Table of Contents

• What are Elliott Waves?
• The basic form of Elliott Wave
  • Motive wave
  • Corrective wave
• Do Elliott Waves Work?
• Summary

What are Elliott Waves?

Elliott waves are a theory (or principle) used by investors and traders in technical analysis. The basic basis of this principle is that financial markets are not affected by time cycles and tend to follow specific patterns.

Elliot Wave Theory (EWT) essentially proposes that market trends follow the natural sequence of mass psychological cycles. Patterns are built based on current market sentiment, alternating between bearish and bullish.

The Elliott Wave Principle was created by American accountant and author Ralph Nelson Elliott in the 1930s. The theory did not enter the public consciousness until the 1970s, thanks to the efforts of Robert R. Prechter and A. J. Frost.

Originally, Elliott Wave Theory (EWT) was called the wave principle and was a description of human behavior. Elliott based his writing on his extensive research into market data, particularly the stock market. His systematic research covers at least 75 years of rich information.

Today, traders use Elliott Wave Theory (EWT) as a technical analysis tool to determine market cycles and trends, and it is widely used in financial markets in many fields. However, Elliott Waves are not a trading indicator or technique, but a theory that helps predict market behavior. As Prechter says in his book:

[...] The Wave Principle is not essentially a predictive tool, but a detailed description of market behavior.

– Robert R. Prechter, "The Elliott Wave Principle" (p. 19).

Basic Pattern of Elliott Wave

Usually, Elliott Wave There are eight different basic patterns of Little Waves, consisting of five Motive Waves (waves that follow the main trend) and three Corrective Waves (waves that go against the trend).

So, in a bullish market, the complete Elliott Wave cycle looks like this:

Note that in the first example we see five motive waves: three moving up (1, 3, and 5) and two moving down (A and C). In short, any movement that conforms to the main trend is considered a motive wave, which means that 2, 4 and B are all corrective waves.

According to Elliott's theory, the shape of financial markets has fractal properties. Therefore, if zoomed out to a longer time frame, the moving trend from 1 to 5 can also be considered a single impulsive wave (i), while the moving trend A-B-C represents a single corrective wave (ii).

If narrowed down to a more specific time frame, a single driving wave (e.g. 3) can be further divided into five smaller waves, as shown in the next section.

In contrast, the Elliott wave cycle in a bearish market looks like this:

Motive waves

As Pretchett said By definition, motive waves always move in the same direction as the more dominant trend.

As we just saw, Elliott described two types of wave trends: Motive waves and Corrective waves. The previous example involved five motive waves and three corrective waves. However, if we look at a motive wave in isolation, it is made up of smaller five-wave structures. Elliott called it the "five-wave pattern" and created three rules to describe this structure:

• Wave 2 does not It will retrace 100% of the previous wave 1.

• Wave 4 will not retrace 100% of the previous wave 3.

• Wave 3 will not be the shortest wave among waves 1, 3, and 5, but is usually the longest. Moreover, wave 3 will always cross the end of wave 1.

Corrective waves

Different from driving waves, corrective waves usually consist of a three-wave structure. A common structure is a smaller corrective wave between two smaller motive waves. These three waves are often called A, B, and C.

Compared with the driving wave, the corrective wave moves in the opposite direction to the more mainstream trend, so it tends to weaken. In some cases, this countertrend confrontation can make corrective waves more difficult to identify because they can vary widely in length and complexity.

Prechter believes that the key rule to remember is that corrective waves will never occur in five waves.

Do Elliott Waves Work?

People have always debated the role of Elliott Waves. Some believe that the success of the Elliott Wave Principle largely depends on traders' ability to accurately divide market movements into drivers and corrections.

In fact, these waves may be drawn in several ways, and this does not necessarily break the rules established by Eliot. This means that it is never easy to draw a wave correctly. This not only requires specific practice, but may also involve strong personal subjectivity.

Critics believe that the Elliott Wave Theory is highly subjective and relies on poorly defined rules, so it is not a tenable theory. Despite this, there are still tens of thousands of investors and traders who have successfully used Elliott's Principle to achieve profitable trading.

Interestingly, more and more traders are using Elliott Wave Theory in conjunction with technical indicators to increase trading success rates and reduce trading risks. The Fibonacci Retracement and Fibonacci Extension indicators are perhaps the most popular choices.

Summary

According to Pretchett, Eliot did not really Anticipate why the market tends to exhibit a 5-3 wave structure. He came to this conclusion simply by analyzing market data. Human nature and mass psychology determine the inevitable market cycle, and all of this gave rise to the Elliott Principle.

However, as mentioned above, Elliott Wave is not a technical analysis indicator, but a theory. The Elliott Wave Theory is inherently subjective and there is no correct way to use it. Traders who want to accurately predict market movements through Elliott Wave Theory require practice and skill, starting with understanding how to plot wave counts. This means that there are risks in the Elliott Wave Theory, and beginners need to be cautious.