Introduction
The prevalent impression among investors is that the market is driven by economic factors and forces of demand and supply. These forces indeed make a considerable impact on the marketplace.
However, the market is also affected massively by another important force which is known as human perception. The psychology of investors can make or break the price movement for any trading product. Therefore, investors should learn to read these signs and ingrain them into their trading strategies.
What is Elliot Wave Theory?
Elliot Wave Theory is a technical analysis method that has been designed to do the difficult task of measuring the prevailing market sentiment. In any trading market, there are thousands of investors who are making millions of individual trade decisions based on their mental perception of an asset.
Therefore, it is almost impossible for a trader or a market analyst to measure whether the current perception of a given asset class is positive, negative, or neutral.
Rather than making guesses based on personal experiences regarding a given asset class, the investors are in a much better position if they have the right tools to formally measure the market sentiment and collective psychological force that is governing the market dynamics.
Elliot Wave Theory is a tool that measures long-term price patterns with a view to the market sentiment and investors’ psychology.
How does Elliot Wave Theory Work?
Elliot Waves take its reference from the price movements happening in the market to create a Wave Chart that investors can read. These waves are identified as the psychological changes and variables happening in the marketplace based on the perception of investors.
In simple words, when an analyst is looking at an Elliot Wave graph, they are looking at the presentation of all major and minor changes in the collective perception of asset class based on the collective reaction of all the investors in the market during a given period.
Elliot Waves are divided into two basic types, namely Motive or impulses and Corrective or lettered phase. The Motive waves are the ones that are identified as moving in the same direction as the current market trend.
On the other hand, the Corrective waves are seen as the waves that are moving to oppose the current market trend. With a combination of motive and corrective waves, the analysts can understand the changes in the attitude of the investors as a collective reflection and make tradeoffs based on this information.
Origin of Elliot Wave Theory
Elliot Wave Theory was first introduced by Ralph Nelson Elliot in 1930. He was an investor who was working on refining the method of trading after his retirement on account of an unfortunate disease.
To keep himself busy and productive, he started to delve into 75 years of yearly, monthly, weekly, and daily trading records. He then started to create hourly and 30-minute-long charts based on various market measuring stock indexes at the time. He has already generated a technical analysis pattern during his research and experimentation phase.
However, the Elliot Wave Theory was brought into the limelight when its inventor predicted the stock market bottom of 1935 with increasing accuracy.
Once under the observation of other noteworthy investors and market analysts, this theory started to gain more traction among investors. A collective expression of his works was published in 1994 with the title Elliot’s Masterworks.
Since that time, there are numerous articles, blogs, books, and letters have been penned on the subject to explore its wider applications. It is important to note that Elliot did not make any outlandish remarks about his technical, analytical method of producing accurate market predictions.
On the contrary, he maintained that investors could use his theory for fishing out the important probabilities happening in the marketplace. He also advised the investors to use Elliot Wave Theory in conjunction with other technical analysis tools and techniques.
Types of Elliot Waves
As noted before, the Elliot Wave Theory depends on dividing the wave patterns into different types and conducting technical analysis based on these comparative analytical forces. To understand how this theory works in practice, investors should know about the following basic types of Elliot Waves:
Impulse Waves
Impulse Waves are the founding pattern for the formation of Elliot Waves. These waves are present in a specific number, namely, 5. These five waves move in the same direction as the ongoing trend, either bullish or bearish. This set of 5 sub-waves is the easiest to identify. Each impulse wave can be further broken down into five more subsets.
Out of these five subsets, three are essentially motive waves, while the remaining two are corrective. The Impulse wave pattern should abide by the following principles; otherwise, they cannot qualify as the Elliot Wave Pattern:
- Wave 2 of Impulse cannot retrace greater than 100% of Wave 01.
- The 3rd Wave of the Impulse pattern should not be the shortest one in comparison to Waves 1, 3, and 5.
- 4th Wave cannot go beyond the 3rd Wave throughout Elliot Wave.
Corrective Waves or Lettered
Corrective Waves are also called diagonal waves by analysts. These are a set of 5 sub-waves that are followed by the aforementioned Impulse Wave Pattern. Furthermore, they are characterized by moving in the opposite direction of the ongoing price trend. Sometimes, the total corrective waves do not consist of a total of 5 waves, but they are limited to 3 waves only.
The distinct feature of these corrective waves is that they look like expanding diagonal or contracting wedges. The condition for a diagonal wave is that each new wave can never fully retrace the pattern of the previous diagonal wave.
Furthermore, the sub-wave 3 of the diagonal must never be the shortest wave in the set. Here are three important Elliot Wave Corrective Patterns that every investor should understand:
Zigzag
When corrective waves form a sharp-edged meandering pattern, they are seen as a Zigzag formation. Another sign of this pattern is that Wave B is the shortest in comparison with Wave A and C.
Zigzag patterns indicate smaller changes in prices that are going in the opposite direction of the motive wave trend, and it can take place multiple times.
Flat
The flat formation is very self-explanatory in terms of aesthetics. These waves are more or less the same length. Furthermore, sideways movement for wave A is a very common observation while the correction for impulse is underway.
Triangle
Triangle formation is based on 5 sub-waves in total for a corrective wave pattern. Each wave is then divided into 3 subsets that form a 3-3-3-3-3-3 design. Triangle formation is seen as a complex correction pattern.
Additionally, it can also contain both zigzag and flat corrective waves within it while expanding or collapsing. Triangle corrections are synonymous with a decline in price volatility and trading volume. They take place during consolidation for price momentum and when the top and bottom trends are collapsing into a singular point.
Special Considerations
Elliot created an exception when using Elliot waves in tandem with the Fibonacci sequence. He pointed out that the number of waves, both impulses and corrections, are correlated with the Fibonacci numbers.
As per his observation, the wave connection with price and time was a reflection of Fibonacci ratios like 38% and 62%. In layman’s terms, he noted that when corrective waves retrace, they form 38% of the previous wave.
The impulse and corrective waves are sewn into a sequence of fractals to give birth to larger and more visible patterns. The Elliot Wave graph for a year of price movements can show the middle of a corrective wave.
On the other hand, the 30-day Elliot Wave graph for the same asset can indicate the development of a new impulse wave. Therefore, investors can deduce that the Elliot Wave impression for the market is long-term bearish while bullish in the short-term.
Types of Elliot Wave Fractals
It has been established that Elliot Waves can be divided into both impulsive and corrective types. However, analysts also consider each wave from either Corrective or Impulsive sets as an independent entity. Therefore, when an analyst deconstructs each wave, it can be divided into nine smaller fractals.
Fractals represent the difference in Elliot Wave conclusions based on a variation of time frames. These fractals also allow the analysts to pinpoint the position of each wave under the pretext of overall market progress. Here are these nine Elliot Wave Degrees or Fractals:
- Grand Super Cycle (multi-century)
- Super Cycle (a few decades)
- Cycle (a few years)
- Primary (almost one year)
- Intermediate ( a few months)
- Minor (a few weeks)
- Minute (a few days)
- Minutte (a few hours)
- Subminutte (a few minutes)
Indicators to Use with Elliot Waves
As mentioned by the creators of Elliot Wave Theory, it is not a standalone and foolproof technical indicator for measuring market movements. Therefore, most investors use it in combination with other technical indicators. Here is a list of the most useful technical indicator combos that are paired with Elliot Wave Theory as follows:
Relative Strength Index or RSI
Relative Strength Index or RSI is one technical indicator that is used to measure whether an asset is overbought or oversold. However, RSI readings can merge with Elliot Waves and point in the direction of upcoming price swings. Thereby, the investors can identify the best locations to open a new trading position.
Simple Moving Average or SMA
Simple Moving Average or SMA also has an inverse proportional relationship with the Elliot Wave Indicator. When there is a negative or corrective development within a 50-day SMA, it can point towards a downward trajectory of price. On the contrary, the Elliot Waves are predominantly impulsive during a 50-day SMA; it can signal bullish development.
Moving Average Convergence-Divergence (MACD)
Moving Average Convergence-Divergence or MACD is used to find the relationship between two EMAs. MACD can help the analysts identify the third wave in Elliot Indicator, which is supposed to be the strongest and longest wave in the five-wave structure.
With this, the investors can ascertain if the wave bracket is under development or has completed its course for the period.
Fibonacci Ratio
Fibonacci numbers are founder everywhere in nature. The Fibonacci indicator is useful for locating the reversal points and the stalling areas for any trading product.
In conjunction with the Elliot Wave Theory, the Fibonacci Ratio is used for measuring the target waves within the Elliot Wave structure. The measure of the difference between correcting and retracing Elliot Waves can be classified within the parameters of Fibonacci ratios:
- 2nd Wave could be 50%, 61.8%, 78.6%, or 88.2% size of 1st Wave.
- 3rd Wave can be 161.8% of 1st Wave.
- 4th Wave is usually 14.6%, 23.6%, and 38.2% of 3rd Wave.
- 5th Wave may be within the range of 1.236%-1.168% in inverse proportion to the 4th Wave.
- 5th Wave might also be equivalent of 1st Wave or 61.8% of 1st and 3rd Waves.
Advantages of Elliot Wave Theory
As mentioned before, the Elliot Wave Theory can be a useful tool in the arsenal of a professional cryptocurrency investor. Here are some of its major benefits listed that investors should keep in mind:
Diagnostic Tool
Elliot Wave is a wonderful tool for diagnosing market conditions. Investors who wish to identify profitable trading opportunities can take advantage of this trading strategy.
Rather than going depending a lot on the market dynamics and knowledge of the fundamentals, it can enable the investors to get an accurate picture of price movements and other important changes.
Graphical Representation
Elliot Wave Theory is a type of market representation graph that is likely to be free from any type of data manipulation. The investors can drive different results using the same trading tool based on their perception of the market or the indicators they are using as the baseline.
However, the end product is always going to grant a bird’s eye view of the market enclosed in a simple and visible wave graph that encapsulates several aspects of the market into one singular grid.
Market Psychology
More often than not, when investors wish to get to the real facts about the impression of a certain asset or cryptocurrency, they can face forgeries. Most cryptocurrency aggregators that are free for use are often biased and speculative. Therefore, investors cannot depend fully on a particular indicator or sentiment source.
However, Elliot Wave Theory is a great way to quantify something as intangible as market sentiment and gets a good idea of the collective psychology of the market without getting swept into the herd mentality.
Freedom from Speculation
For the most part, an investor can’t find the same results conducted by two different analysts using the same tools. Therefore, with the implementation of Elliot Wave Theory, the investors can draw their conclusions from the market behaviour and refrain from having to depend on the speculative results that are provided by outside sources.
Furthermore, with EWT, the investors are safe against the harm of the news and media outlets that can cloud their judgment about the true impression of an asset among the investors.
Remedy for Confirmation Bias
It is a human factor to stick with biased opinions and conclusions despite the emergence of new evidence. Even the most trained and experienced investors can fall victim to this vice without realizing it.
Therefore, tools like Elliot Wave Theory are great for removing the unwanted lapse in judgment for both novice and senior investors.
Limitations of Elliot Wave Theory
As mentioned before, no technical indicators should be considered the tool for predicting market movements with 100% accuracy. Here are some limitations attributed to the EWT that can caution investors when they are working with EW indicators:
Uncertain Predictions
The results of the Elliot Wave Theory are often seen as vague and unclear. Rather than granting accurate mathematical answers, EWT results can be open for interpretations based on subjective experiences.
Therefore, this technical indicator is seen as providing mixed or vague results. Furthermore, the end and closing points of waves are also unclear most of the time. There are also instances where the investors are unable to detect the EWT pattern until after it is already passed.
Lack of Accuracy
The main stigma attached to EWT is that it is not a legitimate scientific theory of technical indicators. Therefore, it can lack empirical conviction in its results. At the same time, it is largely difficult to quantify a value like market sentiment with precision.
Despite being one of the earliest tools to attempt to calculate the collective market psychology, the results of EWT do not capture the market sentiment completely.
Precision and Skills
Many investors and brokers do not have sufficient training or qualifications to conduct a reliable EWT analysis. Some investors even claim that the intricate details of this technical indicator system require as much dexterity from the investors as could be expected of a PhD candidate with a specialization in this particular subject.
Conclusion
Elliot Wave Theory forms a crucial part of the Wyckoff Accumulation Theory in addition to the Dow Theory. Investors who wish to improve and increase their skills in trading and market analysis must learn more about these topics.
Using different trading techniques and strategies, investors can learn how to sway the market in their favour and increase their chances of success while mitigating risks.
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