Elliott Wave Theory: What it is and Why it is important?

To forecast the direction and future happenings of the stock market, many traders, stock market experts, and analysts study the past market data, using charts or graphs based on various stock market theories. Today we have come up with one of such theories i.e. Elliott Wave Theory which is one of the significant stock market theories. Elliott wave theory helps in predicting market moves based on the wave patterns. Elliott wave theory was discovered by Ralph Nelson Elliott and what he suggested was that the market moves up or down in recognizable patterns. He gave these recognizable patterns a structure and he represented them in the form of waves or rather what he found was that these structural movements in the market happened in the form of waves.

Every theory that you have heard about in the market can be classified into a predictive theory or a reactive theory. The reactive theory is the one that makes you follow the market whereas a predictive theory is the one that at some extent gives you insight into the probable future direction of the market.

Elliott wave theory is not a forecasting tool rather it gives you insight into how mass psychology is behaving. Once you start practicing this theory in real time you would know that this theory has some predictive value going into the future. In this blog, we have covered what is Elliott wave theory, the principles of Elliott wave theory, Elliott wave theory rules, understanding Elliott wave theory, does Elliott wave theory work?

What is Elliott Wave Theory?

Ralph Nelson Elliott (28 July 1871 – 15 January 1948) an American accountant and author had presented a theory based on his thorough observation and research that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves and this theory is named as Elliott Wave Theory.

Elliott has deeply analyzed and studied the market, identified the specific characteristics of wave patterns, and made detailed market predictions based on the patterns. Elliott was inspired by and took help from Dow Theory, which defines price movement in terms of waves. But Elliott discovered the fractal nature of market action. He has founded this theory in 1930 but he first published his theory of the market patterns in the book titled The Wave Principle in 1938.

Basic Principles of Elliott Wave Theory

Elliott wave theory consists of the study of wave patterns i.e. movement in the direction of the trend is unfolding in 5 waves labeled as 1, 2, 3, 4, 5 and are called motive wave while any correction against the trend is in three waves labeled as A, B, C and are called a corrective waves. These patterns can be observed in the long-term and short-term charts. The Elliott Wave Principle suggests that there exists a five-wave pattern.

As you can see in the banner image, the Elliott Wave is a five-wave structure where waves one, three and five essentially determine the direction of the market. Wave two and wave four are basically counter waves to wave one three and five. Smaller patterns can be recognized within bigger patterns.

This information about smaller patterns fitting into bigger patterns coupled with the Fibonacci relationships between the waves gives the trader a level of anticipation and ability of prediction when searching for and identifying trading opportunities with great reward/risk ratios.

Elliott wave theory rules

There are three essential rules that no one who practices the Elliott Wave can break. If one breaks these rules then what he will be practicing would not be the actual Elliott Wave Principle and this is where many analysts make mistakes. They often argue that you know one rule here and that could be violated but anyone who is violating any rule that is suggested in this theory is essentially practicing some other principle. Now let’s see these rules:

Rule No. 1: Wave 2 never moves below wave 1

This rule that a lower of wave 2 cannot be lower than lower of wave 1. Wave 2 can retrace entirely up to the lower of wave 1 and still it can classify as wave 2 but it cannot at any cost move down.

Rule No. 2: Wave 3 can never be the shortest

Either way, wave 1 can be the shortest or wave 5 can be shortest but wave 3 cannot be the shortest. When measuring whether wave 3 is the longest or the shortest you need to keep your chart at a semi-logarithmic or a logarithmic scale but not keep it on the arithmetic scale because sometimes it becomes difficult to know which wave is the longest and which is the shortest. Usually, in stock markets wave 3 is the longest wave but in commodities wave 5 is the longest.

Rule No. 3: The price territory of wave 4 does not enter the price territory of wave 1

That means the high of wave 1 cannot enter the low of wave 4.

Understanding Elliott wave theory

The Five Waves Pattern (Motive Wave and Corrective Wave)

Elliott stated that wave development essentially takes place in two distinctive phases.

The Motive Waves: It is the first phase which is usually the five wave structure.

The Corrective Waves: This is the second phase which is the three wave structure. Corrective waves are simply those waves that correct the motive wave.

So remember motive waves form a five-wave structure and corrective waves form a three-wave structure and when they are put together it forms a complete wave cycle of eight waves.

As we can see in the chart wave 1, wave 2, wave 3, wave 4, and wave 5 this is the motive wave structure, and see the corrective waves wave A, wave B, and wave C this is the corrective wave structure. The motive waves are labeled as 1-2-3-4-5 whereas the corrective waves are labeled as A, B, C. Now what we have to identify is whether the broader market is within this structure or not? That is the key whether we are in wave 3 or wave 4 or wave 5 or whether in the correcting wave C or wave B.

The most positive point of this theory is that if your numbering is correct and if you practice the theory correctly then there is a very high probability of you knowing where you exactly are within the eighth wave cycle. Within a 1-2-3-4-5 pattern of a larger degree, there are subdivisions of 1-2-3-4-5 and A-B-C within that pattern. Since we know from our previous discussion that anything that corrects the primary trend of the market, corrects in a three-wave structure because corrective waves move in a three-wave structure.

Wave Degree

Elliott has developed a wave language to identify wave cycles so that market analysts can identify the position of a wave within the overall progress of the market and that language is called Wave Degree. Elliott has proposed nine degrees of waves, which are labeled as shown in the image below starting from largest to smallest:

Does Elliott Wave Theory Work?

Traders who practice Elliott Wave Theory often are under stress because market fractals do not make the market easily predictable. One limitation here could be that the trading environment today is completely different than the one in the 1930s when Elliott first proposed his wave principle. The definition of a trend and counter-trend move has also changed today.

The theory was originally derived from the observation of the stock market but certain markets such as forex exhibit more of a ranging market.

In today’s market, 5 waves move still happen in the market but 3 waves move happens more frequently in the market than 5 waves move. Today’s market trends do not have to be in 5 waves and trends can unfold in 3 waves. Therefore, when trying to find the trend and label the chart it is important not to force everything in 5 waves.

The Elliott wave pattern may have waves within the wave. At such times, it becomes difficult to differentiate between the primary and the secondary waves. The advanced technical analysis charting techniques have provided up to 8 levels of waves.

The theory was proposed in 1930 and there several structural changes have occurred which have impacted world trade as well as the stock market resulting in weakened predictive ability from the theory.

Elliott wave patterns are not easy to understand and demand advanced charting tools which might be heavily budgeted for the small-scale investor.

The patterns may last more than your investment time horizon which makes it more time-consuming and this may lead to uneasiness and making irrational decisions.

Conclusion

Traders can make use of Elliott wave theory as an indicator of market movements. This theory can help with market trend reversals. This helps make profitable trades. But as every system has limitations you should be cautious while using Elliott's theory. To recognize the final result there is a need to include sub-waves within each primary wave. Therefore, using technical patterns (RSI, MACD, oscillators, Bollinger bands, etc.) in conjunction with Elliott waves becomes necessary. We advise you to invest smaller amounts in the beginning and then increase your investments as you get used to it and develop intuition over time.