Elliott Wave Theory

The Elliott Wave Theory is considered one of the ‘holy grails’ in the financial markets. Developed in the 1930s by Ralph Nelson Elliott (and named after him), Elliott Waves are essentially a law of nature that describe how the collective psychology and sentiment of market participants drive the demand and supply of underlying assets.

Ralph opined that it is possible to discern extreme behaviours of market participants and thus, predict the start, continuation or end of different market cycles with investable accuracy. The Elliott Wave theory explains how market sentiment shifts between optimism and pessimism, simultaneously manifesting in the supply and demand of an underlying asset’s price.

Broadly, Elliott Waves are made up of impulsive and corrective phases. Ralph detailed that in trending markets, the impulsive phase will consist of 5 waves whereas the corrective phase will consist of 3 waves, with all the waves alternating between impulse and correction.

Generally, impulsive waves move in the direction of the main trend, whereas corrective waves move opposite to the trend. When understood, Elliott Waves help traders to put the prevailing price action into context so as to take advantage of possible future moves.

Elliott Wave Principles

As mentioned above, prices in trending markets move in a 5-3 wave pattern. The first 5 waves (impulsive) are labelled 1-2-3-4-5, while the last 3 waves (corrective) are labelled a-b-c.

*The explanation below assumes a bull market. In bear markets, the opposite applies.

Impulsive Waves

The impulsive waves describe investor sentiment as follows:

• Wave 1
  This is the start of a bullish trend. Prices are low and early contrarian investors consider the market oversold and cheap. There is a slight uptick in prices with minimal volume driving demand higher.
• Wave 2
  This is the first corrective wave of the impulsive phase. Wave 2 corrects the movement of Wave 1. In terms of investing psychology, Wave 1 investors are still fearful, and some are keen to book profits of the initial higher surge. This triggers the corrective move. As a rule, Wave 2 can never go below the low of Wave 1.
• Wave 3
  This is an impulsive phase, and by now, the underlying asset has caught the attention of investors who view it as undervalued. The underlying asset’s fundamentals are also coming in positive and investors drive up demand aggressively. This is one of the biggest trending waves and it attracts the ‘crowd’ as prices continue to push higher. As a rule, Wave 3 will never be the shortest of the first three waves and will always go beyond the high of Wave 1.
• Wave 4
  This is the second corrective wave of the impulsive phase. With a previous high breached, profit-taking is bound to happen. This is the trigger for Wave 4. But investor sentiment is bullish overall, and the correction lacks sufficient volume to sustain a bigger bearish movement. As a rule, Wave 4 cannot overlap with Wave 1. This means that the low of Wave 4 cannot breach the high of Wave 1.
• Wave 5
  This is the final impulsive wave of this phase. Investors’ sentiment is very bullish and Wave 4 triggered huge demand to a now ‘very informed’ investor crowd.

Corrective Waves

After Wave 5 of the impulsive phase, early contrarian investors now deem the market way overpriced and this triggers the a-b-c corrective phase.

The waves describe investor sentiment as follows:

• Wave A
  This is the first impulse bear move of the corrective phase. Investor sentiment is still bullish but very cautious. The inherent fear drives prices downwards.
• Wave B
  This wave corrects the impulsive bear move by Wave A. Some investors may still consider this wave as a return to the previous dominant bull trend, but Wave B is backed by low volume and fails to take out the high of Wave A.
• Wave C
  Prices tumble and investors now realise that the market is now in bear mode. Usually, Wave C extends beyond the low of Wave A. An important principle to understand about the Elliott Wave theory is the view that waves can and indeed exist within waves. Impulsive waves will be composed of 1-2-3-4-5 sub-waves and corrective waves will be made of a-b-c sub-waves and so on. As well, Elliott Waves also affirm that markets are fractal in nature, and the waves can be analysed in any timeframe or market.

Elliott Waves and Fibonacci

Elliott Waves work fundamentally using Fibonacci principles, which is no surprise considering both tools are considered ‘laws of nature’. Elliott Waves seek to place the constant ebb and flow of the market into discernible patterns that can enable the easy forecast of future price action.

But it is the Fibonacci tool that provides the mathematical basis for establishing definitive price zones, where a wave can start from or end.

The Fibonacci tool draws retracement and extension levels when plotted. Fibonacci retracements show where a retracing move may end so prices can resume in the direction of the trend, whereas Fibonacci extensions attempt to forecast where trending moves may reach before retracing or reversing. It is essentially the Fibonacci levels that traders observe so as to take advantage of Elliott Wave trading opportunities.

Elliott Wave Trading Opportunities

The wave principles discussed above guide how investors take advantage of Elliott Wave trading opportunities. Typically, it is easier to identify trading opportunities in the direction of the main trend during the impulsive phase rather than attempting to catch the a-b-c phase.

Here are examples of how to implement Elliott Wave trading opportunities:

• Wave 3 and Wave 5
  Since Wave 1 represents the beginning of a trend, investors can seek to ride Wave 3, which is also one of the longest waves in the cycle. To time the start of Wave 3, traders will watch out for the end of Wave 2 (which cannot go below Wave 1). This is where the Fibonacci retracement tool comes in. The retracement levels to watch out for are 23.6%, 38.2%, 50% and 61.8%. The retracement levels represent possible support zones (in a bull market) where Wave 3 will kick-off. The same can be applied when trading Wave 5, which will involve watching where the corrective Wave 4 will end.
• Placing Stops and Take Profits
  In investing, a solid exit strategy will ensure profit maximisation and risk minimisation. Elliott Waves help in placing optimal stop loss and take profit points. For instance, when trading Wave 3, investors will know that Wave 2 cannot go below the low of Wave 1; this means that the best time to place a stop-loss order will be just below the low of Wave 1. Similarly, Wave 4 cannot overlap with Wave 1; this means that when trading Wave 5, the best point to place a stop loss would be just below the high of Wave 1. Take profit levels are placed using the Fibonacci Extension tool, with investors targeting the 161.8% level.