Elliott Wave theory

The Elliott Wave theory gained popularity in 1935 when Elliott made a prediction of a stock market bottom. To this day, price fluctuations in the financial markets still pose somewhat of a conundrum for the scientific community. However, in the early 1900s, theorists were already trying to link the markets’ behaviour with nature, an innovative concept known as “biomimicry” and the basis for the Elliott Wave theory.

Ralph Nelson Elliott is still considered by many the only worth successor to Charles Dow in analysing market movements. He not only confirmed Dow’s studies, but also introduced a series of more precise definitions for each market phase. In particular, he added a series of forecasting elements that no longer merely identified market trends (upward or downward), but also calculated achievable price levels. In a similar way to Dow theory, the Elliott Wave theory distinguishes price movements in terms of waves.

Overall, Elliott’s approach aimed to find a synthesis of the laws that govern natural phenomena, of which the stock market is simply an aspect. Elliott placed great importance on the systematic observation of nature in order to grasp its most significant cycles.

The Elliott Wave principle is based on the assumption that each market represents a phenomenon fuelled by economic flows, induced by psychological currents and governed by natural laws. If these were missing, it would not be possible to achieve any balance and the prices would lead to convulsive disorganised fluctuations. The market must be considered a phenomenon created and fed by men and therefore permeated by irrational attitudes that characterise people’s daily lives.

Since the movement of the market prices is the product of human activity and therefore subject to natural rules, it tends to express recurring sequences of bullish and bearish waves, which can be traced back to a general model.

Elliott Wave Theory relates these wave patterns to the mass psychology of investors. Their mood swings and confidence in the market create these price movement patterns, alternating between optimism and pessimism. The market does not record political, social and economic events​, but rather human reactions to these events.

Elliott Wave represents the most famous and historically significant technical analysis tool used for trading forex and other financial markets. Understanding Elliott Wave theory and its numerous variations is an asset for traders, since it is still one of the most effective technical analysis trading tools​ discovered to date.

In his theory, Elliott defined two types of waves: the impulsive wave (which has a structure consisting of 5 waves) and the corrective wave (which has a structure consisting of 3 waves). The basic cycle consists of 8 waves: the first 5 waves create an upward “impulse” movement, whereas 3 sub-waves create a corrective wave. This cycle is endless: each wave can consist of one or more cycles of shorter duration. The complete cycle consists of 34 waves, where each wave can be divided based on the basic cycle.

According to Elliott’s theory, waves that move in tune with the trend are called impulse waves, while those that move against the trend are called corrective waves. We will explore both wave types in more detail below.

Zigzag: If the corrective waves are in a zigzag formation, wave B tends to be the shortest compared with A and C. This depicts steep moves in price, going against the initial trend, and can occur numerous times.

Flat: The flat formation is simpler, as typically the waves are all the same length. A sideways pattern will occur, correcting the impulse waves.

Triangle: Triangle formations are made up of 5 sub-waves, with each side subdivided further into 3 waves, hence forming a 3-3-3-3-3 structure. This may be a combination of complex corrections, including both zigzags and flat formations, and are either converging or diverging trend lines moving sideways. Triangle formations are associated with decreasing volatility and volume, and when the price momentum consolidates, the top and bottom trendlines​ culminate in a single point.

There are three rules that must be adhered to in an Elliott Wave pattern:

Elliott found that financial markets primarily respond to swings in mass psychology. Since human psychology is a constant factor over time, the profound nature of price movements should also remain constant over time, and its theory should, therefore, continue to be proven year after year.

Although appealing on paper, Elliott Wave is often confronted with the reality of financial markets, and it’s not always easy to count the waves without breaking the rules of the theory’s very strict principles. Therefore, some followers of this analysis method opt for a more flexible approach and a freer interpretation of price movements.