Elliott Wave Theory is a facet of technical analysis used to decipher the pricing charts of equity, futures or currency products. Developed by accountant-turned-analyst Ralph Nelson Elliott in the first half of the 20th century, Elliott Wave Theory (also known as the Elliott Wave Principle) aims to quantify the mass psychology involved in the trade of financial instruments.
The tenets of Elliott Wave Theory attempt to measure degrees of trend extension, market correction and points of reversal. Given its historical track record of success, Elliott Wave has become a popular technical tool among traders and investors alike.
The Elliott Wave Theory first rose to prominence as a trading approach for stocks in the 1930s. After successfully identifying a bear market reversal point for the Dow Jones Industrial Average, Elliott published a treatise on his theory called "The Wave Principle" in August 1938.
Decades later, the Elliott Wave Theory underwent a revival throughout the financial community. Beginning in the late 1970s, technical analysts A.J. Frost and Robert Prechter reintroduced the concept to the public in their book "Elliott Wave Principle: Key To Market Behaviour." In doing so, Frost and Prechter are credited with predicting the 1980s bull market in U.S. equities and the subsequent crash of Black Monday.
Breaking Down The Elliott Wave Theory
The basis of Elliott Wave Theory is that price fluctuates in patterns known as "waves." Each wave is a series of price points, including a periodic high and low value.
According to the theory, individual waves are fractals. Fractals are naturally occurring phenomenon found in nature, each exhibiting characteristics consistent with a collective whole. Examples include lightning, ferns, peacock feathers and shorelines.
The Elliott Wave Theory is a probabilistic methodology, meaning it assigns a specific chance to a future event taking place. It aspires to accomplish this objective by determining two aspects of market behaviour from the analysis of wave patterns:
- Trend Exhaustion: The point at which a market is most likely to make a reversal.
- Trend Extension: The point at which a prevailing trend resumes its course.
In order to simplify the task of studying chart patterns and defining market structure, pricing waves are characterised in one of two ways:
- Impulsive: Impulsive waves move in the same direction as the prevailing trend, and they are composed of five sub-waves in a completed pattern.
- Corrective: Corrective waves move in an opposing direction of the prevailing trend, and they consist of three sub-waves in a completed pattern.
According to Elliott Wave methodology, there are nine distinct pattern sizes or "degrees" of impulsive and corrective waves. Each degree represents a different frame of reference and are viewed in a hierarchy from large to small:
- Grand Supercycle
It is important to remember that both impulsive and corrective waves behave as fractals. Aside from the Grand Supercycle, each is part of a larger pattern as well as being made up of smaller patterns.
Identifying the proper degree and wave count relative to current price action is the key to successfully applying Elliott Wave. It is through this process that a series of trends and corrections may be quantified, and that a future market direction may be predicted.
Although originally developed for stocks, Elliott Wave Theory is popular among traders of cryptocurrencies, futures and forex products. There are a number of different guidelines and ways of applying the principles of Elliott Wave to pricing charts. It may be used on a stand-alone basis or in conjunction with other technical devices such as momentum oscillators or Fibonacci retracements. However, its predictive capabilities typically depend upon the effectiveness of the individual "Elliottician."
Perhaps the most important function that the Elliott Wave Theory performs is that it quantifies current market sentiment. By examining the degrees of various wave patterns, repetitive cycles of investor cynicism to euphoria and vice-versa become clear. Through understanding these tendencies of mass psychology, information useful for crafting timely trading decisions may be determined.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…