Elliot wave theory analysis & how to apply it to any market
Elliott Wave theory is one key method of forming market predictions, with a host of rules and complimentary theories providing a key tool for technical analysts. Ralph Nelson Elliott developed the Elliott Wave Theory in the 1930s. He believed that stock markets, generally thought to behave in a somewhat random and chaotic manner, in fact, traded in repetitive patterns.Elliott proposed that trends in financial prices resulted from investors' predominant
Elliott's theory somewhat resembles the Dow theory in that both recognize that stock prices move in waves. Because Elliott additionally recognized the "fractal" nature of markets, however, he was able to break down and analyse them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. Elliott discovered stock index price patterns were structured in the same way. He then began to look at how these repeating patterns could be used as predictive indicators of future market moves.
He made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern. A corrective wave, on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found.
This next pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically.
In the financial markets, we know that "what goes up, must come down," as a price movement up or down is always followed by a contrary movement. Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.
The psychological element of trading can often provide waves rather than simple straight lines, and these waves form one of the biggest features of Elliott’s theory. To a large extent this is a reflection of Elliott’s studies of Charles Dow’s work, with Dow Theory stating that stock prices typically move in waves. He also relies on cycles, which accounts for the restitutive nature of the patterns. The theory refers mainly to waves as the key form seen throughout markets, with the fractal nature of his waves proving that the same patterns can be seen in both short-term and longer-term charts. Given that Elliott observed the same patterns over and over again, he suggested this to be a potential tool to predict future price movements.
Elliott believed that every action is followed by a reaction. Thus, for every impulsive move, there will be a corrective one.
The first five waves form the impulsive move, moving in the direction of the main trend. The subsequent three waves provide the corrective waves. In total we will have seen one five-wave impulse move, followed by a three-wave corrective move (a 5-3 move). We label the waves within the impulsive wave as 1-5, while the three corrective waves are titled A, B and C.
Once the 5-3 move is complete, we have completed a single cycle.
However, those two moves (5 and 3) can then be taken to form the part of a wider 5-3 wave.
Taking the moves in isolation, the first impulsive move includes 5 waves: 3 with the trend and 2 against it. Meanwhile, the corrective move includes three waves: 2 against the trend and 1 with the trend.
Interestingly, the fact that the corrective wave has three legs can have implications for the wider use of highs and lows for the perception of trends. Thus, while the creation of higher highs and higher lows will typically signal an uptrend, Elliott Wave theory highlights that you can often see the creation of a lower high and lower low as a short-term correction from that trend. This does not necessarily negate the trend, but instead highlights a period of retracement that is stronger than the previous corrections seen within the impulsive move.
The use of corrective waves highlights the potential cross-study of Fibonacci retracements. Elliott didn’t specifically utilise Fibonacci levels, yet traders have applied them as a way to add greater complexity to the traditional theory.
The rules previously specified highlight which Fibonacci retracement levels could be used at different points in the trend. Given rule three, a trader would be looking for a fourth wave to be relatively shallow, with the 23.6%-50% levels of particular interest. We can also look for the correct A, B, C move to be a 50%-61.8% retracement of the entire 1-5 impulse move.
Prices move in impulsive and corrective waves. Knowing which wave is likely underway, and what recent waves were, helps forecast what the price is likely to do next.
An impulse wave is a large price move and has associated trends. An uptrend keeps reaching higher prices because the moves up are larger than the moves down which occur in between those large up waves.
Corrective waves are the smaller waves that occur within a trend.
Trade in the direction of the impulse waves, because the price is making the largest moves in that direction. Impulse waves provide a better chance of making a large profit than corrective waves do.
Corrective waves are used to enter into a trend trade, in an attempt to capture the next bigger impulse wave.
Buy during pullbacks or corrective waves during uptrends, and ride the next impulse wave as it takes the price higher. Short sell during corrective waves in a downtrend to profit from the next impulse wave down.
The idea of impulsive and corrective waves is also used to determine when a trend is changing direction. If a price chart shows big moves to the upside, with small corrective waves in between, and then a much larger down move occurs, that is a signal the uptrend may be over. Since impulses occur in the trending direction, the big move to the downside—which is bigger than prior corrective waves, and as large as the upward impulse waves—indicates the trend is now down.
If the trend is down, and a big up wave occurs—that is as big as the prior down waves during the downtrend—then the trend is now up and traders will look to buy during the next corrective wave.
Nelson found that when an uptrend is underway it typically has three large upward price moves, interspersed with two corrections. This creates a five-wave pattern: impulse, correction, impulse, correction, and another impulse. These five waves are labeled wave one through wave five, respectively.
The uptrend is then followed by three waves lower: an impulse down, a correction to the upside, and then another impulse down.
Nelson also found that these movements are fractal, meaning the pattern occurs on small- and large-time frames. For example, the first impulse wave higher within an uptrend on a daily chart is composed of five waves on an hourly chart. Corrective waves are composed of three smaller waves if viewed on a smaller chart time frame.
This fractal pattern span decades, with smaller versions of the pattern even visible on one-minute or tick charts.
Just as impulsive and corrective waves help determine when to enter trades, and in which direction the trend is moving, this price structure can do the same. Assume there was just a big move to the upside—an impulsive wave—then a correction is likely to follow. That correction to the downside will often unfold in three waves: a drop, a small rally, and then another drop. Use this to improve trade timing by waiting for that second drop. Getting it right when the price starts to drop the first time is too early, as another drop is likely coming.
Similarly, once there have been three big moves to the upside, the uptrend may be nearing completion. An impulse wave to the downside would then confirm that the price is likely to head lower and the uptrend is indeed over.
This pattern tends to occur in widely traded markets with high volume, such as the SPDR S&P 500 ETF (SPY). The pattern is harder to spot, or doesn't occur, in individual stocks which are more prone to movements based on the buying and selling of only a few individuals.
When buying on corrections during an uptrend or selling on corrections in a downtrend, it is helpful to know how large the typical correction is.
Based on the five wave pattern, wave one is the first impulse wave of a trend and wave two is the first correction. Wave three is the next impulse, followed by corrective wave four and impulse wave five.
Wave two is followed by impulse wave three. The third wave of a trend is often the largest, usually much bigger than wave one. Wave four comes next and is typically 30 to 40 percent the size of wave three. The same concept holds true for a downtrend.
These are averages seen over many trades and trends. Corrections may be smaller or larger than average on any single trade. Yet, even having an approximate idea of how big a correction is likely to be can help improve trade timing.
These three Elliott Wave concepts may improve trader's analysis skills or improve their trade timing, but it is not without its own problems. The theory can be complex to apply, as it isn't always easy isolating the five wave and three wave patterns. The pattern also isn't often present in individual stocks, but rather applies to only heavily traded assets which aren't susceptible to the buying or selling of only a few traders. The concept of impulse and corrective waves is applicable to all markets and time frames, though, and can still be used even if the theory of the five wave and three wave price patterns isn't.
Elliott Wave theory is something that continues to provide a sense of structure to markets for a lot of people worldwide. The ability to constantly shift the theory when a rule is broken can hinder the use of the theory as a means to place trades. However, it also adds a significant degree of clarity to the art of trend recognition. How much complexity a trader wishes to add to Elliott’s initial rules is up to them, yet it is certainly a method that many choose to place front and centre in their market strategies.
Elliott Wave practitioners stress that simply because the market is a fractal does not make the market easily predictable. Scientists recognize a tree as a fractal, but that doesn’t mean anyone can predict the path of each of its branches. In terms of practical application, the Elliott Wave Principle has its devotees and its detractors like all other analysis methods.
One of the key weaknesses is that the practitioners can always blame their reading of the charts rather than weaknesses in the theory. Failing that, there is the open-ended interpretation of how long a wave takes to complete. That said, the traders who commit to Elliott Wave Theory passionately defend it.
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