Elliot Wave Theory is a technical analysis method that is based on the idea that market prices move in predictable patterns, called waves, that can be used to identify trends and assist in making trading decisions. The theory is based on the work of Ralph Elliot, who observed that market prices move in repetitive cycles, which he called "waves." According to the theory, these waves are caused by the collective behavior of market participants and reflect the emotions and psychology of investors.
Elliott was an accountant who became interested in the stock market and began studying price charts to understand market behavior. He noticed that market prices moved in repetitive cycles, which he called "waves."
Elliott asserted that these waves did indeed reflect the collective behavior of market participants as well as the emotions and psychology of investors. He also believed that these waves could be used to predict future market movements - in his book "The Wave Principle," published in 1938, Elliott described his theory and presented his wave counting method.
Despite the publication of his book, Elliott wave theory did not gain widespread acceptance among traders and analysts until the 1970s, when Robert Prechter, a market analyst, began promoting the theory and publishing a newsletter on the subject. Since then, the theory has become widely used by traders and analysts in the stock, forex and commodity markets.
The theory states that markets move in a series of five waves in the direction of the trend (1-5), followed by three corrective waves in the opposite direction (A-C). These waves are labeled and described as follows:
Wave Descriptions
uptrend.
- Wave 1 - Usually starts as a sleeper. At the beginning of a new bull market, fundamentals appear weak and analysts predict lows. This wave starts to bring in volume, yet not enough to onboard anyone with urgency.
- Wave 2 - Correction of wave 1, but this model is invalidated if wave 2 proceeds below wave 1. Public sentiment remains bearish. Volume in second wave is lower than wave 1; this checks out- there are fewer sellers in this wave than were buyers for the first wave. This wave shouldn’t retrace more than 68.1%, and prices may fall in a trifold pattern.
- Wave 3 - This is typically the big daddy wave ( although some markets assert wave 5 is the largest.) When wave 3 starts, sentiment is still bearish, but about half way through the wave, the news starts to turn positive and analysts start predicting bull about half way through. Prices start to soar, and there usually isn’t a chance for peepish buyers to get in on a pull back- which instigates even stronger FOMO. Crowd retail investors pile in on this wave.
- Wave 4 - An obvious correction, and prices may trade sideways for a time within wave 4. Typically doesn’t retrace more than 38.2% of Wave 3, and again, volume on this corrective wave is much lower than the last pump wave. Good time to buy pullbacks before wave 5 starts.
- Wave 5 - This is the home stretch for the bulls. Usually the whole world is bullish at this point. Many average investors buy here at the top. Volume is lower in 5 than 3 (typically.) Prices reach new high, but other indicators show divergences in the direction of the trend. When people start scoffing at the bears, you can be sure the top is near.
downtrend.
This A-B-C movement that begins the downtrend is can manifest as a zigzag correction or as a flat correction.
- wave A - Impulse wave, which heads back up towards the height of wave 5.
- wave B - Corrective wave; usually the biggest volume wave as trading heats up. In the zigzag correction, wave B goes below wave A. In the flat correction, wave B retraces to where wave A began before beginning wave C.
- wave C - Last impulse wave that either traces back up to wave A and continues uptrend, or traces back to A before meeting more corrective waves.
It is important to note that the theory is not universally accepted and some traders and analysts disagree with its validity. Additionally the theory is more of a guideline than a rule, and it's not always easy to identify the correct wave count, which makes it a subject of debate among traders and analysts. Here some of the reasons why the theory is still debated among analysts.
1. Subjectivity: The wave count and identification of wave patterns is often subjective, leading to different interpretations of the same market data. This can make it difficult to apply the theory consistently and can lead to disagreements among practitioners.
2. Lack of clear rules: The theory does not have clear rules for wave identification and counting, making it difficult to apply consistently. This can lead to different wave counts and interpretations among practitioners.
3. Lack of empirical evidence: There is a lack of empirical evidence to support the validity of the theory, making it difficult to test its accuracy.
4. Inconsistency in predicting market movements: Some traders and analysts argue that the theory does not consistently predict market movements, calling into question its usefulness as a forecasting tool.
5. Complexity: The theory is complex and requires a significant amount of expertise and experience to apply correctly.
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