corrective ones. (When the market is in a downtrend, they point downwards.) Waves 3 and 5 are longer than wave number 1. Wave 5 is the longest, while wave number 4 is shorter than wave 2.
Now that you have been acquainted with the Elliott Wave Theory, you should be able to recognize the main features of the model. It contains altogether five waves – three of which are impulse waves (in the direction of the main trend), and two of which are corrective waves (against the main trend). A question then emerges: “What happens after the price peaks at the end of wave 5?”
The answer is – a real correction happens. “Correction” is a term traditionally used for a drop in the price of equities, after this price has steadily risen. For the purpose of trading other financial instruments – such as currency pairs, for instance – a correction might also imply a surge in the price, if beforehand it has steadily plummeted. In other words, this is a reversal of the main trend.
This type of movement has its own rules. There are three stages of actual correction (that shouldn’t be confused with the two corrective waves during the main trend). In order for to recognize them more easily, they are marked with the letters “a”, “b” and “c”, instead of numbers. Now let’s take a look at a visual example – of an entry into a bearish market – following a serious 5-wave price surge.
And now, let’s take a look at an example of correction, after a downtrend market:
The three waves forming part of the actual correction have specific features. Ralph Elliott was able to distinguish 21 different types. Their individual study is not pragmatic, so let’s focus only on the most frequent ones.
The Zig-Zag Formation
This pattern is perhaps the most often encountered one. Many of the price movements could perhaps be classified under this category, since its structure looks slightly “random”. What’s typical for it is that wave B is often shorter than waves A and C.
The Flat Formation
With this kind of correction, the price enters a somewhat narrow range. Most often, but not always, the waves are of equal length. If there are anomalies, they are most frequently expressed in the fact that wave B is longer than waves A and C.
The Triangle Formation
Triangles are very close to flat formations. But perhaps you yourself notice the key difference – that either one or both lines (of support and resistance) are inclined, rather than horizontal. This leads to a “narrowing” of the price range, and perhaps to a bigger future movement.
Now let’s take a look at Elliott’s Wave Theory, but this time with an emphasis on how it is applied. The actual model is based on three main factors: the psychology of market participants, the cyclical patterns of markets, and their fractal structure.
When it comes to market behavior, as well as major economic and political developments in the world, there are multiple cyclical theories. For example, the Kondratiev waves are some of the most famous. The Elliott Wave Theory model, on the other hand, illustrates a number of cycles – from multiannual, to yearly and monthly, and so on. Each cycle has a 5-3 structure (that is – 5 phases of main movement and then 3 phases of actual correction).
The fractal market structure makes the model applicable to all kinds of timeframes. This theory claims that the rules for price movement repeat themselves in smaller time periods as well. In other words – we have a “wave within the wave.” This means that each price movement, following the scheme of 5-3, is composed of others, with exactly the same structure.
In theory, this type of repetition – on a fractal principle – is supposed to be infinite. In practice, however, the smaller the time frame, the lower the accuracy of the analysis.
The combination of these three factors makes the model universally applicable. Still, let’s not forget that it is not ideal. Prices never move “exactly” along the lines, but only approximately. These seemingly minimal variations at a first glance could influence our trading results significantly.