Elliott Wave Theory
The Elliot Wave Theory represents a development of the well-known
Dow theory. It applies to any freely traded assets, liabilities, or
goods (shares, obligations, oil, gold, etc.). The Wave Theory was
proposed by accountant and business expert Ralph Nelson Elliott in his
study titled "The Wave Principle" published in 1938.
After he had retired and a serious illness had been discovered in
his organism, Elliott started to observe stock markets and their charts
in the hope of understanding the market behavior. After he had
performed a large work, he concluded that the market, being a product
of predominant psychology of the masses, followed some laws.
The Elliott Wave Theory is based on a certain cyclic laws in human
behavior psychology. According to Elliott, the market price behavior
can be clearly estimated and shown in the chart as waves (wave is here
an explicit price move). The Elliott Wave Theory says that the market
can be in two large phases: Bull Market and Bear Market.
Elliott proposes, as well, that all price moves on the market are divided into:
- five waves in the direction of the main trend (waves 1 to 5 in Fig. 1);
- three corrective waves (waves A, B, C in Fig. 1).
The waves are divided into:
his Wave Theory, Eliott was based on the waves subdivision principle.
This means that every wave is a part of a longer wave and is subdivided
into shorter waves itself (Fig. 2). Every wave is subdivided into 3 or
5 waves. This subdivision depends on the direction of the longer wave.
main principle in the Elliott's theory is that every impulse wave
consists of five shorter waves and every corrective wave (against the
trend) is composed of three waves, which can be well seen in Fig. 2.
For example, Wave 1 in Fig. 2 is composed of 5 shorter waves since it
is an impulse wave that creates the trend.
The longest cycle,
according to Elliott, is called Grand Supercycle that is compose of 8
Supercycle waves. The latter ones are each composed of 8 Cycles, etc.
For example, Fig. 2 shows 3 basic cycles. It can easily be seen that
impulse waves and the subsequent corrective waves are proportional. The
stronger impulse is, the stronger correction is, and vice versa.
Elliott Wave Theory is criticized for there is not always a clear
definition of when a wave starts or ends. Corrections are especially
difficult in this regard.
Elliott Wave Theory and Fibonacci NumbersFibonacci Numbers
provide the mathematical foundation for the Elliott Wave Theory.
Fibonacci numbers play an important role in the construction of the
complete market cycle described with the Elliott's waves. Each of the
cycles Elliott defined are comprised of a total wave count that falls
within the Fibonacci number sequence.
Under closer examination
of Fig. 2, one can notice that the complete market cycle is composed of
two large waves, eight middle waves, and 34 small waves. Similarly, at
a bull market, we can see that a bull Grand Supercycle is composed of
one large wave, five middle waves, and 21 small waves. If we continue
this subdivision, we will be able to observe the consequent 89 even
smaller waves, etc.
Respectively, a bear Grand Supercycle is
composed of one large wave, three middle waves, and 13 small waves. At
the next sublevel, there are 55 very small waves, etc.
This principle is normally used in the Elliott
Wave Theory as follows: movement in a certain direction should continue
until it reaches some point in concordance with the summational Fibonacci number sequence
For example, if the time, during which the trend does not change,
exceeds 3 days, this direction should not reverse until the 5th
day begins. Similarly, the trend should continue up to 8 days if it has
not changed the direction within 5 days. 9-day trend should not be
completed until the 13th day begins, etc. This basic pattern of how the
trend movements can be calculated equally applies for both hourly,
daily, weekly, or monthly data. However, this is just an "ideal model",
and nobody can expect that prices' behavior will be so definite and
predictable. Elliott noted that deviations could happen both in time
and in amplitude and individual waves would hardly develop exactly in
these regular forms.
Characteristics of Waves
Calculations within the Elliott Wave Theory
resemble a road-map. Every wave has a set of characteristics. These
characteristics are based on market behavior of masses.
Elliott Wave Theory, a special attention is paid to individual
description of each wave. Besides, there are certain laws used for
proportional formations of Elliott waves (Fig. 3). These laws enable
proper definition of where the wave starts and how long it is. The wave
lengths are measured from high to low of the corresponding wave.
||Classical Relations between Waves|
|| 0.382, 0.5, or 0.618 of Wave 1 length|
|| 1.618, 0.618, or 2.618 of Wave 1 length|
|| 0.382 or 0.5 of Wave 1 length|
|| 0.382, 0.5, or 0,618 of Wave 1 length|
|| 1, 0.618 or 0.5 of of Wave 5 length|
|| 0.382 or 0.5 of Wave A length|
|| 1.618, 0.618, or 0.5 of Wave A length|
The above classical relations between waves are
confirmed by actual ones with a 10%-error. Such error can be explained
through short-term influences of some technical or fundamental factors.
In whole, the data are rather relative. Important is that all relations
between all waves can take values of 0.382, 0.50, 0.618, 1.618. Using
this, we can calculate relations between both wave heights and wave
lengths. Let us consider characteristics of each wave:
- Wave 1
Happens when the «market psychology» is practically
bearish. News are still negative. As a rule, it is very strong if it
represents a leap (change from bear trend to the bull trend,
penetration into the might resistance level, etc.). In a state of
tranquillity, it usually demonstrates insignificant price moves in the
background of general wavering.
- Wave 2
Happens when the market rapidly rolls back from the
recent, hard-won profitable positions. It can roll back to almost 100%
of Wave 1, but not below its starting level. It usually makes 60% of
Wave 1 and develops in the background of prevailing amount of investors
preferring to fix their profits.
- Wave 3
Is what the Elliott's followers live for. Rapid
increase of investors' optimism is observed. It is the mightest and the
longest wave of rise (it can never be the shortest) where prices are
accelerated and the volumes are increased. A typical Wave 3 exceeds
Wave 1 by, at least, 1.618 times, or even more.
- Wave 4
Often difficult to identify. It usually rolls back
by no more than 38% of Wave 3. Its depth and length are normally not
very significant. Optimistic moods are still prevailing in the market.
Wave 4 may not overlap Wave 2 until the five-wave cycle is a part of
the end triangle.
- Wave 5
Is often identified using momentum divergences.
The prices increases at middle-sized trade volumes. The wave is formed
in the background of mass agiotage. At the end of the wave, the trade
volumes often rise sharply.
- Wave A
Many traders still consider the rise to make a
sharp come-back. But there appear some traders sure of the contrary.
Characteristics of this wave are often very much the same as those of
- Wave B
Often resembles Wave 4 very much and is very
difficult to identify. Shows insignificant movements upwards on the
rests of optimism.
- Wave C
A strong decreasing wave in the background of
general persuasion that a new, descreasing trend has started. In the
meantime, some investors start buying cautiously. This wave is
characterized by high momentum (five waves) and lengthiness up to
1.618-fold Wave 3.
Unfortunately, Elliott's waves are well observed in the "old"
market, but they are rather dimmed for the future. This is why
practical use of the Elliott Wave Theory is often difficult and
requires special knowledge.
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