The Elliott Wave Theory is a form of technical analysis that investors use to predict future market trends by analysing historicals
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In this article, we’re going to understand in-depth what technical analysis is, why it works, and how the Elliott wave theory is linked to its origins.
The history of the Elliott wave theory
Developed by Ralph Nelson Elliott in the 1930s, the theory postulates that financial markets follow a certain trend over time, and that this trend tends to repeat in regular intervals.
Elliott wave theory says that market psychology, or the psychology of investors with respect to the market, moves from pessimism to optimism and back again, in a repeating sequence. Elliott further explained that these swings, reflected in wave-like patterns on a chart, could be replicated and used to generate profits.
The key elements of the Elliott wave theory
Here are some key characteristics of the theory that will help you understand it better:
The five-wave and three-wave patterns
The theory suggests that the overall upward or downward trend in a security’s price unfolds in a five-wave structure called the motive wave. Within this motive wave, every sub-wave represents a different kind or phase of investor sentiment.
- Wave 1: Impulse wave (beginning of the trend)
- Wave 2: Corrective wave (pullback after the initial rise)
- Wave 3: Strongest and most impulsive wave (heart of the trend)
- Wave 4: Corrective wave (smaller pullback before the final push)
- Wave 5: Final wave completing the trend
Following this pattern, there’s a corrective action that occurs in the price, which is represented by waves A, B, and C.
This signifies the ending of one wave and the beginning of another.
Fractals and similarity
The Elliott wave theory also posits that these waves are self-similar, meaning that they can be seen throughout the price charts of different securities at different points in time, considering a large-enough horizon.
Analysts can spot these trades on hourly, daily, weekly, and even monthly or yearly charts.
Fibonacci ratios
If you’ve ever been into technical trading, you must have come across a very popular tool called the Fibonacci Retracement Pattern. This is similar to the tool, but not exactly. The Elliott wave theory also incorporates Fibonacci ratios, a mathematical sequence found in nature, to identify highs and lows as well.
These ratios are usually used as a guide, not fact.
Criticisms and considerations of the Elliott wave theory
Here are some considerations you should know before you go off finding your own Elliott waves.
Subjectivity is rampant in this business
Technical analysis is largely subjective, which means that there’s no single, universally accepted method or technique for spotting these waves and labelling them properly. Different analysts could look at the exact same chart and label waves quite differently, which could lead to conflicting predictions of future price performance.
Not only that, Elliott waves can also lead to confirmation bias due to this subjectivity, which means that analysts who are confident but wrong could lose a lot of money.
Could be self-fulfilling
Some experts also think that Elliott waves could be a self-fulfilling prophecy, since analysts could “spot” these waves in the chart and make buying and selling decisions off it. If enough people do this, they could move markets or influence price action as if these waves were actually present, making a shared illusion come true.
Doesn’t take into account fundamentals
Companies don’t trade on technicals alone. In fact, there are much more important metrics that need to be considered when investing in stocks – such as economic data, earnings reports, or industry trends that could drive growth long-term.
Bottom line
When you’re investing money in the stock market, make sure you’re making fundamental analysis the core contributor to your decisions. Technical analysis is best used as a supplement to your understanding of the company’s core financials and its potential for future growth or dividend payouts.
While technical analysis can certainly make you money in the short-term, more often than not, the retail investor loses money in the long run. Stick to the fundamentals, keep your horizon long, and as long as you’re adequately diversified, you’ll be set.
Frequently Asked Questions
EWT proponents believe the theory identifies recurring wave patterns that foreshadow future trends. However, critics argue that these patterns can be subjective and prone to misinterpretations like you read above.
EWT is built on analysing historical price data. These data points are historical, and usually, when predicting future movements, they don’t take into account black-swan events like the COVID-19 pandemic. But then, this is very difficult to do, even for professional investors.
Absolutely! EWT shouldn’t be used in isolation. Combining it with indicators like support/resistance levels, volume analysis, or momentum oscillators can provide a more well-rounded perspective on potential entry and exit points.
Focus on identifying the overall trend using higher time frame charts (weekly or monthly) before zooming in on shorter time frames for more detailed analysis. You can also try using tools like Fibonacci retracements to identify potential support and resistance levels within a wave.
Practice! Utilise historical charts and paper trading to test your wave identification skills. Backtest your predictions to see how they compare to actual price movements. Remember, there’s no single “correct” way to interpret wave patterns.