What is Elliott Wave Theory? A Comprehensive Guide

A professional accountant by occupation, he started to research stock market behaviors in his retirement. He concluded that the market always moves in “waves,” whether during an uptrend or downtrend. He published his findings in a book called The Wave Principle in 1938, where he introduced what has since become known as the “Elliott wave theory” to the world.

Of note, even though the Elliott Wave Theory was discovered using the traditional stock market, this methodology is also used by crypto traders.

The origins of Elliott Wave theory

Ralph Nelson Elliott's research focused on identifying recurring patterns in market data. He believed these patterns reflected the collective psychology of investors, which drives market cycles of optimism and pessimism.

His theory aimed to provide a framework for understanding and predicting these cycles.

Understanding Elliott Wave Patterns

The core concept of Elliott Wave Theory is that market prices move in specific patterns called "waves."

These waves represent time periods of concentrated heavy buying or selling when an asset sees a significant change in price, followed by a price correction, representing the optimism and pessimism in the market driven by human psychology.

The basic Elliott Wave pattern consists of eight waves: five "impulse waves" that move in the direction of the main trend, followed by three "corrective waves" that move against the trend. This is known as the 5-3 wave structure.

The 5-3 wave structure (impulse and corrective Waves)

The 5-3 wave structure represents one complete cycle within a larger trend.

Impulse Waves (1, 3, and 5)

The impulse waves represented in Elliott wave theory form as a result of psychological factors influencing investors and traders.

• Wave 1 is often formed by the smallest number of people, as this is the initial wave and most of the people usually stay in denial of the upcoming price changes.
• Wave 3, usually the strongest wave, is formed by many people joining the ride in the market trend.
• Wave 5, the final wave in the market’s trend direction, forms when all the late traders and investors start buying (or selling – in a bear trend) an asset. However, irrational and emotion-based trade execution (FOMO) has tricked them, as after wave 5 there comes a significant ABC correction, which would offer traders a much better buying or selling price.

Further, there are three rules that must be fulfilled in the Elliott wave pattern:

1. Wave 2 can never retrace more than 100% of wave 1.
2. Wave 3 cannot be the shortest of the three impulse waves (1, 3 and 5).
3. Wave 4 must not reach the price territory of wave 1.

Corrective Waves (A, B, and C)

Corrective waves move against the main trend, representing periods of consolidation or retracement.

• Wave A: The first corrective wave, often sharp and sudden, as early trend followers take profits.
• Wave B: A temporary retracement against wave A, creating a "false hope" for trend continuation.
• Wave C: The final corrective wave, completing the correction and often reaching new lows (in an uptrend correction) or new highs (in a downtrend correction).

Elliott Wave Theory and Fibonacci relationships

Another aspect of Elliott Wave Theory is its connection to Fibonacci ratios. Fibonacci retracements (38.2%, 50%, 61.8%) and extensions (161.8%, 261.8%) are used to predict the potential targets for wave terminations. For example:

• Wave 2 often retraces 38.2% or 61.8% of wave 1.
• Wave 3 is often 1.618 times the length of wave 1.
• Wave 4 often retraces 38.2% of wave 3.
• Wave C is often equal in length to wave A.

These ratios provide potential price targets and help traders anticipate where waves might end.

Limitations of the Elliott Wave Theory

While Elliott Wave Theory can be a valuable tool, it has limitations, such as:

• Subjectivity: Interpreting Elliott Wave patterns can be subjective, leading to different interpretations by different analysts.
• Real-Time Application: Identifying waves in real-time can be challenging, as patterns can evolve and change.
• No Guarantee of Success: Elliott Wave Theory is not a foolproof system and does not guarantee profitable trades.

Elliot Wave Theory essentials

• Elliott Wave Theory, developed by R.N. Elliott, proposes that market prices move in predictable patterns of eight waves—five impulse waves aligned with the main trend and three corrective waves against it—reflecting cyclical shifts in investor psychology.
• The 5-3 wave structure is governed by three key rules (Wave 2 < 100% of Wave 1; Wave 3 not the shortest impulse wave; Wave 4 not overlapping Wave 1) and is often analyzed in conjunction with Fibonacci ratios to project potential price targets and wave terminations.
• While a valuable tool for technical analysis, Elliott Wave Theory is subjective in interpretation, challenging to apply in real-time market conditions, and does not guarantee trading success, making it essential to consider its limitations.