What Is the Elliott Wave Theory?

Financial markets or immature forms of them have been in existence as long as currency has. In all that time, accountants and mathematicians have sought to develop theories and principles that enable investors and traders to make as much profit as possible by applying them.

A thorough understanding of the financial market and current trends is beneficial when trading in a competitive market. Technical analysts often make use of seasoned principles in making profitable market predictions. This article discusses the history, characteristics, and application of one of them, The Elliott Wave Theory.

Who Created the Elliott Wave Theory?

The Elliott Wave Theory was created in the 1930s by an American accountant and author. Ralph Nelson Elliott developed the theory by spending a lot of time studying market charts of various types. After being forced into early retirement due to an illness, he threw himself into studying stock market behavior.

Elliott studied half-hourly, hourly, daily, weekly, monthly, and yearly market charts spanning 75 years to discover patterns in stock market behavior. All the market charts were self-created across various market industries. By the end of 1935, Ralph Nelson had made significant strides in the development of the theory, so much so that he successfully predicted the final stock market bottom of the DOW Jones Average.

Upon making this groundbreaking prediction, he collaborated with Charles J. Collins of Investment Counsel in Detroit in writing a book on the Wave Theory.

What Is the Elliott Wave Theory?

The Elliott Wave theory is a principle in technical analysis that was developed to predict price movements in the market. Investors often use the theory to discover price patterns in the market which are referred to as waves.

The Elliott Wave theory is based on the principle that a large part of the changes in the finance market is owed to investor sentiment. The creator of the theory, Ralph Nelson Elliott, developed the theory by studying market data through charts, where he discovered repeating patterns in prices.

The Elliott Wave theory posits that the real engine of stock markets is investor psychology. It argues that collective optimism about a stock or feature in the market can lead to a rise in the feature price. And feelings or thoughts of pessimism about the same feature will result in a dip in prices. It is a technical analysis theory based on probability. By examining market charts and applying the principle, investors can tell what direction the market will take next. In Elliott’s wave theory, changes in the market are illustrated through wavy patterns in the market data illustration.

How Does the Elliott Wave Theory Work?

At the Elliott Wave Theory’s core is a hypothesis that price movements in the market occur in recurring up-and-down patterns caused by investor sentiment or psychology. The manifestation of the direction of investor sentiment also occurred in fractal patterns or waves.

Fractal patterns in this context refer to mathematical structures that repeat themselves on infinitely smaller scales. So each wave pattern, if examined, will reveal a group of smaller waves, and within those smaller waves are more waves, such that it goes on infinitely across differently-timed charts.

When examining market charts, Elliott, the creator, noticed two main wave patterns: the Impulse/Motive waves and the Corrective wave.

Impulse/Motive Wave

A wave consisting of five sub-waves collectively moving in the direction of a positive trend is known as an impulse or a motive wave. It is often referred to as the 5-wave pattern and is the most commonly spotted on market charts. A motive wave is played out in three upward and two downward waves. The motive waves consist of three smaller-scale motive waves and two smaller corrective waves. Both waves alternate so that the first, third, and fifth waves are directed upward, while waves two and four point downwards.

Rules governing Motive Waves

In spotting a motive wave within a market chart, some strict rules are often used as guidance. These rules determine what qualifies as a motive wave.

1. The Second Wave cannot fall farther than the entirety of the first wave. This means that the stock price at the end of wave 2 cannot be lower than the stock price at the beginning of wave 1.
2. Wave 3 cannot be the shortest wave of the impulse waves. In most cases, it is the longest wave in the entire pattern.
3. Wave 4 never retraces the entire Wave 3.

Corrective Wave

Also known as diagonal waves, a corrective is made up of three sub-corrective waves that indicate a downward trend in the market. Each corrective wave is indicated using letters A, B, and C.

Corrective waves often follow a motive wave with the purpose of consolidating the preceding trend. They often come in three common patterns: triangle, zigzag, and flat.

Rules governing corrective waves

1. They consist of three sub-waves: A, B, and C.
2. A corrective wave partially retraces the movement of the preceding motive wave.

Elliott Wave Price Cycle

A complete price cycle is a two-phase wave pattern consisting of both impulse and corrective trends. The first phase, the motive wave, is labeled using numbers 1-5, and the second corrective wave is labeled using letters A-C.

A complete Elliott Wave Price Cycle illustrates a fully developed bull market and how it is succeeded by a bear market that consolidates the stock.

This Eight Wave price cycle is the foundation of the principle and the building block upon which other rules of the principle are applied.

Wave Definitions

In almost ten decades since the Elliott Wave Principle first emerged, several technical analysts have developed upon it with more additions. Some analysts posit that each wave within the Motive and Corrective wave patterns has specific characteristics.

Motive Wave Definitions

Wave 1: Wave 1 often takes a while to spot. The fundamental news is virtually always bad when a fresh bull market’s first wave starts. A common belief is that the prior tendency is still very much in effect. If fundamental analysts keep lowering their earnings projections, the state of the economy is probably not good. Put options are popular, sentiment polls are unmistakably gloomy, and implied volatility in the options market is high. As prices climb, the volume may somewhat increase, but not significantly enough to concern many technical experts.

Wave 2: Wave 2 corrects the upward trend of wave 1 but never extends farther than the starting point of Wave 1. At this stage, the general outlook is that bearish sentiment controls the charts. However, there are some positive signs; the stock volume is often lower during the second wave, and the prices do not fall further than 61.8% of the gains made in wave 1.

Wave 3: This is often the longest and strongest powerful in a motive trend. At this stage, the general feeling is positive as some investors may have already made a profit. The Prices in the third wave rise quickly, with short-lived and shallow sub-correctional waves. Towards the end of the third wave, many investors may jump in to join the bullish trends.

Wave 4: Another corrective wave, the fourth wave, directs the prices sideways for an extended period. Based on Fibonacci relationships, Wave 4 will retrace as far as 38.2% of its preceding wave. However, Wave 4 is commonly considered frustrating because of the slowed progress within the larger motive trend.

Wave 5: The final stage of the dominating motive trend comes with generally positive feelings. Unfortunately, investor sentiment is at its highest during this stage. In a desperate bid to profit off the closing trend, investors buy in right before the wave comes to an end.

Corrective Wave Definitions

Wave A: The beginning of a corrective trend is often harder to identify compared to its counterpart motive trend. The first wave of the bear trend sees positive feelings remaining because prices are just starting to drop. Some analysts refer to Wave A as a continuation of the preceding bull market. Characteristics of Wave A include increased stock volume, rising implications of volatility, and an apparent increased interest in future markets.

Wave B: The only motive wave within the corrective trend, Wave B, features higher price reversals. This reversal is often misconstrued as a return to the departed bull market, but technical analysts understand it’s merely the second part of the three-part reversal trend. The volume of the stock at this stage is even lower than in the previous wave.

Wave C: The last leg of the corrective trend is often at least as large as Wave A and may extend slightly past it. The volume begins to pick up as prices spiral even lower, signaling a fully developed bear market.

Applications of the Elliott Wave Theory

In making accurate price predictions, technical analysts often apply other technical analysis tools to identify the potential subsequent directions of waves within the Elliott Wave principle.

Elliott Wave Principle and Fibonacci Relationships

In developing the Elliott Wave principle, R.N. Elliott concluded that the mathematical properties of the waves and patterns within the theory are based on Fibonacci tools. The Fibonacci sequence is a set of integers developed by Leonardo Fibonacci in the 13th century. The summation series, one of the Fibonacci tools, goes this way: the first two numbers in this series are 0 plus 1. The numbers in the series go from 0 to 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and 89 to infinity by adding the two preceding numbers.

Elliott posited that the waves in the wave cycle are numbers in the Fibonacci sequence. In analyzing the Elliott Wave, analysts often use the Fibonacci retracement and extension tools to analyze Eliott waves. Because each Fibonacci tool serves an independent purpose, they are used differently.

For example, the Fibonacci retracement tool is closely linked to the retracement of Wave 2 in the impulse wave pattern. Further, the relationships between waves, in terms of price and time, often exhibit Fibonacci ratios.

Elliott Wave Oscillator (EWO)

In an attempt to simplify the application of the Elliott Wave theory, analysts have developed several indicators. One such is the Elliott Wave Oscillator (EWO), a computer-generated model that uses two moving averages to predict potential price action. Created by the Elliott Wave International firm, EWO or EWAVES is based on an artificial intelligence system programmed with the functions that make up the foundation of the Elliott Wave Principle.

The EWO is often positioned at the end of the market chart and has indicators that signify the beginning and ending of differently numbered waves.

1. Wave 3 can be represented by the highest and lowest values of the oscillator.
2. Where the oscillator pulls back all the way to the bottom (zero) line, it represents Wave 4.
3. Finally, if there is a significant peak in the market price but a not-so-significant move on the oscillator, it points to the last leg of the sequence.

Can You Apply the Elliott Wave Principle to the Crypto Market?

There are some specifics to employing the Elliott Wave Theory in cryptocurrency markets, especially given how chaotic and turbulent its price fluctuations usually are.

Elliott Wave trends can be found in mainstream coins like Bitcoin and Ethereum, among other cryptocurrencies.

Bitcoin and the Elliott Wave Theory

Since Bitcoin’s inception in 2013, technical analysts have closely measured the coin’s market performance in hopes of predicting its price movements. Reports suggest that Bitcoin does, in fact, follow the Elliott Wave Cycle pattern. It has featured each of the sub-waves in an impulse wave, with a price rocketing from $0 to $32.

The Elliott Wave Theory is a strictly powerful one that has the potential to yield a return for invested analysts who spend a lot of time trying to understand the fractal measures used in principle. However, crypto users need to keep in mind the essentially unpredictable nature of markets.

Conclusion

The Elliott Wave Theory, a market analysis technique, has been used for almost a century. It has shown to be much more useful as a tool for making an informed purchase based on where the price is in the various cycle phases than for forecasting price movement.

Nevertheless, the smartest thing to do before entering a financial market is to conduct as much research as possible. Each finance market carries its risks, and it is important to learn about them before buying into a stock option or cryptocurrency.