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:

• impulses that create a directed trend (bull or bear) and cause the market to move very actively (waves 1, 3, 5, А, С in Fig. 1);
• corrections (rollbacks) that are characterized by moving against the trend (waves 2, 4, В in Fig. 1).

Figure 1. A part of bear trend.

In 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.

The 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.

The 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 Numbers

Fibonacci 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.

Figure 2

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

In the 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.