An Introduction to Elliot Wave Theory
The Elliott Wave Theory is a technical analysis tool used to describe price movements in financial markets. Ralph Nelson Elliott developed the theory after observing and identifying recurring fractal wave patterns in financial market prices and other data. Equity price movements, according to Elliot's hypothesis, move in repeating and therefore predictable up-and-down patterns or waves. These waves are caused by investor behaviour or sentiment. The interpretation of the theory is subjective, therefore not all investors will interpret it the same way or agree that it is a profitable trading strategy.
Per the theory, there are two wave types in Elliot Wave Theory - motive (or impulse) waves and corrective waves.
1. Impulse phase
A motive/impulse phase comprises of five sub-waves that move in the same direction as the trend of the 'next largest degree'. Of the five sub waves, three are motive waves and two are corrective waves. Its formation is defined by three rules:
If any of these rules are broken, the structure is not an impulse wave.
2. Corrective phase
The corrective phase, also known as diagonal waves, are made up of at least three sub-waves that move in the opposite direction of the trend of the "next-largest degree". Each sub-wave of the diagonal, like in the motive phase, never fully retraces the previous sub-wave, and the third sub-wave may not be the shortest wave. They are often labelled, A, B, and C.
To create larger patterns, these impulse and corrective waves are nested in a "self-similar fractal" - in practical terms like a matryoshka doll. This means that a one-year chart, for example, may show that the price is in a corrective phase, whereas a 30-day chart may show a developing impulse phase. It is therefore possible that an investor utilising Elliot Wave Theory may have a long-term bearish outlook and a short-term bullish outlook (and vice versa).
Fibonacci Ratios and Elliot Wave Theory
The first number in a Fibonacci summation series is zero. Adding 1 to 0 yields the next number. The series is then derived by adding the previous two numbers to get the next number. The Fibonacci summation series is composed of the numbers 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on to infinity.
To calculate a Fibonacci ratio, one Fibonacci number is divided by another. These ratios are used to determine market levels of support and resistance. Fibonacci retracement is the use of Fibonacci ratios to determine where a correction ends so that the primary trend can resume. Fibonacci retracements are used to calculate the depth of a trend's pullbacks. Wave 2 could, for example, be half the length of wave 1.
Fibonacci extensions are another widely used tool. Fibonacci extensions are used to identify pivot points in a primary trend. They indicate where a motive phase can go before a correction in a bull market. They can also be used to determine support levels in a bear market. Fibonacci extensions are used to calculate profit taking levels.
Identifying an Elliot Wave pattern
Elliott recognises the Fibonacci sequence, which aids in the determination of impulse and corrective waves. By drawing a horizontal line based on the previous move, Fibonacci retracements identify areas of support and resistance. The fundamental retracement levels are 23.6%, 38.2%, 50%, 61.8%, and 78.6%. Elliot Waves oscillate in fives and threes - five moves in an upward direction of the main trend (impulse phase), and three moves in the corrective phase.
In practice
Looking at the Top 40 Index to mid-February 2023, a typical wave pattern can be seen marked with the waves labelled as 1, 2, 3, 4 and 5 and then the A, B and C correction. By drawing a "roadmap" (see the red price roadmap), one can anticipate the next price movement.
In closing
Elliott Wave Theory can provide a sense of structure to markets for traders and investors and adds clarity to the art of trend recognition. However, the ability to constantly adjust or shift the theory when a rule is broken can make it difficult to implement practically. It is up to the investor how much complexity they wish to add to Elliott's original rules, but in its essence, Elliot Wave Theory is often front and centre in traders market strategies.
