Introduction to Elliott Wave Theory: Principles of Financial Market Analysis

What is Elliott Wave?

Elliott Wave Theory is a method of technical analysis that traders and investors use to predict price movements in financial markets. The key concept of the theory is that market movements form consistent patterns regardless of time frames.

Essentially, the Elliott Wave Theory (EWT) is based on the observation that market movements follow a natural sequence of cycles that reflect the collective psychology of market participants. These patterns are formed according to prevailing sentiments, which cyclically shift between optimistic (bullish) and pessimistic (bearish).

The creator of this theory is Ralph Nelson Elliott – an American accountant and market researcher who developed his principle in the 1930s. However, the theory gained widespread recognition only in the 1970s thanks to the works of Robert R. Prechter and A.J. Frost.

Initially, EWT was called the Wave Principle and represented a model for describing human behavior in financial markets. Elliott developed his theory based on systematic analysis of stock market data over a period of at least 75 years.

In modern technical analysis, Elliott Wave Theory is used to identify market cycles and trends across various financial markets, including the cryptocurrency market. It is important to understand that the Elliott Wave is not an indicator or trading strategy, but rather a theory that helps to understand market behavior. As Prechter notes in his book:

[...] The wave principle is not primarily a forecasting tool; it is a detailed description of how markets behave.

• Prechter, R. R. Elliott Wave Principle ( p. 19).

Basic Elliott Wave Pattern

The classic Elliott wave pattern consists of an eight-wave structure, consisting of five impulse waves ( moving in the direction of the main trend ) and three corrective waves ( moving against the main trend ).

The complete cycle of Elliott waves in a bull market looks as follows: five impulse waves, of which three are directed upwards (1, 3 and 5), and two are directed downwards (A and C). Any movement in the direction of the main trend is considered an impulse wave. Accordingly, waves 2, 4, and B are corrective.

According to Elliott's theory, financial markets form patterns of a fractal nature. This means that when considering larger time frames, the movement from wave 1 to 5 can be interpreted as one larger scale impulse wave (I), while the movement ABC can be seen as one larger scale corrective wave (II).

When moving to smaller time frames, one impulse wave (, for example, wave 3) can be divided into five smaller waves, reflecting the fractal structure of market movements.

In a bear market, the Elliott wave cycle has a similar structure but is directed in the opposite direction.

Impulse Waves

According to Prechter's definition, impulse waves always move in the direction of the larger trend.

If we take a detailed look at one impulse wave, we will find that it consists of a smaller scale five-wave structure. Elliott formulated three main rules for identifying this five-wave pattern:

• Wave 2 cannot retrace more than 100% of the movement of the previous wave 1.
• Wave 4 cannot retrace more than 100% of the movement of the previous wave 3.
• Among waves 1, 3, and 5, wave 3 is never the shortest and is often the longest. Moreover, wave 3 always exceeds the end point of wave 1.

Correction Waves

Unlike impulse waves, corrective waves usually have a three-wave structure. They form between two larger impulse waves and are denoted by the letters A, B, and C.

Correction waves are usually shorter than impulse waves as they move against the main trend. The counteraction to the trend also makes correction waves more difficult to identify, as they can vary significantly in duration and structure.

According to Prechter, the most important rule for corrective waves is that they never consist of five waves.

The Effectiveness of Elliott Wave Theory in Trading

The question of the effectiveness of Elliott's wave theory remains a matter of discussion. The success of applying this method largely depends on the trader's ability to accurately identify market movements as trends or corrections.

In practice, wave patterns can be interpreted in various ways without violating the basic rules of Elliott. This makes the process of correctly identifying waves a rather complex task that requires not only experience but also takes into account a high level of subjectivity.

Critics of the theory point to its subjective nature and insufficiently clearly formulated rules, which raises doubts about the scientific validity of the method. Nevertheless, there are many successful investors and traders who have managed to profitably use Elliott's principles in their trading.

It is interesting to note that more and more traders are combining Elliott Wave Theory with other technical indicators to enhance the accuracy of their analysis and reduce risks. Combinations with Fibonacci tools—"Fibonacci Retracement Levels" and "Fibonacci Extensions"—have gained particular popularity.

Conclusion

According to Prechter's observations, Elliott himself did not attempt to explain why markets form a 5-3 wave structure. He simply analyzed market data and arrived at this conclusion empirically. Elliott's wave principle reflects the inevitable market cycles generated by human nature and the psychology of mass behavior.

It is important to understand that Elliott Wave Theory is not a technical indicator, but a theoretical concept. Therefore, there is no one-size-fits-all way to apply it, and the method is inherently subjective. Accurate forecasting of market movements using EWT requires practice and skills, as traders need to learn how to correctly identify waves. This means that using this theory can be associated with certain risks, especially for beginner traders.