Elliott Wave Theory: What You Need To Know

Stock market movements that seemed random to most analysts revealed a hidden order to Ralph Nelson Elliott. In the 1930s, during the depths of the Great Depression, the professional accountant set out the basis of one of technical analysis's most controversial ideas—the idea that market prices move in predictable, repeating waves driven by investor psychology.

Elliott's breakthrough came from observing that financial markets follow patterns that repeat themselves on multiple scales, much like patterns found in nature. These recurring structures, which would later be called fractals, offered a new way to understand and potentially forecast market movements.

The theory suggests that market trends move in a series of five waves in one direction followed by three waves in the opposite direction, forming patterns that can be seen across different periods—whether minutes or decades.

Elliott's Waves

Elliott proposed that financial price trends result from investors' predominant psychology. He found that swings in mass psychology always showed up in the same recurring fractal patterns, or "waves," in financial markets.

Elliott's theory resembles Dow's in that both recognized that stock prices move in waves. Because Elliott also recognized the "fractal" nature of markets, he was able to break them down and analyze them in much greater detail.

Fractals are mathematical structures that infinitely repeat themselves at larger and smaller scales. Elliott argued that stock index price patterns were structured similarly. He then began to look at how these repeating patterns could be used to predict market moves.

How To Use Elliott Waves While Trading the Market

Elliott's key claim involved identifying two types of waves. An impulse wave, which travels in the same direction as the larger trend, always comprises five waves in its pattern. A corrective wave, on the other hand, travels in the opposite direction of the main trend.

Like Russian nesting dolls, each of these waves contains even smaller versions of the same patterns. For example, during an upward impulse wave, you'll find five smaller waves moving up, and within each of those, you'll find five even smaller waves.

Elliott claimed this pattern helped him identify where prices were heading. For instance, if he spotted four waves completed in an impulse pattern, he would expect one more wave up before a reversal occurred.

To use the theory in everyday trading, a trader might identify an upward-trending impulse wave, go long, and then sell or short the position as the pattern completes five waves and a reversal is imminent.

The Shapes To Look For

Here's how the general shape of Elliott's waves break down:

• Five waves move in the direction of the main trend, followed by three waves in a correction. Within this five to three move, two subdivisions of the next higher wave then move.
• The underlying five-three pattern remains constant, he claimed, though the time span of each wave may vary.

Let's have a look at the following chart made up of eight waves (five heading up and three trending downward) labeled 1, 2, 3, 4, 5, A, B, and C.

Waves one, two, three, four, and five form an impulse, and waves A, B, and C form a correction. The five-wave impulse, in turn, forms wave one at the next-largest degree, and the three-wave correction forms wave two at the next-largest degree.

The corrective wave normally has three distinct price movements—two in the direction of the main correction (A and C) and one against it (B). In the figure above, waves two and four are corrections. These waves typically have the following structure:

In this figure, waves A and C move toward the trend at a degree one larger. They are, therefore, impulsive and composed of five waves. Wave B, by contrast, is countertrend. Thus, it's corrective and consists of three waves.

An impulse-wave formation, followed by a corrective wave, forms an Elliott wave degree consisting of trends and countertrends.

As you can see from the patterns in these figures, the five waves do not always travel wholly upward, and the three waves do not always travel fully downward. For instance, when the larger-degree trend is down, so is the five-wave sequence.

Technical Charts That Automate Elliott's Wave Principle

Elliott wave oscillators, as customized and imported into various trading platforms (see the example below from TradingView), provide a way to support wave pattern identification. Essentially, these oscillators act as a momentum indicator that help confirm wave counts.

These tools calculates the difference between two moving averages—typically a five-period and a 35-period simple moving average of closing prices—and displays the result as a histogram below the price chart.

When the histogram bars are above zero, they indicate bullish momentum that often corresponds to impulse waves up, while bars below zero suggest the bearish momentum often seen in corrective waves down.

Wave Degrees

Elliott identified nine degrees of waves, which he labeled as the following, from largest to smallest:

1. Grand super cycle
2. Super cycle
3. Cycle
4. Primary
5. Intermediate
6. Minor
7. Minute
8. Minuette
9. Sub-minuette

Since Elliott waves are a fractal, wave degrees theoretically expand ever larger and ever smaller beyond those listed above.

The Drawbacks of Elliott Wave Theory

In the 1970s, the theory became far more popular through the work of A.J. Frost and Robert Prechter. In the "Elliott Wave Principle: Key to Market Behavior," the authors are said to have predicted the bull market of the 1980s.

Today, much of Elliott's theory is intuitive to most traders. In the financial markets, many trade based on the dictum that "what goes up, must come down," as a price movement up or down is often followed by a contrary movement. Technical analysts following price action also know it's divided into trends and corrections. Thus, a zigzag-like pattern fits much of what we see every day on the charts of various assets, from stocks to cryptocurrencies, in all time frames.

Yet the seductive simplicity of Elliott Wave Theory makes it easy to miss significant challenges that both critics and practitioners acknowledge. Applying the theory in real time proves far more difficult than analyzing it in hindsight.

Subjectivity plagues wave counting, the theory's fundamental tool. Two experienced analysts often disagree about where one wave ends and another begins, making consistent application challenging. In addition, as with most things, time is its biggest challenge. Elliott Wave Theory says nothing about how long each wave should take, leaving traders guessing whether a pattern might be completed in days or years. A wave pattern you think will take months could stretch out for years, wreaking havoc with your trading and risk management plans.

A supposed major advantage of the theory—its flexibility at different scales or periods—is instead a substantial drawback: it can explain any market move after the fact but struggles with enabling reliable predictions. When a forecast fails, practitioners can always claim they miscounted the waves rather than acknowledge potential flaws in the theory itself.

The Bottom Line

Elliott Wave Theory offers one of the first major frameworks to try to get a chart-based understanding of market psychology through recurring patterns. However, it requires careful application. While its fractal approach provides some insight into how investor sentiment drives price movements, the theory's subjective nature makes it more suitable as an added tool on the side.

More experienced practitioners use Elliott wave analysis with technical indicators and fundamental analysis, treating wave patterns as one of many inputs into their trading decisions rather than relying on them exclusively.