Established by stock market analyst Ralph Nelson Elliott in the 1930s, the Elliott Wave is a technical analysis pattern used by traders to predict market price movements. Elliott held the belief that there was a pattern to the seemingly chaotic movements in market charts and set out to trace it by deriving the Elliott Wave Theory.
What is the Elliott Wave Theory?
The Elliott Wave Theory is founded on the idea of crowd psychology as a market mover. Elliott believed that it is not political and financial news itself that causes changes in market price movements, but investor reactions to such news. The theory postulates that people, with our oscillations of optimism and pessimism, are the actual driving forces of financial markets. The theory also proposes that these oscillations are bound to repeat themselves in cycles, which means that market price movements are, too, bound to repeat themselves accordingly. These repetitions culminate and make up a pattern. In financial markets, price movements in a pattern are labelled as waves. Each wave is a movement in one direction on the market chart. Traders apply the theory in chart analysis to predict price movements and to get an idea of when to buy and sell. The Elliott Wave theory also postulates that the nature of these chart patterns is fractal. This means that aside from the pattern repeating itself infinitely, it will also occur on different scales, with each pattern containing smaller versions of the same pattern within itself. We will explore this later.
The Elliott Wave pattern explained
The Elliott Wave chart pattern consists of 8 waves in total that can be divided into 2 broad phases: motive and corrective, both of which contain individual sub-waves that are impulsive and corrective in character.
Motive waves make a net movement in the direction of the main trend. These are the first 5 sub-waves, numbered 1 to 5. You may have noticed that while motive waves are said to travel with the main trend, the individual sub-waves actually alternate between uptrend and downtrend. Sub-waves 1, 3, and 5 are impulsive in character and go with the prevailing trend, while Waves 2 and 4 are corrective in character—they are smaller retracements of Waves 1 and 3 respectively, and they dip in the opposite direction. There is a logical explanation for the movement of motive waves:
- Wave 1 represents the initial buying stage. The market price increases as investors begin to buy until it reaches a certain level, which is when buyers decide to sell to make a profit.
- This offsets Wave 2 when the price begins to decrease with the increase of sellers.
- A lower market price attracts buyers once again, and Wave 3 represents a second wave of purchases. With the price increasing again in a similar manner as Wave 1 and reaching a new high, buyers again decide to sell to make a profit.
- This offsets Wave 4. With a collective selling, traders push the market price down once more.
- With the establishment of the first four sub-waves, traders familiar with the Elliott Wave pattern begin to buy with the goal of capturing the last of the motive waves before movements shift again. This behaviour generates Wave 5.
Corrective waves make a net movement against the direction of the main trend. These are the 3 sub-waves lettered A, B, and C. Again, you may notice that while the 3 sub-waves are said to be travelling against the main trend, they actually alternate. Sub-waves A and C are corrective in character while sub-wave B is impulsive in character.
The pattern in real-time charts
The Elliott Wave pattern manifests differently in real-time charts, depending on if the market is bullish or bearish. In a bullish market, the 5 motive waves have a net upward trend, and the 3 corrective waves have a net downward trend. In a bearish market, naturally, the pattern reverses, and the 5 motive waves have a net downward trend, while the 3 corrective waves have a net upward trend. Regardless of the direction of the main trend, each pattern will always contain 8 sub-waves divided into 2 broad phases—the first containing 5 sub-waves and the second containing 3 sub-waves. In real-time charts, Elliott Waves may be slightly harder to spot as each pattern is not as clear-cut as it is presented in examples, with clean movements. However, as a highly visual pattern, it is still relatively easy to identify as each one follows four important rules.
Fundamental rules for the Elliott Wave theory
There are four fundamental rules that all patterns abide by theoretically, in a bullish market:
- Wave 2 cannot retrace more than, or dip below, the beginning of Wave 1.
- Wave 3 cannot be the shortest impulsive sub-wave amongst the motive waves.
- Wave 4, retracing Wave 3, cannot overlap with the price territory covered by Wave 1.
- Wave 4 cannot be longer than Wave 2.
In a bearish market, the rules are reversed. These rules govern the theory and provide a good basis for the identification of the Elliott Wave pattern in a market chart. However, as mentioned, market price movements do not always end up following these rules too strictly. Some technical analysts are flexible in their interpretation and application of the theory and only use it as a basis for analysis, and they accept occasional deviations from the rules.
The fractal nature of chart patterns
The Elliott Wave pattern is fractal in nature, meaning that it repeats itself over and over again, infinitely, and on different scales. While analysing charts, you may notice there are smaller Elliott Waves imbedded within larger ones, which are imbedded within larger ones still, and all of these patterns resemble each other in structure. In financial markets, Elliott Wave patterns can occur over both short- and long-terms. Smaller patterns can occur in smaller timeframes and be embedded within larger patterns that occur in larger timeframes. How long a pattern spans is known as a wave degree, and Elliott identified and labelled nine wave degrees.
Elliott Wave degrees
- Grand supercycle: multi-century
- Supercycle: multi-decade, about 40 to 70 years
- Cycle: one to several years
- Primary: a few months, up to a year or two
- Intermediate: a few weeks, up to a few months
- Minor: a few weeks
- Minute: a few days
- Minuette: a few hours
- Sub-minuette: a few minutes
The bottom line
The Elliott Wave theory is founded on the idea that investor sentiment causes price movements instead of external events. These sentiments oscillate between phases of optimism and pessimism and form a pattern which repeats itself over time. Within the theory, each pattern consists of 8 sub-waves, divided into 2 phases—motive and corrective. The motive waves are made up of 5 sub-waves and make a net movement in the direction of the main trend and the corrective waves are made up of 3 sub-waves and make a net movement in the direction against the main trend. As the pattern is fractal in nature, each one contains smaller versions of the same pattern within itself, repeating infinitely. There are nine different wave degrees, which indicate the different timeframes each wave pattern spans. The Elliott Wave theory is used to identify and predict price movement patterns. Although it does not negate the risks involved in trading, it can be used in conjunction with other technical analysis patterns, such as Fibonacci retracements, for traders to potentially make better speculations. Open a free demo account today to gain a deeper understanding of market movements before making real trades.