The Elliott Wave Principle is a type of technical analysis used by traders to evaluate financial market cycles and anticipate market trends by recognizing extremes in investor psychology, price highs and lows, and other aggregate characteristics.
In the 1930s, professional accountant Ralph Nelson Elliott (1871–1948) uncovered the underlying social concepts and created the analytical tools.
Elliott claimed that market prices follow particular patterns, which are now known as Elliott waves, or simply waves.
Elliott presented his theory of market behavior in 1938 in the book “The Wave Principle,” summarized it in a series of pieces in Financial World magazine in 1939, and covered it most thoroughly in his final major work, “Nature’s Laws: The Secret of the Universe,” published in 1946.
“Because man is susceptible to rhythmical process, estimates concerning his actions may be projected far into the future with a rationale and accuracy hitherto unachievable,” Elliott remarked.
The Elliott Wave Principle
- The Elliott Wave Principle
According to the Elliott Wave Principle, collective investor psychology, or crowd psychology, swings in natural sequences between optimism and pessimism.
These emotional swings produce patterns in market price movements at all levels of trend or time scale.
As seen in the picture, market prices in Elliott’s model rotate between an impulsive, or motive, phase and a corrective phase on all time scales of trend.
Impulses are usually split into a series of five lower-degree waves that alternate between motive and corrective nature, so that waves 1, 3, and 5 are impulses while waves 2 and 4 are smaller retraces of waves 1 and 3.
Corrective waves are divided into three smaller-degree waves, beginning with a five-wave counter-trend impulse, followed by a retrace and another impulse.
Because the primary tendency in a bear market is downward, the pattern is reversed—five waves down and three waves up.
Motive waves always follow the trend, but corrective waves do not.
The patterns connect to produce five and three-wave structures, which in turn underpin self-similar wave structures of increasing size or degree.
Take note of the lowest of the three idealized cycles. Waves 1, 3, and 5 in the first short five-wave sequence are motive, whereas waves 2 and 4 are corrective.
This indicates that the wave is moving upward one degree higher.
It also marks the beginning of the first tiny three-wave correction sequence.
After the initial five waves up and three waves down, the process is restarted, and the self-similar fractal geometry continues to unfold in accordance with the five and three-wave structure that it underpins one degree higher.
The finished motive pattern consists of 89 waves, followed by a 55-wave completed corrective pattern.
In a financial market, each degree of a pattern has a name.
Practitioners employ symbols for each wave to denote function as well as degree—numbers for motive waves, letters for corrective waves (shown in the highest of three idealised series of wave structures or degrees).
Degrees are relative; they are determined by their shape rather than their actual size or length.
Waves of the same degree can have vastly varying sizes and/or durations.
Although practitioners usually agree on the normal sequence of degrees (approximate durations provided), the categorization of a wave at any specific degree might vary:
- Grand Supercycle: Multi-century
- Supercycle: Multi-decade (about 40-70 years)
- Cycle: One year to several years
- Primary: A few months to a couple of years
- Intermediate: Weeks to months
- Minor: Weeks
- Minute: Days
- Minuette: Hours
- Subminuette: Minutes
Elliott Wave Personality and Characteristics
Elliott wave technician believe that each every wave has its own signature or feature that reflects the psychology of the moment.
Understanding those personalities is critical to applying the Wave Principle; they are outlined below.
(The definitions assume a bull market; the characteristics go in reverse in bear markets.)
The Five Wave Pattern (Dominating)
Wave 1: Wave one is rarely visible at the start.
When a new bull market’s initial wave begins, the fundamental news is nearly always unfavorable.
The preceding trend is still seen to be quite robust.
Fundamental experts continue to reduce their profit predictions; the economy appears to be weak.
Put options are popular, and implied volatility in the options market is high, according to sentiment surveys.
Volume may increase slightly when prices climb, but not significantly enough to raise the ire of many technical experts.
Wave 2: Wave two corrects wave one, but it can never extend beyond wave one’s beginning point.
Typically, the news remains negative.
As prices retest the previous low, pessimistic sentiment swiftly grows, and “the mob” haughtily reminds everyone that the bear market is still very much in place.
Still, for those who watch, some good indicators emerge: volume should be lower during wave two than during wave one, prices should not retrace more than 61.8 percent of wave one gains, and prices should fall in a three wave pattern.
Wave 3: Wave three is often the strongest and most powerful wave in a trend (however other study shows that wave five is the largest in commodities markets).
The news is suddenly good, and fundamental experts are beginning to boost their earnings predictions.
Prices increase rapidly, and corrections are brief and shallow.
Anyone hoping to “get in on a downturn” will very certainly miss out.
As wave three begins, the news is likely to be pessimistic, and most market participants will remain bearish; but, by wave three’s midpoint, “the crowd” will frequently join the new positive trend.
Wave three frequently outnumbers wave one by a factor of 1.618:1.
Wave 4: Wave 4 is almost always obviously corrective.
Prices may go sideways for a long time, and wave four generally retraces less than 38.2 percent of wave three.
Volume is significantly lower than in wave three.
If you comprehend the possibility for wave 5 ahead, this is an excellent moment to purchase a pullback.
Nonetheless, fourth waves are sometimes disappointing due to their lack of advancement in the wider trend.
Wave 5: Wave 5 is the final leg in the main trend’s direction.
The news is nearly entirely favourable, and everyone is upbeat.
Unfortunately, immediately before the top, this is when many ordinary investors finally get in.
Volume is frequently lower in wave five than in wave three, and several momentum indicators begin to diverge (prices reach a new high but the indicators do not reach a new peak).
Bears may be mocked at the end of a strong bull market.
The Three wave pattern (Correcting)
Wave A: Corrections are generally more difficult to spot than impulsive movements.
Fundamental news is generally still good in wave A of a bear market.
The dip, according to most analysts, is a correction in a still-active bull market.
Increased volume, growing implied volatility in options markets, and perhaps a shift upward in open interest in linked futures markets are some technical indications that precede wave A.
Wave B: Prices reverse higher, signaling the restart of the now-defunct bull market.
Those who are familiar with traditional technical analysis may recognize the top as the right shoulder of a head and shoulders reversal pattern.
Wave B’s loudness should be lower than wave A’s.
Fundamentals are likely no longer improving at this time, although they have not yet gone negative.
Wave C: Prices fall abruptly In five wave sequence.
Volume increases, and by the third leg of wave C, virtually everyone knows that a bear market has taken hold.
Wave C is generally at least as huge as wave A and frequently exceeds it by 1.618 times.
Elliott’s market concept is highly reliant on price charts.
Practitioners examine evolving trends in order to detect waves and wave structures and predict what prices will do next; hence, using the wave principle is a type of pattern recognition.
Elliott’s structures also fit the standard description of a fractal (self-similar patterns that emerge at every degree of trend).
Elliott wave practitioners argue that, much as naturally occurring fractals expand and become more complex with time, the model demonstrates that collective human psychology evolves in natural patterns, as reflected in market prices: “It’s as if mathematics has programmed us in some way.”
We are all linked by the same order, whether we are a seashell, a galaxy, a snowflake, or a human.
Elliott Wave Rules and Guidelines
A proper Elliott wave “count” must follow three rules:
1) Wave 2 always retraces less than 100% of wave 1;
2) Wave 3 cannot be the shortest of the three impulse waves (waves 1, 3, and 5).
3) Except in the unusual event of a diagonal triangle, wave 4 does not intersect with the price territory of wave 1.
A popular rule of thumb is that in a five-wave pattern, waves 2 and 4 will frequently take alternative shapes; for example, a sharp move in wave 2 will imply a gentle motion in wave 4.
Corrective wave patterns have the shape of zigzags, flats, or triangles.
These corrective patterns can then be used to build more complicated fixes.
Elliott’s examination of the mathematical characteristics of waves and patterns led him to the conclusion that
“The Wave Principle is founded on the Fibonacci Summation Series.”
Fibonacci numbers appear often in Elliott wave structures, including motive waves (1, 3, 5), a single full cycle (5 up, 3 down = 8 waves), and the entire motive (89 waves) and corrective (55 wave) patterns. Elliott created his market model before realizing it mirrored the Fibonacci sequence.
The Fibonacci sequence is also linked to the Golden ratio (1.618).
This and related ratios are widely used by practitioners to create support and resistance levels for market waves, i.e. the price points that help define the characteristics of a trend.