Elliott Wave Principle: Meaning, How To Use, Importance and Limitation

Did you know? A telegram stating – ‘NOTWITHSTANDING BEARISH (DOW) IMPLICATION ALL AVERAGES ARE MAKING FINAL BOTTOM’ changed the world of technical analysis. 

This telegram was written by Ralph Nelson Elliott, who formulated the Elliott Wave Theory. 

Born in 1871, Elliott was forced into retirement at 58 due to an ailment after a lengthy career in accounting. During recovery, Elliott immersed himself deeply in understanding the stock markets. He dived into yearly, monthly, weekly and daily charts of the markets from the previous 75 years (yes, that's right!). By 1934, the yet-to-be-dubbed Elliott Wave Theory solidified, and Elliot presented his findings to Charles J. Collins of Investment Counsel, Inc. in Detroit, to whom he wrote the telegram.

Collins, accustomed to countless market beating systems (which actually were futile), found Elliott Wave Theory to be a revelation. At the same time, Dow Jones averages were declining, and pessimism was high because of the 1929 Great Depression. On March 13, 1935, when Dow Jones averages closed near the day’s lows, Elliott sent that telegram to Collins. On March 14, 1935, the 13-month correction had concluded, and the markets embarked on an upward trajectory, just as Elliott stated in his telegram. And the rest, as legends say, is history. 

Two months later, Collins and Elliott joined hands to pen ‘The Wave Principle, ' which would become the basis of the Elliott Wave Theory. 

A century later, countless retailers, traders, analysts and investors still use the Elliott Wave Theory to make predictions and analyse markets. 

What Are Elliott Wave Principles?

Elliott Wave Theory runs on the same principles as the Dow Theory, which states that markets can be analysed and predicted. The principles of the Elliott Wave Theory are essentially a set of rules and guidelines to forecast market trends. It is based on the idea that market and stock prices follow a repetitive pattern of five waves in the direction of the main trend, followed by three corrective waves.

Another key principle is the concept of fractals, which asserts that the same wave patterns can be identified at different degrees of trend, occurring at various periods. This, in other words, implies that the markets are inherently self-similar, displaying similar patterns at both micro and macro levels. 

The Elliott Wave principles also emphasise how the human psyche works. They shed light on how people may act according to collective group emotions of fear, greed and more. For instance, positive sentiment may lead to the creation of Wave 1 or 3. However, the human mind may introduce pessimism and doubt and can cause markets to correct. In simpler words, Elliott Wave Theory theory believes that market trends are not random; they follow patterns influenced largely by how people think and feel collectively! 

The Elliott Wave Theory also uses the Fibonacci ratio as a critical tool for measuring and predicting wavelengths. The Fibonacci theory is considered an extension of the law of nature and finds application in nearly every field in the world!

Thus, Elliott Wave Theory combines the laws of nature, mathematics and human psychology to understand how markets function! If that’s not cool, we don’t know what is! 

The Basic Trade Terminologies Used in Elliot Wave Theory

To understand Elliott Wave Theory correctly, it is paramount to understand certain terminologies and concepts. Let’s start with the backbone of this theory – motive wave.

Motive Waves

The motive waves represent the primary trend and can be considered one way in the larger direction.  It is further divided into five smaller waves: 1, 2, 3, 4, and 5. Waves 1, 3 and 5 typically show an uptrend, while waves 2 and 4 show a downtrend. 

The motive wave is now further divided into sub-waves called impulse waves. 

Impulse waves in an uptrend unfold in five distinct waves with three (waves 1, 3, and 5) advancing in the direction of the primary trend while the others (waves 2 and 4) providing corrections in the opposite direction. In a downtrend, waves 1,3 and 5 move downwards, while waves 2 and 4 move upward. 

Corrective Waves

After the motive wave completes its five-way sequence, a corrective wave follows, representing a counter-trend movement. Now, corrective waves will oppose the primary trend and are typically of three main types – Zigzags, flats and triangles

• Zigzags

The most common type of corrective wave, the zigzags, has three waves in a distinctive pattern. In an uptrend, the first wave, named ‘A’, is in downward correction, followed by an upward wave ‘B’, and finally another downward wave called ‘C.’ This will reverse in a downtrend. 

• Flats

Flats represent a corrective pattern characterised by sideways movements. Like zigzags, it consists of three waves – A, B and C. Here, in an upward trend, wave A is upward, while wave B moves sideways, and wave C moves upward again. 

• Triangles

Triangles are slightly complicated. They are corrective patterns with five waves that come together or converge. They may also resemble a small head and shoulders pattern. In an uptrend, the triangle moves from higher peaks into lower ones.  In a downtrend, peaks consistently decrease.

Take a look at this image for  better understanding:

Wave Degree

A crucial aspect of the Elliott Wave Theory is the concept of wave degrees, which capture the magnitude and duration of trend waves. This can help traders identify the scale of market movements.  

There are nine wave degrees

Wave degree	Duration	Description
Grand  supercycle	Several centuries	It is the longest and most significant trend.
Supercycle	Extends over decades	Long-term trends which can shape the generational financial landscape.
Cycle	Lasts several years	Depicts various economic and market cycles
Primary	Several months to a year	Captures market and investor sentiment  along with economic conditions
Intermediate	A few weeks to a month	Represents medium-term trends within the broader context of the primary trend
Minor	Several weeks	Identifies shorter-term market movements that contribute to the large intermediate trend
Minute	Several days	Examines short-term trends that may be influenced by daily market noise.
Minuette	Several hours	Focuses on intraday movements
Sub-minuette	Several minutes	Represents the smallest measurable market movements.

Fibonacci 

Fibonacci is like a mathematical pattern that starts with two numbers, 0 and 1, and each new number is the sum of the two before it (like 0, 1, 1, 2, 3, 5, 8...). Traders look at certain percentages from this sequence (like 23.6%, 38.2%, and 61.8%) to predict how much the market might go back (retrace) before continuing in its original direction.

These Fibonacci levels help traders find potential support (where the price might stop falling) and resistance (where the price might stop rising) levels. They're often used with Elliott Wave theory. The idea is that after a big move, markets will pull back a bit but stay within these Fibonacci percentages before continuing the trend.

Let's imagine we're looking at a stock, which has recently made a significant move up from ₹100 to ₹200 over a certain period. Traders using Fibonacci retracement would look at this upward move and try to predict where the price might pull back before continuing its upward trajectory.

To apply Fibonacci retracement levels, traders would calculate the key Fibonacci percentages of the total move. Here's how it might look:

• Starting point (low point): ₹100
• Ending point (high point): ₹200
• Total move: ₹200 - ₹100 = ₹100

Now, applying the Fibonacci percentages to this ₹100 move:

• The 23.6% level: 23.6% of ₹100 is ₹23.60. 

Subtracting this from the high point gives us ₹200 - ₹23.60 = ₹176.40. This is a potential support level.

• The 38.2% level: 38.2% of ₹100 is ₹38.20. Subtracting this from the high point gives us ₹200 - ₹38.20 = ₹161.80. Another potential support level.
• The 61.8% level: 61.8% of ₹100 is ₹61.80. Subtracting this from the high point gives us ₹200 - ₹61.80 = ₹138.20. This is often considered the most important Fibonacci level, indicating a strong potential support level.

Traders would watch these levels (₹176.40, ₹161.80, and ₹138.20) closely as the price retraces from its high. If the price bounces off any of these levels, it might be seen as a confirmation that the trend is likely to continue upwards. If it breaks through these levels, traders might reassess their analysis.

This method is particularly popular because it offers a blend of mathematical rigour and market psychology. It allows traders to make more informed decisions based on historical price movements and human behaviour patterns. It is, however, important to remember that these are just tools, and don't guarantee what the market will do. They're more about probabilities and helping traders make educated guesses.

How To Use Elliott Wave Principles in Trading?

Now that we understand different types of waves and the Fibonacci retracement, let’s begin with impulse waves to understand how to apply the Elliott Wave Theory in real-time markets. 

As discussed, the impulse wave is composed of 5 waves – 1, 2,3, 4 and 5.

The 1st wave is the accumulation phase. Very few market participants are observed to participate here, and it is the shortest of the 3 upward waves (1, 3 and 5). Wave 1 is typically not spotted early on as markets are still assumed to be in a bear run. Wave 2 is corrective, i.e., it opposes the primary trend and runs in the mood of bears only. Volume should be low during wave 2 as compared to wave 1. Traders here will typically be confused if this is the beginning of a new trend or wave in the same direction. 

Wave 3 is the end of the accumulation phase and is the largest and most powerful of all waves. It is also characterised by the highest volume levels among all waves. High market participation is seen, and the market is perceived to have changed from a bear to a bull run. 

Wave 4, just like wave 2, is again corrective, but this time, the correction is steep, i.e. the price may fall higher when compared to wave 2. This wave may see a sideways market, and volumes will be lower than in wave 3. 

Wave 5 is the last upward wave. The market is largely bull in nature, and traders who missed wave 3 may look to join here. Here, volumes are relatively low. Now, let's use Fibonacci to deduce the impulse waves and identify potential support and resistance levels. 

1. Wave 2 - Retracement will not be a full advance of the first wave. In other words, wave 2 should be 50%, 61.8% or 76.4% in most typical cases. It cannot be 100% of wave 1. 
2. Wave 3  – To qualify as wave 3, the Fibonacci extension will be ~162% of wave 1.
3. Wave 4 - Retracement levels are typically 23.6%, 38.2% to 50% of wave 3 and no more. 
4. Wave 5 - Wave 5 will have a Fibonacci extension of 61.8%, 100% or 123.6% of wave 1. 

Now, let’s look at corrective waves A, B and C

Corrective way A begins after the completion of an impulse wave. It corrects the preceding impulse wave. Volume may rise slightly as traders who missed the previous upward move may try to enter the market. 

Wave B is a counter-trend move, but it does not retrace wave A 100%. Wave B may also move sideways or upwards; however, the volume is lower than that of wave A. This is because traders may be confused about what the current trend is. 

Wave C is the final wave in the corrective sequence. It may be as large as wave A or extend it by 61.8% and confirm the presence of a bear market. 

Significance of the Elliott Wave Theory

Below are some advantages of the Elliott Wave Theory that make it an important technical indicator:

1. Reliability: Elliott Wave Theory has been a dominant force in the world of technical analysis. Analysts and traders have used this theory for decades to swing by the markets. You may also appreciate the fact that the theory is not random and has been developed by Elliott after analysing charts of over 75 years! 
2. Market Insights: The Elliott Wave Theory, by identifying and interpreting wave patterns, can help traders gain insight into the collective sentiment driving the markets. You may look at it with a psychological lens to understand greed, fear, optimism and all other emotions that shape market dynamics. 
3. Predictability: The biggest benefit of this theory is its predictive nature. As waves unfold, the theory can provide a roadway to navigate them (and also can give a probable future price). Imagine this – the market is currently experiencing wave 2. Now, as a trader, you can anticipate and predict future movements using Elliott Wave Theory, as well as the price where wave 5 would occur. This can directly aid in identifying suitable entry and exit points and stop losses. 

• Adaptability: Elliott Wave Theory scores above certain other indicators for its adaptability across various time frames. Whether you are a day trader seeking short-term gains or an investor eyeing long-term gains, this theory is relevant. Also, the principles of the Elliot wave can be coupled with many other technical indicators, such as RSI and MACD, to help gain a comprehensive view of the market. 
• Risk management: Risk management is another feature of the Elliott Wave Theory. As you study different waves and predict future outcomes, you can formulate suitable strategies to gain the maximum out of market movements and minimise risks. 

Limitations of the Elliott Wave Theory

The Elliott Wave Theory, though popular amongst technical analysts and traders, is not immune to criticisms and limitations. 

• Complexity:

As you may have observed, Elliott Wave Theory is highly complex and technical. While it is a go-to tool for expert technical analysts, ordinary investors and market participants may find it extremely difficult to understand, analyse, and implement this theory. 

• Non-ideal in uncertain markets:

Elliott Wave Theory outlines specific rules and guidelines for identifying waves, but real market scenarios may not always conform to these idealised patterns. For instance, during periods of heightened market uncertainty or high-frequency trading, price movements may be severely erratic and choppy, making it challenging to differentiate clear wave patterns. 

• Subjectivity:

A primary concern surrounding the Elliott Wave Theory is the inherent subjectivity in wave counting, identification and analysis. The identification of wave patterns, in reality, is susceptible to interpretation, leading different analysts to propose varying wave counts. This can cause ambiguity and disagreements. 

For a better understanding, let’s take the example of wave degrees. The Elliott Wave Theory categorises the waves into different degrees, such as grand supercycle, supercycle, cycle, primary, intermediate, minor and minute waves. Now, determining the precise degree of a wave can not only be complex but also subjective, leading to potential misinterpretations. 

• Reliance on historical data:

A prominent limitation that follows the Elliott Wave Theory is excess reliance on the analysis of historical price data. While the data can be a useful barometer to identify waves and forecast movements, the Elliott Wave Theory may face challenges in dynamic and fast-changing markets. Market conditions evolve, and solely relying on historical data may not be wise. 

Also, concerning the historical data is the hindsight bias. After studying this theory, analysts may try to apply and make sense of it on historical price data (in attempting to align with the past market). This forceful process of trying to make sense of the data may result in overfitting.

• Omission of external factors:

The Elliott Wave Theory does not consider external and fundamental factors such as political events, economic data releases, or unforeseeable events, which again impacts the theory’s reliability. In other words, this omission limits the theory’s accuracy in predicting future price movements, as it does not account for economic and geopolitical context. 

• Adherence to EMH:

Another interesting criticism of the Elliott Wave Theory is its adherence to and reliance on the Efficient Market Hypothesis (EMH). This assumption is generally contested by proponents of behavioural finance, who argue that market participants often may exhibit irrational behaviour, which can impact price movements. 

In simpler terms, this theory focuses on price data and wave patterns but may not fully account for psychological factors, emotional reactions, market sentiments and behavioural biases that impact the markets and share prices. 

Also, the Elliott Wave Theory typically assumes that market trends persist predictably. This may often give rise to inaccuracies as markets are inherently dynamic and volatile.

Now that you understand the advantages and limitations of the Elliott Wave Theory, it is important to remember that, like any technical tool, the Elliott Wave Theory is not immune to false signals and wave failures. Market dynamics may often deviate from expected wave patterns and generate false waves. Thus, traders must tread with caution. It is important to not rely solely on any one theory, tool or indicator.

With this, we conclude the chapter on Elliott Wave Theory. The next chapter explores a fascinating mathematical phenomenon called the Fibonacci series. Explore how this concept finds application in the stock markets.