Trading 101: Elliot Wave Theory

The Elliott Wave theory was developed by Ralph Nelson Elliott in the 1930s. He suggested that trends in financial prices resulted from the predominant psychology of the investors, and that as a result swings in mass psychology resulted in recurring fractal patterns, or “waves”, which could help predict imminent price action.

Elliott’s Waves

Elliott identified two types of wave – impulsive and corrective – after repeatedly observing the same patterns. He found that a movement typically starts with an impulsive wave which moves with the trend, followed by a corrective wave which is counter-trend. Elliott said that five waves typically make up one larger impulsive wave before undergoing a three-wave corrective phase, which looks like this:

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Looking at the moves in isolation, the first impulsive move includes five waves – three with the trend and two against it. The corrective move includes three waves – two against the trend and one with it. The fact that the corrective wave has three legs can impact the assumptions given to highs and lows in the perception of trends: while the creation of higher highs and higher lows typically signals an uptrend, Elliott Wave theory suggests that you can see the creation of a lower high and lower low as a short-term trend correction. This does not necessarily negate a trend, but highlights instead a period of retracement stronger than the previous corrections seen within the impulsive move.

Cycles

Elliott assigned a series of categories to his waves, also called degrees, which highlight the fact that you will see the same patterns within both long- and short-term charts. These categories are:

  • Grand supercycle – multi-century
  • Supercycle – multi-decade (approx. 40 to 70 years)
  • Cycle – one year to several years
  • Primary – a few months to a couple of years
  • Intermediate – weeks to months
  • Minor – weeks
  • Minute: days
  • Minuette: hours
  • Sub-minuette: minutes

Use and Limitations of Elliott Wave Theory

Traders use the Elliott Wave theory to identify an upward-trending impulse wave, at which point they go long, and then short or sell the position as the pattern completes its five waves on the basis that a reversal is imminent. Elliott Wave theory continues to provide a sense of market structure for many traders and investors, but the fact that traders can constantly shift the theory when a rule is broken can render it unreliable as a means to place trades. There is also the argument that just because a market is a fractal it does not mean its direction can be predicted.

Conclusion

Like most trading methods, Elliott Wave theory has a dedicated set of practitioners who swear by it and passionately defend it. Of course, no theory is perfect, but having it in the back of your mind when analyzing an upward move (in tandem with other indicators of course) can help you predict where a good place to set a sell or a short might be.

We hope you have enjoyed this installment of Trading 101. Make sure you check back next week where we will cover Ichimoku Cloud.

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