What are Elliott waves?

[Sam Button]

[Justin Freeman]

The Elliott Wave theory was put forward in the 1920s by Ralph Nelson Elliott as a way to illustrate the cyclical nature of equity markets. Prior to his development of Elliott Wave theory it was believed that markets were completely chaotic.

Elliott Waves and Cycles

Elliott’s theory was that markets actually moved in cycles, and that the cycles were the result of investor responses to external events. In essence, he developed a way to measure the psychology of the investors within markets. His research showed that mass psychology caused markets to move in the same repetitive forms, which he called “waves.” Elliott’s theory wasn’t completely unique. It was based in part on Dow theory, which also said that stock prices tend to move in waves. Elliott was able to analyze markets in greater detail however, since broader markets tend to have a more fractal nature. Fractals, being mathematical structures, infinitely repeat themselves on smaller and smaller levels. Elliott discovered that market patterns were structured in the same way as fractals. Once he had discovered this pattern, he began to investigate how these fractal patterns could be used to forecast price.

Wave Patterns used for Market Prediction

Elliott was able to make detailed predictions of market movements based on his wave theory. He discovered that any main trend would have five waves, and this he called an impulsive wave. Like fractals, when an impulsive wave was looked at on a smaller scale, he found five waves again. Within each smaller pattern the five wave pattern repeats itself, infinitely. Elliott made this discovery before scientists discovered fractals. As it does in physics, we know markets follow the principle of “every action creates an equal and opposite reaction.” We see this over the longterm as price movements up or down are matched with equal and opposite price moves. Over time price action in markets creates trends. Trends are the main direction price is taking at any time, and corrections will move against the trend. Elliott called the trends impulsive waves, and the corrections corrective waves.

Interpreting Elliott Wave Theory

Elliott Wave Theory in interpreted like this:

• There are always reactions to every price action in the market;
• The main trend consists of an impulsive move with 5 waves and is always followed by a corrective move of 3 waves. This is called the 5-3 move;
• Each cycle consists of a 5-3 move;
• Each 5-3 move is also two parts of the larger impulsive move;
• The duration of a wave can vary from extremely short (seconds or minutes) to extremely long (months or years).

  Here’s a chart that shows the 5-3 pattern in an uptrend: It’s easy to see that the three waves in the trend are impulsive, and if we looked more closely, we would see that each of those waves also has a 5-3 pattern. A corrective move will consist of three movements rather than five. In the chart above waves 2 and 4 are corrections from the impulsive wave. While the illustrations above are from a bullish trend, the same theory applies to bearish moves when the main trend is down.

Elliott Wave Theory Popularity

Elliott’s Wave Theory didn’t really catch on and gain popularity until the 1970s when A.J. Frost and Robert Prechter wrote their book on Elliott Wave Theory entitled Elliott Wave Principle: Key to Stock Market Profits. This book became legendary as it predicted the 1970s bull market, and Prechter later predicted the 1987 market crash.

Series of Wave Categories

The 5-3 waves in Elliott Wave Theory are categorized from longest to shortest, beginning with the Grand Supercycle and ending with the Sub-Minuette. Just below the Grand Supercycle is the Supercycle, followed by the Cycle. The remaining categories are Primary, Intermediate, Minor, Minute, Minuette and finally Sub-minuette. When used in practice a trader typically determines the supercycle and trades based on the moves within that cycle, following the impulsive waves and corrections. Longer term trades can also be made by following the Grand Supercycle, but these would require an extreme amount of patience as the Grand Supercycle might take years or even decades to play out completely.

In Conclusion

Like any technical analysis theory, you’ll find both adherents and skeptics of Elliott Wave Theory. One of the major complaints against the theory is that analysts using Elliott Wave Theory can blame failures on their poor chart reading rather than on any flaws in the theory. There have also been complaints regarding the subjective nature of determining cycle length.