This article and videos will explain exactly what the Elliott Wave Theory and Principles are. This will help you understand how stock markets move in cycles and waves, which will aid you in developing your trading and investing strategies.
Learning Elliott Wave Theory as a beginner can seem daunting. Apply and using Elliott Wave theory in the stock market is part science and part art. I provide detailed examples using S&P-500 charts to illustrate the key factors you need to understand. I will also share some sharp realities about the Elliott Wave Theory.
Who Created The Elliott Wave Theory?
Ralph Nelson Elliott created the Elliott Wave Principle in the 1920s; it is an inciteful look at how stock market prices move not in random distribution but regular recurring cycles or waves.
What Is Elliott Wave Theory?
In Elliott wave theory, the hypothesis suggests that any major market move is a cycle, and inside every cycle, there are 8 Waves. The Cycle is classified as the first leg in a primary bull market or primary bear market.
What is an Elliott Cycle?
As with the business cycle, there are times of growth and decline, largely attributed to the macroeconomic situation, specifically monetary and fiscal policy. For example, an Elliott Wave cycle could be the first bull market in an economy emerging from a recession. Or it could be the second bull market after a market retracement during a strong overall economic revival.
What are Elliott Waves?
There is a cycle in any market move, and inside the cycle, there are 8 waves. The easy way to remember them is 1 2 3 4 5 ABC. The 1 2 3 4 5 is the primary stock price moves up, and the A B C is the market pullback (market correction)
Video: Understanding Elliott Wave Theory & Principles
Elliott Wave Patterns in Bull & Bear Markets
The most important element to understand is that in a Bull market, the Elliott impulse waves (1-2-3-4-5) move up, and the corrective waves (1-2-3) move down. In a Bear market, the impulse waves (1-2-3-4-5) move down, and the corrective waves (1-2-3) move up.
The 5 Important Elliott Wave Rules
- An Impulse Wave always divides into 5 impulse sub-waves.
- Wave 3 always ends higher than wave 1.
- Wave 2 never ends lower than wave 1.
- Wave 3 is never the shortest wave.
- Wave 4 never drops below wave 1.
4 Practical Examples of Elliott Wave Theory
1. Elliott Waves in a New Bull Market 2009
In this example, we apply Elliott Wave Theory to the emergence of one of the best all-time Bull Markets in history – 2009 to 2018. The chart below is the exact bottom of the 2007 to 2009 financial crisis bear market.
As you can see here, this S&P move is actually a classic textbook Elliott Wave.
- Wave 1: Impulse Wave – the initial start of a new bull run. In a bear market recession, it is the initial push downwards from an all-time high.
- Wave 2: Corrective Wave – this is the correction from Wave 1 when stocks pull back from the new high.
- Wave 3: 2nd Impulse Wave – now we have a strong bullish move upwards
- Wave 4: 2nd Corrective Wave – another move down in stock prices as sellers cash in on their profits.
- Wave 5: 3rd and often longest Impulse Wave – the market is strong, and the bulls decide it is time to buy.
- Wave A: 1st Wave of correction of the primary cycle – the market participants become nervous at the new highs and begin to cash in their profits; however, buyers are not keen on these prices, so the stock prices start to fall.
- Wave B: 2nd Wave of correction (pullback of corrective move) – as stock prices begin to fall, buyers start to outnumber sellers, and the stock price starts to rise.
- Wave C: Correction of primary wave completed – now the bears win, the market participants are nervous, and everyone starts to sell, and there are few buyers.
- This completes the cycle, and we start from Wave 1 again.
Using Elliott’s theory is not an exact science, and one does need to use a little imagination (squint your eyes, tilt your head); however, it does prove useful for reference.
2. End of a Bear Market & Start of New Bull Market 2008
In 2013 the U.S. markets had hit new all-time highs and seemed to be happily advancing despite lackluster economic data. This example shows how to apply Elliott Wave theory both to the end of a bull market and the beginning of a brand new baby bull market.
In this chart, I have mapped approximately the three main waves of Elliott Wave Theory.
- The first impulse wave starts in March 2009 and ends in May 2010.
- The second impulse wave starts in July 2010 and ends in May 2011.
- The third impulse wave starts in October 2011 and is continuing until May 2013.
Elliott wave theory suggests that major bull markets propel upwards in 3 primary waves. After the third impulse wave, we then see a primary downward trend bear market to set us up for the next round of impulse waves up.
3. Elliott Wave Grand Supercycle Example 1983 to 2009
Elliott Wave Grand Supercycle Chart:
- 1984 – 1987 saw a strong Bull move
- 1987 – 1989 saw a sharp correction
- 1989 – 1994 saw a long Bull market
- 1994 – 1995 saw a shallow correction
- 1995 – 2000 saw a massive Bull market
- 2000 – 2003 saw a large three-year Bear market
- 2000 – 2007 saw a long slow advance
- 2007 – 2009 saw a huge volatile Bear market
The key here is the ability to zoom in and out on different timeframes to spot the waves. Intra-day minute-by-minute charts, or long-term multi-decade charts, the waves are usually perceivable.
4. Elliott Waves Corona Crash Example 2020
The start of the Covid-19 pandemic kicked of a volatile time in the stock market with a 34% market decline in 24 days. This marked a clear new leg in the market and allowed one to start an Elliott Wave mapping.
In this chart, I begin with the classic A-B-C correction wave as the market declines and follow it up with the 1-2-3-4-5 impulse wave of the new Bull market that emerged from the ashes of the crash.
The market then experienced another corrective A-B-C wave from September to November 2020. Still, it emerged again with the promise of massive government stimulus into a new 1-2-3-4-5 impulse wave supporting the major Bull market move.
In the chart above, you can see that it really helps with plotting Elliott waves to use supporting indicators; I have used Cumulative Money Flow and Relative Strength Index to confirm the moves. In technical analysis, it is always a good practice to use a price-based indicator (RSI) with a price/volume indicator (OBV or CMF) to give you two different perspectives on the same chart.
By mapping a 9-day moving average (MA) on the RSI and CMF indicators we can see that when the indicators cross down or up through the MA we have a strong confirmation. This helps with recognizing a new wave pattern sooner, rather than retrospectively.
Video: How To Practically Use Elliott Wave Theory – Examples
The 9 Types of Elliott Wave
- Grand Supercycle: An entire multi-decade bull or bear market from boom to bust consisting of many 1 2 3 4 5 ABC sub-cycles
- Supercycle: A large multi-year bull or bear market rally or decline consisting of multiple 1 2 3 4 5 ABC waves
- Cycle: A large bull/bear market run consisting of a 3 or more 1 2 3 4 5 ABC sub-cycles
- Primary: A primary move upwards or downwards consisting of complete 1 2 3 4 5 ABC cycle
- Intermediate: Zooming in on a primary cycle to reveal a sub-cycle of many months
- Minor: Shorter timeframe waves ranging from weeks to months
- Minute: Waves of weeks
- Minuette: Waves of days to weeks
- Sub-Minuette: Intra-day waves
The Problems With Elliott Wave Theory
The problem with Elliott Wave theory is that the mapping is always open to broad interpretation; ask ten Elliott Wave theorists the same question, you will get ten different answers. Elliott Wave theory is unusable for short-term stock market movement prediction because it is imprecise, and the market can be impacted externally by large macro-economic events.
There are some caveats with the Elliott wave theory. The first is that it is only proven accurate and statistically relevant on highly liquid stocks or markets, where there is less likelihood of manipulation of prices by a “few strong hands.”
Elliott himself warns us of this. This means that the not-so-liquid elements of the market are not applicable, which means approximately 65% of the total market.
Critics of Elliott Wave Theory
Please note these quotes from famous technical analysts.
Benoit Mandelbrot has questioned whether Elliott waves can predict financial markets:
“But Wave prediction is a very uncertain business. It is an art to which the subjective judgment of the chartists matters more than the objective, replicable verdict of the numbers. The record of this, as of most technical analysis, is at best mixed.” Source
Technical analyst David Aronson wrote:
“The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a compelling one that is eloquently told by Robert Prechter. The account is especially persuasive because EWP has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. I contend this is made possible by the method’s loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong.” Source
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Further Elliott Wave Reading.
I literally scratched the surface of Dow Theory and Elliott Wave Theory. I would strongly recommend you understand these concepts.