Elliott Wave Theory Basics
The Elliott wave analysis is a popular method of analysing financial markets such as commodity markets, stock markets, etc. Having read this article, you will understand the essence of this method and get acquainted with its main notions. Also, you’ll learn to understand technical analysts’ forecasts, identify wave types in charts and make your own forecasts.
The author of the wave theory is American accountant Ralph Nelson Elliott, who noticed that the market prices alternate following repeated wave patterns. In 1938, after 9 years that Elliot observed and studied continuously the stock market behavior, he published his first work on wave analysis entitled “The Wave Principle”. Eighty years have passed since Elliott discovered the wave principle, but the popularity of the Elliott wave theory among traders is continuing to grow worldwide. The most successful traders apply Elliott wave theory analysis, to a certain extent, in their strategies: some use it only in part and some base their trading decisions and financial market analysis fully on this method. What Elliott discovered works not only in the stock market, you can use it to trade all types of financial assets.
The main idea of this method is the following: the financial market is formed by a crowd of interacting participants. Elliott noticed that the crowd behaves predictably and forms the same wave patterns depending of the price movements, or “waves”, in the price chart. He described and classified all the types of waves one can find in the financial market.
The trader’s task is to understand which type is forming and to which extent it has formed. If the trader succeeds, it will be easy to make the right forecast and make a profitable trading decision.
Advantages of Elliott waves
There are several benefits of the Elliott's wave theory compared to other methods of classical technical analysis.
Market analysis without a time lag
When you analyse a chart’s price movements using many momentum indicators or oscillators there is a time lag. I mean indicators and oscillators reflect the market prices situation with a delay because they are calculated based on historical data.
When a new trend starts in the market, oscillators and momentum indicators start with a sending corresponding signal with a delay. Conversely, the Elliott Wave theory helps to predict a new dominant trend in advance.
This opportunity enables the trader to prepare for a trend change in advance and make the right trading decisions. Due to this feature of the elliott wave principle, you can enter a trade before a new trend starts and increase the potential profit. Or you can exit a trade with the maximum profit, for example, at the trend low when the moving average is far from the price, signalling a strong trend in the market.
Most traders do not expect that the downtrend in a bear market will change soon, supposing the market players remain negative, but an advanced user of Elliott Wave theory sees that the descending impulse has already formed. Moreover, the fifth wave of the impulse is an ending diagonal, signalling the trend reversal. So, the trader familiar with the Elliott's wave theory exits the trade at the most beneficial level. The market starts moving in the opposite direction, and the trader has made a profit.
Accuracy of wave patterns
Also, among the advantages of the elliott wave principle, one can single out its detailed description of elliott wave structures. For example, we have all heard about such a technical analysis pattern as a head and shoulders reversal pattern. We can find countless different wave patterns in the price chart that can be called "head and shoulders". Some will be sharp, others will be extended in time, in some price movements pullbacks are deep, in others - shallow, there are also differences in the structure of all the components of the “head and shoulders reversal pattern”. However, no matter how detailed the description of this pattern is in technical analysis, it is still difficult for technical analysts to spot it in the chart.
If we look at this pattern based on the elliott wave principal analysis, we will see that in one case the head and shoulders pattern extends wave 4 and 5 of the previous impulse and forms waves 1 and 2 of the new opposite impulse waves. In this case, we shall expect the development of wave 3 and make a corresponding trading decision.
However, in another case, we can see that a part of the head and shoulders pattern, based on the Elliott wave international theory, is the linking wave X and zigzag Y, while the other part is the linking wave XX, which hasn’t completed yet. In this case, an Elliott wave analyst will expect the completion of the XX wave, followed by another zigzag Z, unfolding in the same direction as wave Y.
A technical analyst, in this case, could mistake the emerging pattern for a head and shoulders and expect the stock markets to move in the opposite direction supposing that the market players remain negative, while a wave analyst will see that there is the final part of the triple zigzag is forming. There are many such examples. That is because wave structures and wave patterns in this analysis are studied and described in much more detail than technical analysis patterns.
I would also like to give an example of a triangle pattern. In technical analysis, there are only a few points that are said about triangles, and there are no strict restrictions in the rules, there are only approximate recommendations. Technical analysts should determine themselves if the emerging pattern is a triangle. However, if we look at the Elliott wave theory rules regarding triangles, we will see a number of definite and rigid rules that must be followed in 100% of cases. If at least one rule is not fulfilled in the emerging pattern, then it cannot be a triangle. There are no exceptions here.
Such an approach limits the risks of misinterpreting and allows traders more definitely judge whether the pattern emerging is a triangle. In addition to rules, there is a number of guidelines, and observations regarding the structure of waves, their features, which are most commonly present but not always. For example, if the guideline that one of the triangle’s previous sub-wave extends wave of the three wave correction and is not fulfilled for a triangle, then this does not change the matter, this wave can still be a triangle.
In Elliott wave theory analysis, there are clear rules and guidelines regarding a particular wave pattern, which allows a trader to accurately define a pattern, reducing the risk of an error. In conventional technical analysis, everything is much more vague and fewer observations have been made regarding the patterns and, accordingly, there are fewer formalized rules. Perhaps that is why the Elliott wave international analysis is considered to be a rather complicated method.