Elliott Wave Theory: Rules and Principles (2024)

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Elliott Wave Theory is an interesting tool used by technical traders in financial markets around the world. Commonly called the Elliott Wave Principle, this theory enables traders to catch tops and bottoms in the market.

The theory was developed in the 1920s by Ralph Nelson Elliott, a successful American accountant and author from Kansas. Elliott introduced the theory in his book titled “The Wave Principle“. Robert Prechter, a financial author and stock market analyst, later popularised the theory in the 1970s.

Elliott Wave Theory can be used to identify market tops and bottoms. A top refers to the highest price an asset (or an entire market, as measured by a benchmark index) trades at over a given period of time. A bottom is the lowest price an asset trades at over a particular period of time.

This guide explains the Elliott Waves Theory, impulsive and corrective waves, how to read the waves, and their benefits and limitations.

What is the Elliott Wave Theory?

The Elliott Wave Theory is a mathematical approach to explaining trends and cycles in the stock market with investor psychology. It is based on Elliott’s observation that crowd behaviour, or collective investor psychology, trends and reverses in a distinct sequence. According to him, these mood swings form repeatable patterns that can be plotted on a graph.

Elliott developed this theory after analysing decades of stock market data, including annual charts and 30-minute charts. He opined that bull markets tend to rise in five waves (impulsive waves) – up, down, up, down, up – followed by a three-wave correction (corrective waves) – down, up, down.

How to Read Elliott Waves

To read Elliott waves, you need to identify impulsive waves and corrective waves on a chart. Impulsive waves are labelled 1-2-3-4-5, while corrective waves are labelled A-B-C.

Impulse waves

Wave 1

The first wave is highly unpredictable and volatile because it is an onset of the trend strength in the previous time frame. It largely triggers bearish sentiment, negative interpretation of forecasts, and ripples of bad news.

Wave 2

This wave also has negative sentiment. However, things begin to tilt towards the green side. It is important to keep in mind that this wave can’t move beyond the starting point of the first wave.

Wave 3

This is the most fierce wave. It brings positivity in sentiments and forecasts, with high prices and overpowers the negative outlook of the previous waves.

Wave 4

The fourth wave is the onset of lower trade volumes, with prices moving sideways. Things go back to the normal stage once this wave comes to an end.

Wave 5

The fifth wave brings bullish forecasts and sentiments. However, this wave has a lower trade volume than wave three.

Corrective Waves

Wave A

This wave creates positive news for the market. Analysts are still analysing the changes while prices stabilise and trade volume goes up.

Wave B

Stock prices go inverse at a high point, creating an illusion of the dominance of the bull market. However, volume becomes lower compared to the previous wave.

Wave C

This wave signals the start of the bear market. It symbolises wave A and has rising trade volumes.

Advantages of Elliott Wave Trading

Elliott Wave Theory is a useful tool that is often used to spot prospective trade opportunities. As a diagnostic tool, it offers a structure for arranging price data into understandable, graphical representations.

Keep in mind that the relevance of this theory to trading is stronger when a large group of traders is keeping an eye on the patterns and basing their trades on them.

Drawbacks of Elliott Wave Trading

While the Elliott Wave Theory offers some important benefits to traders, it also has limitations that might cause problems and result in incorrect findings during trade analysis. First, this theory is more subjective in its pattern identification compared to Fibonacci patterns and comparable techniques that provide traders with specific thresholds and ratios to watch.

Secondly, the price fluctuations that define the beginning and end of a wave often differ from one trader’s interpretation to the next. Therefore, traders have to detect these patterns on their own, thus making this theory seem too arbitrary to offer consistent trade recommendations.

Moreover, you may lose touch with the real-world forces that cause price fluctuations if the patterns become so constructed in your mind.

FAQs

Conclusion

Investors can benefit from Elliott Wave’s underlying idea that markets move in predictable, repetitive waves or cycles and can be forecasted and measured using Fibonacci numbers. These waves are generated by investor psychology and sentiment.

By applying the Elliott wave theory, you can know what the market is likely to do next and what it will not do.

However, this theory works best when used alongside some other forms of technical analysis, or technical indicators to pick up and benefit from specific opportunities.

Traders often combine Elliott Wave trading with indicators such as the average directional index (ADX) and relative strength index (RSI) to overcome some of its limitations.

Thadeus Geodfrey

Is a regular dad trying to be smart about how we play and win in this big game of life. He has worked within the very best of the financial industry producing numerous training resources. He is an experienced copywriter with immense financial background. Now earns a full time living as a Trader, and as our writer.

His articles help everyday families build sustainable wealth, stop stressing about their financial security, and start living the life they’ve always wanted.
If he is not trading or writing, he is at the gym.

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