A few years ago (2005!) I wrote a guide for another website called “A Beginners’s Guide to Elliot Wave Theory and Application”.
In the eleven years or so that have passed, Elliot hasn’t changed a whole lot and probably never will. But, the theory is sound and now has a decade more testing to back it up. The views of traders themselves largely haven’t changed on Elliot either – some love it, some hate it. I am firmly in the former camp, because I have seen EW work on so many occasions I’ve genuinely lost count.
So, what is Elliot Wave Theory?
The whole thing first came about in the 1930s by Ralph Elliot. This theory was that crowd behaviour – which is essentially the whole basis for market activity – tends to operate in recognisable phases. Hence, price action can be predicted to some degree, and this is what Technical Analysis is all about. Personally, I find TA to be subjective in many areas – some of the traditional patterns work some of the time. However, in my experience, Elliot Wave works a lot of the time and is an awful lot more reliable (if anything in trading can be called ‘reliable’).
How frequently does it work?
The Golden question for all traders! How long is a piece of string? You can’t say. However, once a phase has started, it can be quite easily identified. So, if you stick with it, it can be a useful indicator as to when to get out of a trade, if nothing else.
EW Theory is a collection of TA patterns. These patterns allow the EW trader to understand market action, and predict future trends. Known throughout TA now as the ‘Elliot Wave Principle’.
The concept is somewhat easier to grasp if we use some graphical examples of EW. Look at Figure 1 below:
There are two distinct parts to each ‘wave’. The Numbered Phase, and the Lettered Phase.
In the Numbered Phase, Waves 1, 3 and 5 are called “impulse” waves – minor upwards moves in an otherwise bullish trend. Waves 2 and 4 are the smaller, less powerful “corrective” waves.
In the Lettered Phase, Waves A and C are the stronger impulse waves down. Wave B – the bull wave – is the weaker move.
Waves within Waves
Elliot theorised that the wave in Figure 1 was a small wave, embedded within an overall larger wave, and that each larger wave was, in turn, part of an even larger wave. Look at the example in Figure 2 below, and we can see exactly what he meant.
In Figure 2 below, we can see that Waves 1 through 5, and Waves A through C (see Figure 1) form part of an much larger Wave 3, as shown:
Confused yet? Stick with it because it’ll pay dividends. Not convinced? Check out Google Images.
Elliot believed that there were many cycles of both impulse and corrective waves, and he named each cycle to fit in with his theory. That theory was that the waves were based around the Fibonacci series of numbers – 1, 2, 3, 5, 8, 13 etc. The names are:
- Grand Supercycle
So, boring titles aside, the man put some serious effort into his analysis in the 1930’s.
Elliot provided several varieties of the main wave, and placed particular relevance on the Fibonacci value of 0.618 as the most common level for a retracement to occur. Fibonacci is a whole other story but again, one worth investing some time into.
Real Life Examples
Of course, the examples shown in Figures 1 and 2 are perfect definitions of Elliot Wave Theory. In the real world, things tend not to be quite so clear.
The price action shown in Figure 3 above is taken from the NASDAQ Composite Index, during the later part of 2003. It’s old, but it’s still relevant so I’ve used it again. You can find many more recent examples on the Google link above if you want.
In Figure 3 above, the waves are still there, but somewhat harder to spot to the untrained eye.
Theory and Practice
In theory, to trade using EW is simple – just like everything in trading, right? You identify the main wave, enter long (or short, as applicable), and cover or sell short/long as a reversal occurs.
In practice … well, things can be rather different. Many wave patterns are identified only with hindsight, and disagreements often arise between followers of Elliot as to which cycle the market is actually in at any given time. However, in my experience, if you’re not in on Wave 1 (it may be that another signal has fortunately got you into Wave 1, or you may have missed it completely), you might be able to identify a Wave 3, which is usually the most powerful of all the waves in my experience. Hence, if you can get in on Wave 3, ride 4 out and pick up Wave 5, you will have made a good profit on whatever you’re trading.
I wrote this article merely as a brief overview, and that’s what it is. However, I must confess that I have never really studied EW much more than what I’ve written here and quite honestly, I’m not sure I needed to. The basics are really all that’s needed. I have sat there looking at a screen on numerous occasions, and found myself thinking “this is the start of a wave”, and I’ve been right. I can count on one hand the number of times I’ve been wrong about it. Read into that what you will, but I’ll wager you can analyse any stock or any chart over any time period, and you’ll see EW patterns throughout.