The next candidate for analysis in our series discussing technical analysis is the Elliott Wave theory. This theory can be regarded on its own as an approach to technical analysis or basically a school of technical analysis.
As the name of this theory suggests, Elliott Wave is an approach that focuses on the formation of various types of waves in the market. Waves, whose foundation and basis is also related to the psychology of traders and also the sentiment of them in the market.
In this article, our intention is to analyze the Elliott Wave theory to see what it is, how it works, and how you can implement it to your advantage in trading.
Elliott Wave Theory: What Does It Mean?
When we look at the history of technical analysis, it is full of pioneers and people who stepped outside of the ordinary boundaries of the market to see something that no one else had seen before. Each one of these pioneers and market visionaries contributed something to our knowledge of market analysis and thanks to them, today we have an extensive body of knowledge in the domain of technical analysis.
One of these market visionaries was Ralph Elliott. He started picking up on signs that ultimately led him to the development of the Elliott Wave theory in the early decades of the 20th century. So his ideas date back at least 100 years. But what were his initial observations?
Similar to many other market experts who founded different theories and schools of thought in technical analysis, Ralph Elliott also began detecting patterns in the market. He saw that there were certain formations or patterns that would repeat themselves every so often. The time frame was not of concern at the beginning. Just the mere presence of these repetitive patterns was enough to garner his full attention.
When he conducted more research, he came to the conclusion that the formation of these repeated patterns is directly related to the mentality or psychologies of traders in the market.
This is one of the areas of Elliott Wave theory that sets it apart from other theories – i.e. in how it heavily emphasizes the psychology of traders in the formation of different patterns in the market.
The patterns that were detected by him could be divided into many smaller parts. These smaller parts that made up a larger pattern were then referred to as “waves.” Perhaps he wasn’t the first person to coin this term, but he was certainly a pioneer in doing so.
This is basically how the Elliott Wave theory was born.
Going Deeper into Elliott Wave Theory
When the Elliott Wave theory was formed fully by Ralph Elliot, a large number of books and articles were then published according to this idea. Even to this day, there is an international organization named after the original figure behind this theory that fully specializes on using Elliott Wave to provide financial and market analysis.
Of course the precise nature of how this theory works and the different principles that are involved in it will be discussed in the next section. But the whole idea behind Elliott Wave theory is to help traders to identify these repetitive patterns as well.
It is easy to get swept in by the psychology of traders. When a large number of people panic or are driven by other forms of emotion to rush to take a certain position in the market, chances are you might also go along with the wave.
But Elliott Wave theory can help you to not just be a pawn in this game. But rather be able to identify these patterns in due time and implement them in your trading process to your own benefit.
But how does Elliott Wave theory work exactly? Let’s find out.
How Does the Elliott Wave Theory Work?
As we saw so far, Elliott Wave theory posits that traders’ psychology can drive prices to move a certain wave. These movements can lead to the formation of patterns.
Each pattern is made from certain waves. In Elliott Wave we basically have 2 different types of waves. However, it might be a bit difficult to detect and understand these waves. And that is exactly the crux of the theory. Also, the reason it might be difficult to detect them is the rather subjective nature of this theory as a whole. It is literally based on the sentimentality of traders.
In any case, these 2 major waves that form Elliott Wave theory are trend waves and correction waves. A trend wave is a pattern that is indicative of the major trajectory that currently exists in the market. On the other hand, a correction wave would be one that breaks the trend and moves in the opposite direction to it.
The basic form of the Elliott Wave theory consists of a pattern that itself consists of 8 waves. First, there are 5 trend waves and then there are 3 correction waves. This is what is famously known as the 5-3 Elliott Wave.
This is so fundamental to this theory that it is believed to exist in any financial market and at any point in time.
So, basically a Elliott Wave is a pattern with 8 waves or movements. If you are able to detect such a pattern, naturally you would be able to go long and/or short where necessary.
What Are the Main Waves in Elliott Wave Theory?
As mentioned above, there are 2 main waves in Elliott Wave theory – trend and correction waves. But the real names of these waves in this theory are impulse waves and corrective waves respectively.
An impulse wave is a pattern in the Elliott Wave theory that is made from 5 trend waves. This means waves that move in the main direction of the prevailing market trend at the time.
A corrective wave, on the other hand, is another pattern in Elliott Wave theory consisting of 3 so-called corrective waves that move against the impulse wave.
Comparing Elliott Wave with Other Technical Indicators
There are some major and pronounced differences between Elliott Wave theory and other forms of technical analysis. As we posited earlier, a major difference that was made by Elliott Wave was that it brought in trader psychology and user sentiment into the equation.
This theory was among the pioneers that gave credence to the role of psychology in the financial markets. But this point of divergence also led to this theory becoming a much more subjective theory in technical analysis.
Compared to other indicators, Elliott Wave has a more subjective orientation because of the weight it gives to sentiments and psychology.
The Elliott Wave was developed in the early 20th century. According to this theory, the psychology of traders can make some repetitive patterns form in the market. Patterns that can be detected and divided into smaller parts called waves. There are two major waves that make up an Elliott Wave. These waves are known as impulse waves and corrective waves.