Understanding Elliott Wave Theory

The “Elliott wave theory”, or “Elliott wave principle”, is a form of technical analysis that attempts to analyze financial market cycles and forecast market trends. The theory looks into extremes in investor psychology expressed by highs and lows as well as prices and several other factors. This theory was initially written about by Ralph Nelson Elliott in 1938 in his book The Wave Principle.

The Elliott wave principle suggests that the collective psychology of investors, known as crowd psychology, moves between optimism and pessimism and somewhat natural sequences. The psychological ebb and flow will be evident in the pricing of markets over the longer-term.

Impulsive and corrective waves

In his theory, Elliott said that prices would alternate between impulsive and corrective phases on all timescales in an uptrend. Impulses going with the overall trend are divided into a set of five smaller waves, alternating again between the impulsive and corrective character, making waves one, three, and five impulsive, going with the trend. This makes waves two and four corrective waves, or minor corrections in the overall trend. In the end, this makes for three waves higher, and two waves lower in and uptrend, and of course the reverse in a downtrend.

There are a several basic rules and guidelines that you must follow, followed by a much more complex set of guidelines for a purist. In its most basic form, Elliott wave demands the following:

  • wave two will never retrace more than all of wave one

  • wave three cannot be the shortest of the impulsive waves, which are waves one, three, and five

  • wave four doesn’t overlap with the price territory of wave one

One well-known addition to this is that a guideline known as “alternation” observes that in the typical five wave pattern, waves two and four often take the alternate forms of the other corrective waves. For example, if the second wave is a sharp correction, the fourth wave is quite often very mild in speed, and complex in structure.

In its most simple form, Elliott wave analysis expects this type of pattern in and uptrend:Elliot Wave Theory TRY/JPY

As you can see, on this daily chart of the Turkish lira versus Japanese yen currency pair, I have clearly marked a downtrend with five waves based upon Elliott wave principle. The third wave, which is the longest wave on this chart, is quite often the most impulsive wave, and where most of the profits are collected. Notice that the blue corrective waves, waves two and four, are shorter than the impulsive downtrend waves.

Although possible to use on all time frames, longer-term charts are more reliable.

Although it’s possible to use Elliott wave analysis on shorter-term charts, as with all technical analysis, it tends to be more reliable on longer-term charts. This is because it takes much more information and trading volume to move those longer-term charts, thereby making a move a little bit more believable because it takes so much more effort to procure the up or down trend. There are some people that will use Elliott Wave for short-term charts, but those are rare traders, and quite frankly the theory is a bit subjective for those types of trades. Remember, Elliott Wave was initially started for stock trading, which is quite a bit more forgiving than something like short-term scalping or the currency markets if you are highly leveraged.

There can also be eight waves, or even more

There can also be eight waves through the move, so it makes sense to take a look at that possibility. In these more complex patterns, there are five impulsive waves, labeled one through five, while there are three corrective waves labeled A, B, and C.

Beyond that, there can be impulsive and corrective waves within a larger impulsive wave. For example, you could have five waves within each of the larger three waves that make up the impulsive move. This is really nitpicking the entirety of the pattern and it focuses more on short-term theory. It would seem likely that most traders do not want to get bogged down in some of the minutiae that this theory can bring into play, and thus it would be better to apply the Elliot wave theory to longer time frames only.

In the following chart, we divide up a third wave into the five smaller pieces that make up the longer-term impulsive wave itself. You can see that the impulsive parts of the third wave are red, with the corrective parts blue. This is all within the third wave of a much larger move. This chart demonstrates exactly how complex Elliott wave theory can be, which is unfortunately why it tends to drive a lot of retail traders away.

Complex Elliot Wave Theory

Does it work?

The jury is out on Elliott wave theory for some people, but others swear by it. Quite frankly, the biggest complaint is that it’s almost impossible to know when you are simply correcting or if the wave is breaking down even further. This complexity often has people looking for other alternatives. It does seem to work out better on longer-term charts, but the question then becomes whether or not there is any predictive quality? There is a big debate about that in the technical analysis world, as it is quite easy to draw these patterns after the fact; knowing what you’re going through in real time is more of a subjective art than it is some type of hard technical standard.

For those looking to keep trading simple, Elliott wave certainly is not the way to go. For those who wish to jump into the minutiae of market movement and psychology, it does serve as an interesting tool. It is well known on Wall Street and is used by a lot of technical analysts, but it certainly has its detractors. There is a running joke, “if you get five Elliott wave traders in the same room, you’ll get five different Elliott Wave counts.” Unfortunately, there is a bit of truth to that joke at times, and therefore it should be thought of as nothing more than another tool that gives you the odds of a trade working out, not necessarily the “holy grail” of Forex trading theory.

Christopher Lewis has been trading Forex for several years. He writes about Forex for many online publications, including his own site, aptly named The Trader Guy.

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