Last Updated on September 22, 2022 by Oddmund Groette
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.
At the end of the article, we present you an Elliott Wave strategy.
In this post, we take a look at the Elliot 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.
Source: Corporate Finance Institute
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.
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 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 test. For example, when there is a moving average crossover or when the stochastic 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 back-test 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 back-test. 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
An Elliott Wave trading strategy is coming soon.