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What is the Elliott Wave Theory and how can you use it to trade?

Elliott Wave Theory
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Numerous theories try to explain why financial markets work the way they do. A significant part of them seeks to analyze the psychological aspect of traders’ behavior and explore how the mindset of individuals affects the overall market trend. The most popular among these is the century-old Elliott Wave theory. In this guide, we will focus on the Elliott Wave concept, its main pros, and cons, how to use the patterns, and analyze some real examples to see how the theory works in practice.

What is the Elliott Wave Theory?

The Elliott Wave theory is based on the idea that stock markets and the prices of instruments move in repetitive patterns. These patterns are correlated with the psychology of the masses and the way investors perceive exterior factors. The consistent repetition of these patterns is called “waves”.

The Elliott wave principle is used by traders to analyze market cycles, time entry and exit points, and identify potential extremes.

The concept opposes the idea that financial markets are chaotic and dominated by randomness. In fact, it assumes that everything is rational and can be explained by the behavior of market participants.

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Indicator History

The Elliott wave theory was shaped in the 1930s by Ralph Nelson Elliott. The concept was introduced in the book “Wave Principle”, published in 1938 and was summarized in a series of articles in Financial World magazine in 1939. It was covered extensively in Elliott’s major work, called “Nature’s Laws: The Secret of the Universe”, published in 1946.

Although denied at the time under the context that it lacks “scientific evidence”, later on, the Elliott Wave theory became a key pillar of understanding and a core principle for a whole set of traders.

The Elliott Wave theory shares key similarities with the Dow theory that also analyzes price movements as waves. However, Elliott’s theory goes deeper as it introduces the idea of the fractal nature of markets.

Fractal – a never-ending, continuously-repeating pattern. Fractals are infinite, which in the context of the Elliott wave theory means prices will be shaping in waves as long as markets operate.

The Herd Mentality

A cornerstone of the Elliott Wave theory is the so-called herd mentality. The concept suggests that the large groups of individuals usually affect the way each one thinks and acts on a personal level.

A typical characteristic of herd mentality is that individuals rarely take responsibility and, instead of making their own decisions, are more willing to look for the way the group acts. Or in other words – individuals are more willing to follow, rather than to lead.

The truth is herd mentality isn’t a new phenomenon. It had been around for decades and a subject to a variety of different scientific researches.

 “Men think in herds and go mad in herds, while they only recover their senses slowly, and one-by-one.”
– Charles Mackay, “Extraordinary Popular Delusions and the Madness of Crowds”, published in 1841

According to studies, herd mentality can be found in all aspects of life that involve a large group of individuals, including fashion, family, financial markets, and more.

In the context of financial markets, the Elliott Wave theory tries to forecast the price of instruments based on the repeatable patterns, created by the herd.

Every aspect where herd mentality is present is usually perceived as easier to predict, with repetitive patterns.

Understanding Elliott Wave Patterns

The Elliott Wave theory is based around the concept of impulse and corrective waves. 

The idea is that each price movement that goes in the direction of the trend consists of five smaller waves. Some traders also refer to these smaller waves as “impulse waves”. The same also goes for corrections, with the main difference that each price correction consists of three waves, known as “corrective waves”.

Each impulse or corrective wave contains five/three smaller ones within its pattern. Each of these smaller waves in the pattern consists of another five/three waves, and so on. The process is infinite as the waves are a part of a fractal.

Simply put, Elliott wave fractals are basically Elliott waves within Elliott waves.

A chart explaining the theory from Elliott’s original essay, „The Basis of the Wave Principle”, October 1940

To put it simply, movements in the direction of the trend take place in five waves. Meanwhile, corrections against it unfold in three waves. On the chart above, the movement in the trend’s direction is labeled with numbers (1, 2, 3, 4, and 5). The movement against the trend is labeled with letters (A, B, and C).

Taking a Closer Look

Let’s analyze the figures in a bit more detail. In the example above, we have three charts. Let’s start with the first one (the one on top). We can see that in the first five-wave sequence, waves 1, 3, and 5 are motive (impulsive). Meanwhile, waves 2 and 4 are corrective (or against the trend). This sequence indicates two things: First, the trend is upward. Second, the start of a three-wave corrective series is around the corner.

On the second (middle graph), we see that after the whole eight-wave sequence ends, it starts again and repeats indefinitely. The last graph visualizes a whole completed pattern, consisting of 89 impulse and 55 corrective waves.

These patterns are present in both short- and long-term charts but are better visualized in the latter.

Elliott Wave Patterns

There are two main types of Elliott wave patterns – impulse (motive) and corrective patterns. The former goes with the trend, while the latter goes against it.

To be able to apply the Elliott wave theory successfully, you should be able to distinguish impulse and corrective waves in both, uptrend and downtrend markets.

During an uptrend, a five-wave rise is followed by a three-wave fall. During a downtrend, a five-wave fall is followed by a three-wave rise.

The waves differ from each other in terms of their degree. Each degree in the pattern has its own name. We use these to better distinguish the waves that we can see on the chart, depending on their order of degree. 

Here is the unified understanding of the concept of wave degrees and how they are named depending on their length:

  • Subminuette – minutes
  • Minuette – hours
  • Minute – days
  • Minor – weeks
  • Intermediate – weeks to months
  • Primary – a few months to a couple of years
  • Cycle – one to several years
  • Supercycle – several decades (usually in the range of 40 to 70 years)
  • Grand supercycle – multi-century
  • The Trendy Moves

Let’s analyze the impulse (motive) patterns in detail to find out how to interpret each wave within the dominant trend and what to expect in terms of prices and economic performance:

Wave 1

As with most technical indicators, the first part of their formation is very hard to interpret and rarely obvious. In a bull trend, wave 1 is usually accompanied by negative market news. That is because the strength of the previous trend still hasn’t washed out completely.

During the first wave, you should expect low earnings reports estimations, bearish sentiment surveys, moderate-to-high volatility, and generally negative economic forecasts.

Wave 2

Wave 2 is a corrective wave that reminds you of the recently-dominant bullish trend. However, it is worth noting that the second wave can’t surpass the starting point of the first one. Otherwise, the pattern will break.

During wave 2, the news regarding economic performance is still bad, and prices retest the previous lows. There is a buildup of negative sentiments and a prevalence of investors with bearish views. However, things are slowly starting to look better.

Wave 3

Wave 3 is very decisive. In most cases, it is the biggest and most powerful in the whole trend (except in commodities markets, where the largest wave is usually number five).

During and after the midpoint of wave 3, most of the news starts getting positive, and the effect of the prior trend has usually washed out almost completely. This stage is accompanied by rising prices, positive earnings reports projections and economic forecasts, bullish dominance, etc.    

A rule of thumb is that wave three exceeds wave one by an approximate ratio of 1.618:1.

Wave 4

Wave 4 is the second corrective wave in the sequence. The prices here can move sideways, and you should expect the wave to retrace at less than 38.2% of the previous one. We can also associate wave four with a lower volume than wave three.

Don’t get nervous if things seem to be lacking progress during wave four. This is just typical for the particular wave, and once it ends, things will get back to normal.

Wave 5

Wave 5 completes the pattern in the direction of the dominant trend. All news and sentiments are firmly bullish, the volume is lower than wave 3, and prices start hitting new highs.

Usually, this isn’t the best place to buy as the trend will soon reverse (unless you act quickly and ride just wave 5). Most traders try to buy in wave three instead or combine it with other indicators to get further confirmations.

The Countertrend Moves

Let’s now focus on the corrective trend and analyze the three waves to find out what you should expect and how to interpret them:

Wave A

Bear in mind that corrective waves are usually a bit harder to identify when compared to the impulse ones.

When the market is bearish, the news coming out during wave A is mostly positive as analysts are yet to discover whether there is a correction or the bullish market is slowing down.

During wave A, you can expect increased trading volume and relatively stable prices.

Wave B

Here you can expect prices to reverse at a higher point. This may fool you into assuming a potential continuation of the bull market. However, make sure to take a look at the trading volume. During wave B, it should be lower than during wave A. Consider also the coming news as the positive ones should be decreasing, and there should be initial signs of slightly bearish sentiment.

Wave C

This is the most significant confirmation of the bear market. Wave C is typically as big as wave A and can also extend to 1.618 the first wave.

Wave C is usually accompanied by increasing trading volume.

How can you use Elliott Wave Patterns?

The truth is that, for traders, the Elliott Wave theory is among the hardest tools to use. Although it is easy to learn on paper, when it comes to real trading, many individuals give up somewhere along the way as they struggle to implement the theoretical knowledge in real-life.

To avoid falling in this situation yourself, the most important thing is to start from the basics. With the Elliott Wave theory, there are three crucial rules to understand. These include:

  • The typical retracement for wave 2 is between 50% and 61.8% of wave 1, but never more than 100%.
  • Wave 4 usually declines between 38.2% and 50% of wave 3, but never more than 100%.
  • Wave 3 typically extends wave 1 by a ratio of 1.618:1 and always travels beyond its end. It is never the shortest one.

Before we proceed to see how we can apply these when trading, it is essential to note that the internet is full of tutorials on how to use the Elliott Wave theory. You can find everything from the basics to advanced tutorials and professional videos. However, in the end, everything comes to one thing, to find out which are the best waves to enter a trade.

Applying it in Practice

The years of practical application have made it clear that the two best ones to enter a trade are usually the corrective waves 2 and 4. Great, but which one exactly?

If you combine the theory with other indicators like the MACD or the RSI, which can confirm that the moment for entering a trade is right, then you can do it during wave 2. Over time, as you get more experienced, you will be able to catch the momentum as soon as it arises. 

However, if you are inexperienced or you get mixed signals, make sure to wait for wave 4. It usually follows the longest wave in the sequence (number 3) and makes traders more confident in their decisions.

Some traders wait for the beginning of the formation of wave 5 to open their position. During wave 5, there is no doubt in the direction of the market, which is why it is often considered a “win-win” situation. However, if you decide to wait for wave 5, you should make sure that you act quickly. The reason is that you are basically riding the last wave before the correction.

You can also apply reverse strategies during the corrective waves (A, B, and C). However, here things get more complicated, and, if you are just starting, make sure to avoid trading past wave 5.

So, in a nutshell, no matter the entry point, the exit one usually is within wave 5. Once you acknowledge that you are riding wave 5, make sure to start considering taking out your profits (at least a part of them) and focus on the stop-loss to lock in your remaining profits.

What do you need to avoid when using Elliott Waves?

There are several things that you should avoid when using Elliott waves.

The first and most important – avoid relying on it as a standalone analysis tool. Always apply it as a supportive measurement. For example, you can use it in addition to the RSI, sentiment indicators (analysts surveys), etc. You can also use it with MACD and Fibonacci to find out where the waves are likely to end.

Another thing to avoid is giving up to the emotions and jumping into a trade at a very early stage. Unless you are a life-long Elliott wave analyst, make sure to wait for a confirmation that the trend is actually going to shape the necessary formation. Otherwise, you risk trading a false signal.

Make sure to avoid the application of the theory with real money right from the start. Always do your homework by looking at charts and applying the theory in a demo account. Make sure to plot the waves sequence in both scenarios – a descending and an ascending market.

We should also clarify that if at any point, the waves break one of the rules we covered above, then the pattern breaks, and you should avoid trading on it.

Illustrated Examples

For example, in the image below, you can see that wave 2 retraces at over 100% of wave 1 (breaks below its starting point). Make sure to avoid basing your trading decisions on situations like these.

Always look for the length of wave 3. It should usually be the longest of all waves in the sequence. In the example below, you can see that wave 3 is the shortest one. This means you should start over by counting it as the first one in a new sequence as the pattern breaks there.

Last but not least, look for situations where wave 4 crosses the final point of wave 1. If you notice something similar, then the pattern is broken, and you should proceed counting from the start once again.

Advantages and Disadvantages of Elliott Waves

The Elliott wave theory is among the most widely discussed and polarizing ones within the trading world. Aside from its large number of proponents, it also has some vocal critics. The truth is both sides have reasonable arguments. The best way to evaluate the pros and cons of the theory is to deep-dive in the reasoning of the critics and the fans.

Advantages

The main benefit of the theory is that it tries to eradicate the chaos and randomness, usually associated with trading activity. By organizing market patterns and putting the price action into an easy-to-understand and navigate hierarchy, it basically helps the trader to make calmer, more precise and confident decisions.

Disadvantages

We can trace back the core disadvantage of the theory to the way different traders interpret it. As much as it tries to put things in order, the theory still has some degree of arbitrariness. This makes it hard for different analysts to reach the same conclusion.

“It is an art to which the subjective judgement of the chartists matters more than the objective, replicable verdict of the numbers. The record of this, as of most technical analysis, is at best mixed.”
– Benoit Mandelbrot, mathematician, on the problems with the Elliott wave theory

What this means is the theory has very little predictive power when applied in real-time conditions. The reason for this is the complex and often impossible task of putting the market dynamics within a strict frame.

The critics of the theory point out that the fact it contradicts the EMH means each and every trader who is aware of the tricks of the Elliott Wave theory can apply it, and basically eradicate the waves he is trading on. In other words, if it was so good at predicting, it would have solved financial markets through the masses’ behavior.

Maybe the most significant disadvantage of the Elliott Wave theory is how hard it is to learn to apply it properly. Even seasoned traders often struggle to count the waves correctly, which further affects their strategies’ efficiency.

Some critics also argue that the Elliott Wave theory is out of date. They cite how its introduction was in times when the regulatory, governmental, technological, and economic circumstances were way different. According to these detractors, it does not account for these changes.

A Real Example of the Elliott Wave Theory

There are multiple ways of applying the Elliott wave trading strategy. These include trading wave 3, wave 5, wave A, B, C, etc. Here, we will focus on examples of how to trade by aiming for the best risk/reward ratio.

The best way to do it is by entering the market after you confirm the first eight-wave sequence.

This strategy is suitable for beginners or more conservative traders. It requires to wait for the moment you count 5 waves in the direction of the trend, as well as 3 against it. If the next wave starts replicating the same pattern and gets back in the direction of the market, then we have the basic structure of an Elliott wave entry point.

When the new wave moves past the end of wave B, it is time to open a position.

Next is the time to place your stop-loss. Wait for the completion of wave 1 of the new sequence. After wave 2 calms down and the trend starts forming wave 3, you can place your stop-loss on the level of the highest point of wave 1.

Make sure to adjust your stop-losses as the sequences continue.

Is it worth it to use Elliott Waves today?

The truth is that it is very hard to apply the Elliott wave theory successfully in practice. Some traders compare it to pursuing a Ph.D. The reason is that it takes many hours to master. Even after that, many analysts admit that it is very challenging to spot a wave. Most traders do so only when it had closed.

All of this aside, it is worth it to give it a try. The reason is that many famous investors like Paul Tudor Jones and some of the most successful fund managers use it to make money. However, we should make it clear that it is worth using the theory only if you know how to apply it correctly.

If you want to master the Elliott wave theory, make sure to explore its official site. There, you can find educational videos, articles, guides, and subscribe for the Elliott Wave Theorist newsletter to receive informative materials.

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