Is Elliott Wave theory too subjective?That is not the question you should really ask!
I am starting a new set of articles based on my letters sent to followers. Almost every day I get questions from people who tried the classic Elliott Wave theory but got walked away. Most often they complain about vague rules and high degree of subjectivity when you try to apply those rules in practice.
Question: “ Is the “subjectivity” completely removed by the Harmonic Elliot Wave system? Is it clear and completely rule based?”.
No, I would lie to you if I said that. First, your ability to correctly recognize patterns depends on your experience and skills. You should not only learn and remember them but you have to keep applying that knowledge by recognizing patterns in real trading to automate that skill. However, even an experienced analyst makes mistake from time to time. Sometimes I overlook some clear pattern. Sometimes I try to find a pattern where it does not exist. In many cases two experienced analysts see two or even different scenarios. Let me explain you why that happens. The real problem is not that the rules are vague or numerous. The real issue is that some moves are naturally better predictable than others.
The real issue is that some moves are naturally better predictable than others.
As I mentioned above, two analysts would have two or three different wave counts. But lets dig deeper in order yo understand why that happens. Under the Harmonic Elliott Wave theory there is only one fractal that explains a trending move, the legacy Five Wave fractal (please see below).
This fractal is the real advantage of the Harmonic Elliott Wave theory. Not only it is a very efficient and reliable prediction tool that works on any time frame from 1 minute to daily, weekly and monthly charts. But it also has very specific rules and there are stable repeatable ratios between its segments that we call “waves” (those segments are shown in different colors on the chart above). Because of those stable ratios a trending move that follows the five wave pattern has a specific easily recognizable “look”. That feature lets us find that pattern at a glance in any price chart.
Why price keeps following that fractal in most of rallies? Because any rally is driven by greed. Because behind any rally you have underlying crowd psychology. There are different types of investors with different personalities. And they join rally at different stages based on their susceptibility to the peer pressure. As humans we seek for social approval of our actions. We like to do what others do. We naturally like to follow others. Even contrarian investors who like to trade against the crowd and who may short major rallies would feel uncomfortable if no one agrees with their bearish thesis. This is why those investor conferences are attended by famous fund managers who keep talking about their contrarian calls. Every one seeks for social approval, even those gurus! They naturally need to see whether their contrarian bearish or bullish thesis that go against the prevailing sentiment in the market resonates with anybody else!
The human nature and the way how we interact with others and how we follow others is a foundation of the fractal nature of price charts. Price draws similar patterns again and again because people act in a similar way and the way how we make decisions did not change much since the Tulip Mania. ( Tulip mania was a period in the Dutch Golden Age during which contract prices for some bulbs of the recently introduced and fashionable tulip reached extraordinarily high levels and then dramatically collapsed in February 1637).
For example, Bitcoin price chart is a great illustration that very often crowd gets irrational. People first pumped it up to $20,000. And investors kept buying because of prevailing bullish sentiment at the top. And then it dropped hard to $3,000. What was remarkable is that the majority of analysts expected it to go lower.
The Five Wave fractal is the brilliant breakthrough behind the discovery of the Wave Principle made by R.N.Elliott. However it has its stronger and weaker parts. The strongest part is the discovery that trending moves follow the five wave fractal.
What is the weakest part of Elliott Wave theory? Why analysts have different counts? Why even better version of EWT, the Harmonic Elliott Wave theory is nowhere close to be the Holy Grail you have been searching for so long?
Inside that fabulous Five Wave fractal there are five waves. On the chart above they are labelled as 1, 2, 3, 4 and 5. But only three of them (waves 1, 3 and 5) push prices in direction of the trend. They are the most reliable trading vehicles. We call them “impulsive” waves because there is energy behind them created by one prevailing force. In physics “impulse” is a force acting briefly on a body and producing a finite change of momentum.
In the Five Wave Up fractal the prevailing force is bulls who keep pushing price higher. The fuel of force is their greed that overweight fear of losing money when you buy at the top of a rally that has been going for a while. In bearish Five Wave down fractals that fuel is fear of traders who see the value of their holdings shrinking. And they finally give up and sell holdings with a loss creating more downside pressure for already “oversold” market.
What about other two waves? Waves 2 and 4 are corrective waves. You can also add subwaves B of 1, B of 3 and B of 5. All those waves are marked in red on the chart above. They all push price in a countertrend direction for a limited time. Those are waves where fight between bulls and bears intensifies. Those waves may take ugly shapes because none of the force is prevailing. Every bearish pullback gives hope for bears and makes bulls to double question their conviction in continuation of the move higher. Every bearish pullback is used by some bears to close shorts because they turn bullish. And some bulls sell longs because they are scared to loose the gain. As you can see thee is a lot of going on under the hood during corrective moves. That is why those corrective waves normally have complex structure and are structured as a sequence of short swings pointing in different directions. Simply speaking traders call it “whipsaw”.
Remember I told you that there is only one fractal behind trending or impulsive moves? But there are five major types of corrective waves.
Moreover, very often corrective waves come as combination of two or even three different types of corrective patterns. That increases number of potential corrective structures to hundreds!!! And price normally does not follow those fractals close enough. Despite the fact that we do have some rules that can be applied to recognize type of a corrective pattern in play that remains to be a very challenging task.
Recognition of corrective patterns very often turns into a purely subjective task.
That is where traders start to see very different things on the very same chart. Recognition of corrective patterns very often turns into a purely subjective task. Trading corrective waves may get exciting because of fast almost erratic moves. But very soon after catching 1–2 micro moves inside a larger corrective wave traders experience disorientation. I often hear from my followers who attempt to trade every squiggle : “ I do not longer understand what is going on!”.
When they start focusing on micro moves inside a corrective wave they soon loose the bigger picture. They quickly forget that just several days ago they begged for a pullback even a shallow one because they wanted to join a rally that kept pushing prices higher. But after two days of a flat correction they forget about it. Now they keep shorting in hope for a pullback to get deeper.
Is it possible to avoid subjectivity at all?
I do not think it is possible. But it is possible to reduce cases when your trade depends on your subjectivity in analyzing those hardly predictable spots. It is possible to capitalize on strengths of the Harmonic Elliott Wave theory in tracking impulsive waves and avoid trading those barely predictable corrective waves.
The problem is that it requires a lot of self discipline. It takes time and it takes many failures to learn not to take bad setups. You should acknowledge that your job is not to predict the market’s next move. Your job is, first, to identify whether price follows a trending fractal, then identify current location inside that fractal, and, finally, stay patient waiting until price starts another impulsive subwave in direction of the main trend where probability of continuation is very high. In other words, a trader should be very selective in taking trades. And that brings me to a very important conclusion.
People should distinguish two very different application of Elliott Wave theory. You can use it to align the actual price chart with known fractals and then attempt to predict the next market move by extrapolating the fractal. However that does not mean you should trade every prediction. Even inside an unfolding trending move that is very well aligned with the Five Wave fractal predictions of waves pointing in direction of the main trend will always be more accurate. This is type of predictions that should be taken as high probability winning setups.
The author published regular updates of the wave analysis of the US stock indices, Crude oil and natural gas at www.CastAwayTrader.com
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