Asset markets may seem quite unpredictable, as one can never be sure as to the next price move. However, many attempts have been made to prove otherwise and identify the patterns standing behind the asset price formation. Today, we would like to highlight the Elliott Wave Theory by Ralph Nelson Elliott. It was developed in the 1930s and remains relevant applied by traders worldwide.
Elliott believed that asset value was greatly influenced by investors’ psychology. He established a correlation between swings in investors’ emotions and price action, with both following the so-called cyclic fractal patterns or waves. Fractals are math structures that are self-similar at various scales. Elliott stated that market prices are also based on repetitive patterns that can be useful for predicting future market moves.
Wave patterns to identify future market trends
The Wave theory allows making detailed price predictions building upon specific characteristics. An impulse wave invariably includes five patterns and follows the same direction as the main trend does. A corrective wave, by contrast, moves in the direction opposite to the larger trend. On a smaller scale, each impulsive wave contains another five waves, infinitely repeating itself.
The fractal structure of financial markets discovered by Elliott was proved mathematically only decades since its introduction. The key principle is, the rise is always followed by the fall and vice versa. In terms of finances, it means prices are subject to trends, showing the price direction and corrections, moving against the trend.
Elliott Wave theory explained
Let’s consider the theory in detail:
- The first five waves go in line with the larger trend, while the other three oppose it, representing a correction. Such a 5–3 move makes two subdivisions of the next higher wave move.
- The basic 5–3 pattern doesn’t change, although the interval of each wave may differ.
The chart below illustrates the price move formed out of impulse (five) and correction (three) waves marked as 1, 2, 3, 4, 5, A, B, and C.
The waves labeled with numbers show an impulse, while those marked with letters show a correction. The corrective wave usually includes three different price moves: 2 and 4 form a correction, A and C go in line with it, whereas B opposes it.
The next chart illustrates the structure of the mentioned waves:
Impulsive waves A and C include five waves, while B moves against the main trend, is corrective and consists of three waves. As is seen, five waves don’t necessarily go net upward, and the same is true about three waves, not always going net downward.
There’re nine degrees overall, indicated as follows, in descending order:
- Grand Supercycle
Considering the fractal structure of the waves, they may be smaller or bigger than those presented above.
To make use of the theory, a trader should spot an impulse wave of the positive trend, open a long position, and then go short before the pattern completes five waves, signaling the reversal.
Elliott Wave theory is a go-to trading tool that allows developing a better understanding of how the asset market works. Like any other method, it has both advocates and opponents. Wave theory practitioners highlight that the fractal market nature doesn’t make it predictable. Besides, they believe that chart misinterpretation is to be blamed for others’ failures.
The detractors of the theory state it’s impossible to predict how long a wave will take to complete, making the tool hardly reliable. That said, the Wave theory is still applied globally and is found useful by many traders.
Try putting the theory into practice yourself and reach new heights in trading!