Elliott wave theory is a trading and investment method in technical analysis developed by Ralph Nelson Elliott in the 1930s. A professional accountant by occupation, he started to research stock market behaviors in his retirement. He came to the conclusion 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.
ELLIOTT WAVE THEORY ESSENTIALS
- Developed by Ralph Nelson Elliott.
- He realized that the market moves in waves.
- The Elliott wave pattern is a 5-3 move, where the first five waves are numbered from 1–5 and the last three are lettered A, B, C.
- Waves 1–5 move the market significantly, while A, B, C represent a price correction.
- The waves appear as a result of human psychology driving the market.
What are waves?
The market never moves steadily. There are always time periods of concentrated heavy buying or selling when an asset sees a significant change in price, followed by a price correction. Elliott named these price changes “waves.” These moves represent the optimism and pessimism in the market, driven by human psychology (we will touch upon this later).
The Elliott wave pattern
The Elliott wave pattern consists of eight waves. The general direction of the first five waves is aligned with the current macro market trend. The last three waves represent a price correction after the first five waves. This is called a 5-3 move, where the number 5 represents the first 5 waves, and the number 3 represents the last 3 waves.
The Elliott wave pattern can be found over various timeframes, from hourly to daily charts and so on. For this reason, an Elliott wave pattern within an Elliott wave pattern can sometimes be found.
5-3 move explained
The first five waves in a 5-3 move are numbered 1, 2, 3, 4, 5. These waves form when the price moves significantly in the direction of a general trend. Waves 1, 3 and 5 are aligned with the market trend, while waves 2 and 4 represent a mild price pullback. Waves 1, 3 and 5 are called impulse waves, as they move the price impulsively and vigorously.
The last three waves in a 5-3 move are labeled A, B, C. These represent a severe price correction, which happens after the peak (or the bottom) of the pattern is reached (wave number 5). Letter A represents the start of a bigger correction, letter B is accompanied by a mild pullback from the letter A movement, and letter C is the final big price correction. Waves A and C are called correction waves, as they significantly correct the price after the initial five waves.
Elliott wave pattern rules
There are three rules that must be fulfilled in the Elliott wave pattern:
- Wave 2 can never retrace more than 100% of wave 1.
- Wave 3 cannot be the shortest of the three impulse waves (1, 3 and 5).
- Wave 4 must not reach the price territory of wave 1.
Mass psychology and wave formation
The 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.
Elliott observed that people react to the market by feeling and intuition, which manifests in the waves predicted by his findings. Even though his theory is over 80 years old, it has proven so useful and potent that it is still considered an important trading and investment method today.