Elliott Wave Theory: The Ultimate Guide

To determine the direction of a trend, Elliott Wave Theory is used. It is also used to determine entry and exit points on stock markets. Crypto traders can apply the Elliott Wave principle to determine whether a rally is part of a correction or a resumption of an earlier trend based on the structure of a trend.

Intro

An Elliott Wave Theory in market analysis assumes the market forms the same patterns over a shorter time frame (lower degree) as it does over a longer time frame (higher degree). The patterns give us a glimpse of what may happen next in the market. According to the Theory, market movements follow similar patterns no matter what timeframe you examine.

This Theory was developed by R. N. Evans in the 1930s and most commonly used since Robert Prechter's time. The concept of crowd psychology implies that markets produce patterns and trends; as defined by Elliott, the wave pattern is the physical manifestation of mass psychology in our world. These patterns appear in markets, and everywhere humans make mass decisions. Among the examples might be housing prices, fashion trends, or the number of people riding the subway every day.

There are various patterns seen in Elliott Wave Theory which will be introduced in this section. Learn how Elliott Wave theory can analyze charts in this section. However, keep in mind that using Elliott Wave Theory confidently takes practice.

• Elliott waves in technical analysis predict price movements. Elliot's Wave Theory mainly consists of two waves - motives (impulses) and corrective waves.

• A motive wave consists of five waves – three impulse waves and two retrace waves.

• A corrective wave consists of three waves – A, B, and C. Waves A and C are impulse waves, while Wave B is a retrace wave.

• Real-world markets often exhibit three-wave motive trends instead of five-wave motive trends.

What is the Elliott Wave Theory?

In the 1930s, Ralph Nelson Elliott, an American accountant and author, developed the Elliott Wave Theory. In 1935, Elliott was the first to predict a stock market bottom by studying several years of stock market data across various indices. Since then, the Theory has proven to be a reliable tool for a wide range of portfolio managers. Elliott waves assist in understanding market movements and trading opportunities in addition to other technical analysis techniques.

According to Elliott Wave theory, stock price movements can be predictably predicted by studying price history because markets move in waves based on investor sentiment. The waves move repetitively, rhythmically, and in a predictable way. Additionally, the wave patterns are not guaranteed to occur in the markets; they only illustrate a possible scenario of stock price behaviour.

Use of Fibonacci Ratios in Elliott Wave Theory

As the first number in the Fibonacci summation series, 0 is used. 1 is added to 0 to produce the following number. In order to find the next number in the series, you add the previous two numbers. According to Fibonacci, the summation series looks like 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and infinity. Fibonacci ratios are calculated by dividing two Fibonacci numbers. The ratios determine support and resistance levels.

Fibonacci retracements are used in Elliott Wave Theory to identify when a correction ends to allow the trend to resume. Fibonacci retracements indicate the depth of a trend's pullback. The second wave, for instance, can be on behalf of the first wave.

Fibonacci extensions are another commonly used tool. Fibonacci extensions are used to determine turning points of primary trends. A motive wave indicates where a market can go before a correction in a bull market. As a bear market progresses, they can be used to determine support levels. A Fibonacci extension measures the price level at which a stock can achieve profits.

How Do Elliott Waves Work?

Technical analysts use the Elliott Wave Theory to profit from stock market wave patterns. This hypothesis states that stock price movements are predicted since they follow repeating patterns called waves influenced by investors' psychology or sentiment.

The Theory identifies two types of waves: motive waves (also known as impulse waves) and corrective waves. It is subjective, meaning not all traders interpret the Theory the same way or agree that it is a successful trading strategy.

Wave analysis differs from most other price formations in that it does not equate to that of following a blueprint. With wave analysis, you can gain deeper insights into price movements and trend dynamics.

According to Elliott, financial price trends reflect investors' dominant psychology. According to him, waves or fractal patterns show up in financial markets whenever there is a change in mass psychology. 

Elliott's Theory recognizes that stock prices move in waves, similar to the Dow theory. Elliot also analyzed and broke down markets in much greater detail because he recognized their "fractal" nature. On an ever-smaller scale, fractals are mathematical structures that repeat themselves indefinitely. Similarly, structured stock index price patterns were discovered by Elliott. To predict future market movements, he then began to study these repeating patterns.

Using Wave Patterns to Predict the Market

Elliott made detailed predictions about the stock market based on the wave patterns. Impulse waves, which generally travel in the same direction as a more significant trend, always show five waves in their pattern. Alternatively, a corrective wave is a wave travelling in the opposite direction to the primary trend. On a smaller scale, each impulsive wave can be broken down into five waves again.

At ever-smaller scales, a similar pattern repeats itself indefinitely. Elliott in the 1930s uncovered this fractal structure, but it would take decades for scientists to recognize and prove fractals mathematically.

We know from the financial markets that "what goes up must come down," since any upward or downward price movement always leads to a downward movement. A trend consists of price movements that go up or down. A trend determines the price direction, while corrections move in the opposite direction.

Motive Waves

Optimally, an Elliott Wave pattern is divided into two halves, the Motive Wave and the descending Wave. The Motive Wave continuously extends toward the trend of one degree. As illustrated in the above chart, five smaller waves, marked 1, 2, 3, 4 and 5, are subdivided into it. An impulse wave and a diagonal wave are the two types of smaller sub waves within the motive wave. The two types will be discussed in Part 3 of this article series.

On the chart, you can see 3 sub-wave advancings (waves 1, 3 and 5) and 2 correcting or moving downward (2 and 4). The "actionary" sub-waves in the motive wave are waves 1, 3 and 5. These waves are often motivated themselves, going in the same direction as the more considerable degree's trend. Both waves two and four are "corrective" sub-waves that move against the more significant trend. The motive wave is not uncommon to quickly move toward the more important trend. That makes it easy to identify and interpret.

In order for Motive Waves to form, the following three rules must be met:

• In Wave 2, less than 100% of Wave 1 is retracted.

• When Wave 4 retraced Wave 3, less than 100 percent was given back.

• There is never the shortest wave in Wave 3, which always begins after Wave 1.

If the actionary sub-waves have five waves each, while the corrective sub-waves have three waves each, the larger motive wave will resemble the chart below. The actionary sub-waves, in this case, are five waves each as they are in the direction of the larger motive wave - the larger degree. The 5-3-3-5 structure is also known as this type of pattern.

The Deconstruction of Motive Waves

Following are some general guidelines for identifying a motive wave:

1. Wave 2 cannot be more than 100% of Wave 1.

2. Wave 3 cannot be the shortest wave of the three impulse waves (1, 3, and 5).

3. The price range of Waves 1 and 4 cannot overlap.

Impulse Waves

Five sub-waves of pulse waves make up the wave that moves net towards the next most extensive degree of rotation. Markets often follow this pattern because it is the easiest to spot. The motive wave consists of five sub-waves, two of which are corrective waves and three of which are motive waves. In the example above, a 5-3-5-3-5 structure is shown.

The following three unbreakable rules govern its formation:

• More than 100% of the first wave cannot be retraced by wave two

• In waves one, three, and five, the third wave can never be the shortest

• In wave four, the wave cannot go beyond the third wave

Structures that violate one of these rules are not impulsing waves. Trading the suspected impulse wave would require re-labelling.

Corrective Waves

As seen in the chart above, the corrective wave is generally depicted as a three-wave structure. The three-wave structure has sub-waves labelled as waves A, B, and C. It can be misleading since not all corrective waves are exactly three-wave structures. For our general-purpose discussion, let's say that corrective wave structures include three sub-waves.

We can observe from the structure that Wave A and Wave C are both in the direction of the higher degree trend in this case, which is the correction's direction. As a result (for this general example), we will show them as motive waves consisting of five waves each. Wave B travels in the opposite direction of the more extensive correction (trend one degree higher), which is why it is shown as three waves. Such patterns are referred to as 5-3-5 patterns.

How to Trade Using Elliott Wave Theory?

In the 1930s, Ralph Nelson Elliott developed the Elliott Wave theory. Due to an illness, Elliott's retirement forced him to study 75 years' worth of yearly, monthly, weekly, daily, and hourly charts across various indices across various time frames.

An uncanny prediction of the stock market bottom made by Elliott in 1935 gained the theory notoriety. Millions of portfolio managers, traders, and private investors utilize it daily.

Elliott outlined specific rules for identifying, predicting, and exploiting these wave patterns. A collection of R.N. Elliott's articles, letters, and books is included in   The Elliott Works, which appeared in 1994. Elliott Wave International, a globally recognized independent financial analysis and market forecasting firm, uses Elliott's model to analyze and forecast the markets.

Using these patterns does not guarantee any price movement but rather helps to order the probabilities for future market action.1 They can be combined with other forms of technical analysis, such as technical indicators, to identify specific opportunities. The Elliott Wave structure of a market may have different interpretations by different traders at a given time.

FAQ

What Is Elliott Wave Theory?

Elliott Wave analysis examines long-term price trends and their correlation with investor psychology in technical analysis. This price pattern, called 'waves,' was developed by Ralph Nelson Elliott in the 1930s. They are specifically designed for identifying and predicting stock market wave patterns. However, these patterns are not intended to be precise but are instead intended to predict price movement in the future.

Using Elliott wave theory, what timeframe should you use?

Elliott wave patterns are fractal by nature and should apply to any time frame. In other words, you should use the time frame that you are most comfortable with. One-minute, five-minute, and one-hour candles may be used for day traders. You can use daily, weekly, or four-hour candles when swing trading. If you don't know your strength, try multiple time frames in a demo account to see which one works best.

Do you start counting Elliott waves at the top or the bottom?

The issue with this chart pattern and any other pattern is that you cannot be certain when a pattern begins and ends until it has already occurred. The best way to find out if you're right or wrong is to miss the best entry point for a trade. All of your technical analysis, indicators, and broad market clues will tell you when a wave is about to begin, but you won't know if you're right or wrong until you miss that point. Looking back at historical charts, you can start counting waves at a trend reversal—the point at which an uptrend ends and a downtrend begin.

Describe the meaning of "recounting" Elliott's waves.

Observing that wave three fails to break the high of wave one indicates that your initial assessment of the waves was wrong, and you need to recount. You may need to zoom out or examine another time frame to confirm your Theory about where the stock stands within the Elliott wave count.

Elliot Waves: How Do They Work?

Investing insights can be gleaned from different Elliott Waves, or price formations, within Elliott Wave theory. Impulse waves, for instance, include upswings or downswings accompanied by five sub-waves which may last hours or even decades. The second wave may not retrace or exceed 100% of the first wave; the third wave may not be shorter than the first, third, and fifth waves; and the fourth wave may not exceed the third wave. The corrective waves come in three patterns, along with impulse waves. 

How Does Elliott Wave Theory Work?

Consider a scenario in which a trader notices that the stock moves upwards on an impulse wave. If the stock completed its fifth wave, the trader might decide to go long on it. A trader at this point may then sell the stock short, anticipating a reversal. This trading theory is based on the idea that in the financial markets, fractal patterns repeat. Fractal patterns are mathematical patterns that are infinitely repeated. 

How accurate and reliable is the Elliott Wave Theory?

As with any forex trading strategy, Elliott wave approaches are subject to the accuracy of the trader.

In the case that the trader is able to recognize the setups accurately, this method will provide them with high-probability setups. If properly applied, price action trading can be one of the most profitable and reliable strategies. You must put in time and effort to practice this skill if you wish to master it.

Hence, the best setups should be captured as soon as they occur. To maximize your profits, it is imperative to follow the steps outlined in this post.

The Bottom Line

Using Elliott Waves as a trading technique is not recommended. There is no "right" way to use it for trading, nor are there specific entry or exit rules. Traders and technical analysts avoid Elliott Waves due to this subjective nature, not because they don't understand it, but because they don't know how to use it. Although some traders have successfully used Elliott Wave patterns, others have not. There is the growing popularity of the Theory among both individual investors and professionals. Advocates tend to use various indicators to aid them in trading specific Elliott Wave patterns, even though those methods are unique to the developers.

If you perform Elliott Wave analysis, you will be making "wave counts." It simply means that you will be labelling the waves to see how they conform to the Elliott Wave pattern, allowing you to anticipate market movement.