Elliott Wave Principle

Fundamentals · Sep 26, 2019

Elliott wave principle is a fundamental way of analyzing and predicting price trends in technical analysis.

Illustration

In this article, we’ll explain how the Elliott wave principle works in theory and explore why it has been criticized in recent years.

What is the Elliott Wave Principle?

Ralph Nelson Elliott, a professional American accountant, in 1938 published a book named “The Wave Principle”, where he proposed a model which he thought can explain how the financial market works.

His ideas were formulated earlier in the 30s when he developed a number of tools related to his discovery.

Ralph Elliott argued that any asset on any market behaves in a similar way due to the fact that all market operations are executed by people, and people act according to certain behavioral and phycological patterns. One particular discovery of his was the claim that the price of an asset usually moves in waves: after a rise, there should come a fall (a correction). In his view, those patters were not random or based on news or on some other fundamental factors like income reports. He thought that those movements depend simply on human nature and, to some extent, on Fibonacci sequence.

Five Wave Pattern and its Rules

The core of his theory is the Five Wave Pattern, which you can obverse on the illustration above.

This is a very typical pattern of a price movement and it’s a common sign of a trend (a bull or a bear trend).

Here is how an asset price supposed to move according to Elliott’s pattern:

  • Wave 1 - the 1st wave is very hard to observe and to catch.
  • Wave 2 - the 2nd wave is a correction of the 1st one, but it never goes beyond that.
  • Wave 3 - the 3rd wave is usually the strongest and the longest one. It repeats the 1st wave but goes much further.
  • Wave 4 - the 4th wave is a correction of the 3rd one, it goes back approximately by 40% of the wave 3.
  • Wave 5 - the 5th wave is the final movement towards the trend, but it’s weaker than the 3rd one.

This pattern can be seen on many time scales: minutes, hours, days or years.

Also, one wave that belongs to a big pattern can include a number of smaller waves in a smaller dimension.

Why do We See Those Patterns Often?

Ralph Nelson Elliott was definitely onto something: the fact that the price movement always has a correction and the opposite movement against the trend is how financial markets appear to function. Elliott was right that asset prices reflect on the consciousness of all market players, thus human psychology most certainly plays an important role in price moves.

The Elliott Wave Principle in some sense is even close to the basic laws of physics:

“Third Law: For every action, there is an equal and opposite reaction.”

When the price of an asset goes too high for a long period of time, people tend to question if it’s a fair price and some market participants may start to play against the market. As the trend continues, it gets even more resistance and, at some point, it has to turn around.

➤ Read also: Support and Resistance in Technical Analysis

Of course, the price can’t always go up in a straight line, there will be waves, and, after a wave moving in one direction, the next one will probably move towards the opposite direction, therefore some kind of a back and forth movement is inevitable.

Usage of the Elliott Wave Principle

The Elliott Wave Principle was discovered a while ago yet it’s still quite popular among active day traders and beginners who try to “surf” on those waves hoping to catch a good one.

Usually, the trading strategy would be to determine on what stage of the pattern the price stays at the moment and then to open market positions with a hope that the price will move according to the principle. The problem often is that Elliott’s pattern can be very hard to notice at an early stage. It’s quite visible on a historical graph and, indeed, there are billions of those patterns that look exactly as the principle states, but those graphs are visible only post factum. During the real trading, those patterns are much harder to spot. The Elliott Wave Principle is often used with some other indicators: historical price levels, volatility metrics, changes in trading volume, other chart patterns, etc.

Why is This Principle Criticized?

The main point of the Elliott Wave Principle critics (Benoit Mandelbrot, Robert Prechter, and many others) is that it’s subjective. The pattern described by Elliott can be seen very often on historical graphs, yet it’s very difficult to notice during the real-life trade. One wave can be a start of the cycle, but it also can be something else depending on the scale and the graph’s time period. Some analysts even called the Elliott Wave Principle a bogus theory, others refer to it as a kind of magical thinking.

Should I Use the Elliott Wave Principle?

The Elliott Wave Principle stays relevant to this day at least because some traders still base their actions on it. If many active traders look at the price graph and try to see the start of the wave 3 or 4, they would also act in a predictable fashion and you would often see a reaction when the price gets close to what many people can see as a point of Elliott’s pattern.

So, Elliott’s Principle should be studied just because there are many people who believe that the turn of the price will be at a particular point based on this principle. A better way to apply this theory would be in a combination with many other indicators, chart patterns, news, ideas and findings from the fundamental analysis. Relying solely on the Elliott wave principle can be extremely dangerous.

We should also note that the tendency of an asset price to bounce back does not validate nor contradict Elliott’s principle. Asset prices tend to “return to the mean” in the long-run (we’re talking years and decades here, not a day trader’s intervals). Thus, a period of “abnormally” high returns are likely to be followed by a period of low returns and it has nothing to do with Elliot’s theory.

You can check the great book by Jeremy Siegel for more information.

analytics   finance   indicators   investing   portfolio   strategy   trading   trends   technical analysis

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