In the 1920s and 1930s, stock market analyst, Ralph Nelson Elliott, discovered that the stock market, thought to behave in a somewhat chaotic manner, actually has a structure and follows a pattern. He then proposed what is now known as the Elliott Wave theory to explain his findings. So, what is the Elliot Wave theory?
The Elliot Wave theory is a technical analysis principle that states that the price of an asset moves in recognizable wave patterns. Regardless of the direction of the market trend, the waves are classified into two main types: the impulse waves (motive waves), which move in the direction of the trend, and the correction waves (retracements), which move opposite to the trend. These waves can be used to identify the possible direction of price movements in the future.
In this post, we take a look at the Elliot Wave strategy. At the end of the article, we present you with an Elliott Wave strategy.
What is the Elliot Wave strategy (or theory)?
The Elliot Wave theory is a technical analysis principle that states that the price of an asset moves in recognizable wave patterns, which can be used to identify the possible direction of price movements in the future.
Elliot discovered the patterns after studying 75 years’ worth of stock data. Although he released the theory in the 1920s, it gained popularity in 1935 when Elliott made an uncanny prediction of a stock market bottom. The theory has since become an essential element of technical analysis.
In his explanations, Elliott described specific rules governing how to identify, predict, and use the wave patterns. Regardless of the direction of the market trend, the waves are classified into two main types: impulse waves (motive waves) and correction waves (retracements). The impulse waves move in the direction of the trend, while the correctional waves move in the opposite direction to the trend.
Understanding the structure of the impulse and corrective waves
There are specific rules for identifying the impulse and corrective waves.
The impulse waves
Impulse waves consist of five sub-waves (labeled wave 1, wave 2, wave 3, wave 4, and wave 5) whose net movement is in the same direction as the trend of the market. Out of the five sub-waves, three of them are also motive waves (waves 1, 3, and 5), and two are corrective waves (waves 2 and 4). And, each of the sub-waves has its own sub-sub-waves, as you can see in the diagram above.
An impulse wave has three key rules that define its formation:
- Wave 2 can never retrace more than 100% of the first wave
- Wave 3 cannot be the shortest of waves 1, 3, and 5 (the motive sub-waves)
- Wave 4 shouldn’t go beyond the third wave at any time
The violation of any one of these rules invalidates the structure as an impulse wave, so the trader should relabel the waves.
Corrective waves, which are the usual pullbacks or retracements in a trend, consist of three sub-waves that make net movement in the direction opposite to the trend. As the name implies, it is the price correcting itself after overshooting its mean value.
The corrective wave consists of three sub-waves — wave A (a motive wave in the pullback direction), wave B (a corrective wave in the direction of the main trend), and wave C (another motive wave in the pullback direction). Each of the sub-waves has its own corresponding sub-sub-waves. As with the motive wave, each sub-wave of the pullback never fully retraces the previous sub-wave.
What types of traders use the Elliott Wave theory?
The Elliott Wave theory is mostly used by technical traders, which are traders that use charts and other technical indicators to make trading decisions. The theory is often used by traders in the stock, forex, and commodity markets. These include short-term traders, such as day traders and swing traders, as well as long-term investors, who use it to help identify potential buying and selling opportunities.
While pure price action traders may use the theory alone, some technical traders use the Elliott Wave theory in conjunction with other technical indicators, such as trend lines and moving averages, to help confirm their trading decisions. The Elliott wave theory can be used to predict the movement of the market, so traders use it to make decisions on when to buy or sell a security.
What are the advantages and disadvantages of using the Elliott Wave theory?
The advantages of using the Elliott Wave theory include:
- It leads the price and can be used to predict future market trends.
- The theory can be applied to a variety of different markets, including stocks, forex, and commodities.
- The theory can help traders identify potential buying and selling opportunities based on the market’s current wave pattern.
The disadvantages of using the Elliott Wave theory include:
- The theory relies heavily on the interpretation of chart patterns, which can be subjective, as different traders may have different interpretations of the same pattern.
- There is little hard evidence to support the theory.
- The theory was developed in the 1920s and 1930s, and it has not been updated to take into account more recent market data and trends.
What are the key components of the Elliott Wave theory?
The key components of the Elliott Wave theory include:
- Impulse waves: These are the five-wave patterns that move in the direction of the larger trend and are the building blocks of the Elliott Wave theory. They are labeled 1-5.
- Corrective waves: These are the three-wave patterns that move against the direction of the larger trend and are used to correct or retrace the impulse waves. They are labeled a, b, and c.
- Fractals: The theory states that the patterns found in larger time frames also repeat in smaller time frames and fractals.
- Wave degree: The wave degree is a way to categorize a wave based on its position within the larger wave pattern. The wave degree can range from Grand Supercycle wave to Subminuette wave.
- Fibonacci ratios: The theory states that wave patterns often retrace Fibonacci ratios of the length of the previous wave.
How can traders apply the Elliott Wave theory to their trading?
Some ways traders can apply the Elliott Wave theory to their trading include:
- Identifying the current market trend and swings: Traders can use the impulse and corrective wave patterns to identify the current market trend and swing.
- Identifying divergences: Traders can use price swings to identify divergences between the wave patterns and other indicators, which may indicate potential trend changes.
- Identifying potential trade opportunities: Traders can use the wave patterns to identify potential trade opportunities, such as buying at the end of a corrective wave and selling at the end of an impulse wave.
- Setting stop-losses: Traders can use the wave patterns to set stop-losses to limit their potential losses — for example, a trader might set a stop-loss at the end of a corrective wave in anticipation of a move in the direction of the larger trend.
- Setting profit targets: Traders can use the Fibonacci ratios and other components of the theory to set profit targets for their trades — for example, a trader might set a profit target at the 100% retracement level of the previous impulse wave.
What indicators should be used in conjunction with the Elliott Wave theory?
Some indicators that are commonly used in conjunction with the Elliott Wave theory include:
- Moving averages to identify the trend
- Other trend indicators, such as ADX and the Ichimoku cloud
- Relative Strength Index (RSI)
- Momentum indicators, such as the stochastic oscillator or the Moving Average Convergence Divergence (MACD)
- Volume indicators, such as On-Balance Volume (OBV) and the Accumulation/Distribution Line (A/D)
The Elliott Wave theory is a complex and subjective method of technical analysis, and as such, traders may make mistakes when using it to make trading decisions. Some common mistakes to avoid when trading with the Elliott Wave theory include:
- Not allowing for flexibility in wave counting
- Ignoring other forms of analysis
- Not using proper risk management
- ignoring the larger picture
- Not considering other indicators
- Not being consistent in the interpretation
- Not being patient
How do you trade Elliot Wave?
Elliot noted that the wave patterns do not provide any kind of certainty about future price movement but can help you to order the probabilities for future market action. So, if you want to use the Elliot Wave theory in your trading, use it in conjunction with other forms of technical analysis, such as technical indicators.
For example, you can use the moving average indicator to identify the trend and then use the Elliot Wave strategy to track the various price swings. If you are a swing trader, you want to trade the impulse waves/swings in the direction of the trend. So, you first identify the trend with a trend4line or a moving average indicator and then use momentum oscillators, such as the stochastic or RSI, to know when a corrective wave has lost momentum so you can ride the next impulse wave.
What examples of successful Elliott Wave trades can be found?
There have been several examples of successful trades using the Elliott Wave theory. Some notable examples include:
- Dow 2002/2003: In 2002, market analyst Robert Prechter correctly predicted that the Dow Jones Industrial Average would fall from its then-current level of around 11,000 points to below 7,000 points. The Dow Jones Industrial Average did; in fact, it fell to around 7,000 points in March 2003.
- Gold 2011: In 2011, a market analyst correctly predicted that gold prices would reach a peak of around $1,900 per ounce using the Elliott Wave theory. Gold prices did, and in fact, it reached a peak of around $1,900 per ounce in August 2011.
- Bitcoin in 2017: Some market analysts predicted the top of the bitcoin bubble using the Elliott wave theory, and subsequently the price of bitcoin fell from its then all-time high of nearly $20,000 to around $3,000.
What are some of the challenges faced when trading with the Elliott Wave theory?
Some of the challenges you may face when trading with the Elliott Wave theory include:
- Difficulty in identifying and interpreting wave patterns
- Subjectivity in wave counting
- Limited usefulness in ranging markets
- Limited success rate
- Difficulty in predicting market turning points
- Limited use without proper understanding
What are some of the criticisms about Elliott Wave?
Here are some of the main criticisms of the Elliott Wave theory:
- The theory is very subjective, as different traders may have different interpretations of the same wave pattern.
- Critics also argue that the Elliott Wave theory does not have a high degree of predictive power, as the patterns may not get repeated.
- The theory is not based on any scientific evidence, and there is no concrete proof that the market moves in the way the theory proposes.
What timeframe is best for Elliot Wave?
There is no best timeframe for trading the Elliot Wave strategy. It depends on your trading style and personality. If you are a day trader, you would want to trade on intraday timeframes, such as hourly, 30-minute, 15-minute, and so on. But if you are a swing trader, you would have to track the waves on the daily timeframe.
Is Elliot Wave testable?
Unlike many of the other indicators, the interpretation of the Elliot Wave theory is highly subjective, and therefore, almost impossible to backtest Elliot Wave. For example, when there is a moving average crossover or when the stochastic strategy is in the overbought territory, there’s no second guessing.
But that is not the case with the Elliot Wave strategy, which leaves a lot of things to subjective interpretations — where to start counting the waves, which rules to follow, and how to arrive at a trade signal. You see things like wave 3 should never be the shortest, else it becomes an extension of a complex wave 1 or if wave 2 is sharp, wave 4 is compound. A miserable attempt to create a pattern out of randomness.
Can you backtest Elliot Wave?
No, it is extremely difficult, even with AIs and machine learning. The loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude make it difficult to backtest. With loose rules and interpretations, nearly every movement has an interpretation and a subjective trading approach to it.
There is no clearly defined signal to know when trades are to be placed and when to exit them. The lack of specific entry and exit rules makes room for curve fitting.
Elliott Wave trading strategy
Because the Elliot Wave strategy doesn’t lend itself to backtesting, we obviously have not managed to make a backtest (reasons why a backtest works).
In general, because of the lack of objectivity, we believe classical chart patterns (and technical analysis in general) might be a dead end for traders. Why would you spend time on something that is not backtested where you have no clue if the pattern is profitable or not? How do you know a pattern is profitable if you have not backtested it?
A backtest doesn’t guarantee anything, but at least you know it has been profitable in the past. If the pattern has not been profitable in the past, you can safely skip it and not waste any more time. Trading is about having a portfolio of trading strategies, not having one or a few subjective classical chart patterns. There is no best trading strategy because you need many to smooth returns.
(If you are new to backtesting and it looks like a daunting task, you might be interested in our backtesting course.)
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