Elliott Wave theory, created by Ralph Nelson Elliott in the 1930s, is one of the most well-known tools in technical analysis. Elliott observed patterns that occur in the price movements of financial markets and identified that these patterns often repeat themselves.
In a trend, we can find Elliott wave cycles, which consist of two phases: the impulse phase and the correction phase.
The impulse phase, also known as the motive phase, is characterised by five waves labelled 1, 2, 3, 4, and 5. These waves reflect the dominant trend direction, with waves 1, 3, and 5 moving in the direction of the trend and waves 2 and 4 representing corrective movements against the trend.
On the other hand, the correction phase, also known as the corrective phase, is composed of three waves labelled A, B, and C. These waves counteract the progress made during the impulse phase, typically retracing a portion of the preceding impulse wave.
It’s important to note that Elliott Wave Theory is applicable to both bullish and bearish trends. The same principles discussed in this article can be applied regardless of the direction of the trend.
To illustrate an example of an Elliott wave cycle in a bearish trend, let’s consider this chart using weekly candlestick data. In this case, we can observe a pattern that aligns reasonably well with the expected structure: an impulsive phase (waves 1-5) followed by a corrective phase (waves A-C).
However, it is important to acknowledge that accurately counting waves can be challenging, especially when the cycle has not yet been completed. In the given graph, it’s uncertain whether wave 5 could actually be wave 3, and the corrective phase (waves A-B-C) could represent wave 4.
Particularities of each Elliott Wave
- Wave 1: Wave 1 marks the beginning of a trend. It is often the most challenging to identify since it is still in its early development. It is typically the shortest wave within an impulsive phase and rarely the longest.
- Wave 2: Wave 2 represents a partial correction of wave 1. It is common for wave 2 to retrace a significant portion of the wave 1 movement, as many investors still perceive the previous trend as intact. If wave 2 retraces more than 100% of wave 1, it suggests an incorrect wave count and indicates that the previous trend might still be in progress.
- Wave 3:Wave 3 is generally the longest and most powerful wave within the impulsive phase. It is often the wave with the highest trading volume as investors fully recognise and participate in the established trend. Monitoring trading volume during this wave can provide valuable insights.
- Wave 4: Similar to wave 2, wave 4 represents a corrective movement against the preceding wave, in this case, wave 3. Wave 4 is known to be complex and challenging to interpret. Sometimes, the price consolidates or moves sideways within a range during this wave.
- Wave 5: In derivative markets, wave 5 tends to exhibit a greater magnitude compared to wave 3. As the final wave of the impulsive phase, it may display signs of weakness, such as lower trading volume or technical indicator divergences. A failure of wave 5, where it does not surpass the level of wave 3, can lead to a double top formation and signal a potential trend reversal.
- Wave a: Similar to wave 1, is often difficult to identify as it represents the first wave of a new phase. It is frequently mistaken for a retracement within the prevailing trend (impulsive phase).
- Wave b: Wave B serves as confirmation that the impulsive phase has ended and should not exceed the peak of wave 5. It is typically a wave with less strength, although it may occasionally reach similar levels as wave 5, forming a potential double top.
- Wave c: Wave C usually exhibits more strength than wave B since it aligns with the overall direction of the corrective phase (wave A). It represents the final wave of the corrective phase.
Elliott Waves exhibit a property called fractality, which means that an impulse phase (waves 1-2-3-4-5) in a smaller time frame, such as one hour, can form wave 1 of a larger time frame, such as daily.
Similarly, a correction phase (waves a-b-c) in a one-hour chart can constitute wave 2 of the daily time frame. In essence, complete Elliott wave cycles in smaller time frames can represent waves within larger time frames.
In this graph, we can observe several Elliott wave cycles. The first cycle corresponds to waves (1) and (2) of a higher-level cycle: wave (1) represents the impulse phase, while wave (2) represents the corrective phase.
This pattern repeats in the subsequent cycle, corresponding to waves (3) and (4). Finally, wave (5) is formed by an impulse phase, followed by a correction labelled (a)-(b)-(c). In this case, waves (a) and (c) represent impulse phases, while wave (b) represents the corrective phase. Hence, a wave cycle (impulse phase + corrective phase) is part of a larger time frame cycle.
It is important to remember that fractals are complex geometric figures characterised by self-similarity, where each part resembles the whole. A helpful analogy can be found in nature, such as with broccoli. When a piece of broccoli is cut, it exhibits a miniature version that resembles the overall structure, resembling a miniature tree.
Rules and recommendations of Elliott Waves
We have discussed the concept of Elliott waves, the phases within a wave cycle, and the fractal nature of wave formations. However, certain rules must be followed to validate the formation of a cycle or wave. Let’s consider three fundamental rules of Elliott waves, assuming an uptrend scenario:
- Wave 2 should not end below the starting point of wave 1. If wave 2 breaches the starting point of wave 1, it indicates that we are not dealing with a valid Elliott wave cycle.
- Wave 4 should not retrace beyond the endpoint of wave 1. In other words, wave 4 should not exceed 100% retracement of wave 3.
- Wave 3 should not be the shortest wave. It is commonly the longest wave and should conclude above the endpoint of wave 1.
There are additional guidelines to ensure accurate wave counting:
- Extension: At least one of the three waves (1, 3, or 5) should exhibit a significantly greater price extension compared to the other two waves. Waves 3 and 5 are typically the longest in an impulsive phase. Notable differences in length among the three waves are essential. Counting three waves that are equal or very similar may suggest an incorrect count.
- Similarity: To avoid confusion between waves of different degrees, it is recommended that a corrective wave retraces at least 38% of the preceding wave’s price and time.
- Alternation: The corrective waves within an impulsive phase (Waves 2 and 4) should be as distinct from each other as possible in terms of shape, degree of correction, and temporal duration.
- Channelling: The trend line drawn by connecting the peaks of waves 2 and 4 should be violated in less time than it took for wave 5 to form. Failure to break this trend line within a shorter duration would render the wave count less reliable.
Do you want to find out more about other technical analysis theories? Check out our introduction to technical analysis article.
Advantages and disadvantages of Elliott Wave theory
Among the advantages of Elliott waves, we can highlight:
- Intuitive nature and simplicity of use. To enhance analysis, Elliott waves can be combined with technical indicators like the Relative Strength Index (RSI), adding rigour to the assessment.
- The theory itself tells us that certain conditions must be met to conclude that we are facing Elliott waves. Hence, it is understood that the theory does not apply universally to all scenarios.
- The corrective waves (2, 4, and b) often align with levels derived from the Fibonacci sequence (for a detailed understanding of how Fibonacci relates to trading, please refer to the Fibonacci sequence). This correlation enhances the analysis.
However, the theory also carries certain disadvantages:
- Lack of scientific proof: Elliott wave theory is not scientifically validated. This stands as the primary disadvantage, as it is not an infallible tool.
- Confirmation tool rather than a stand-alone signal: While it can be used to confirm entry or exit points in the market, Elliott waves should not be solely relied upon to identify these trading signals.
- The theory assumes that investor behaviour is cyclical or repetitive. While this assumption finds some grounding in psychology, it does not account for anomalies created by market participants in response to extraordinary events.
- It is important to recognise that the market does not always conform to the phases described by Elliott waves.
In conclusion, while Elliott wave theory offers advantages such as intuitiveness and compatibility with technical indicators, it also has limitations. Its lack of scientific validation, reliance on confirming signals, and assumption of cyclical behaviour highlight the need for caution and a comprehensive approach when utilising this theory in market analysis.
To find out more about trading and technical analysis, check the following articles:
- Technical analysis guide
- Trading guide
- Trend indicators
- Support and resistance
- Best intraday trading brokers
- Best trading platforms
Can Elliott Wave theory accurately predict future price movements?
Elliott wave theory is not designed to provide precise predictions of future price movements. It is a tool used to identify potential patterns and trends in the market based on wave formations.
Is Elliott Wave theory applicable to all financial markets and timeframes?
Yes, the Elliott wave theory can be applied to various financial markets, including stocks, currencies, commodities, and indices. It can also be used across different timeframes, ranging from intraday to long-term charts.
Can Elliott Wave theory be used as a standalone trading strategy?
While some traders may use Elliott wave theory as the primary basis for their trading decisions, it is generally recommended to combine it with other analysis techniques.