Trading in the financial markets is not an exact science because you cannot accurately determine future price movements. Nevertheless, some theories can help you get a fairly clear idea of how the price may likely move. The Elliott Wave Theory is one such set of principles.
Many investors and traders rely on its near-accurate assessment of potential market movements. In this article, we explore what the Elliott Wave Theory is, how Elliott waves work and how you can identify trading opportunities using this theory.
What is the Elliott Wave Theory?
The Elliott Wave Theory proposes that the prices of stocks and securities move in predictable patterns made of fractal waves. The term ‘fractal’ indicates that this is an infinite pattern of waves made up of smaller waves — or, in other words, waves within waves.
The theory traces its origins to the 1930s when it was proposed by Ralph Nelson Elliott, who analysed price data of different indexes across 75 years. The charts he studied varied in frequency from 30-minute and hourly charts to daily, weekly, monthly and annual charts. He then predicted that the market tends to move in a pattern of impulse and corrective waves. More specifically, 5 impulse waves are followed by 3 corrective waves, leading to a 5-3 wave pattern.
The impulse waves are numbered from 1 to 5, while the corrective waves are labelled alphabetically as A, B and C in the stock market. This is why the Elliott Wave Theory is also called the ABC Wave Theory.
Decoding how Elliott waves work
Elliott waves come in sets of 5 and 3 in quick succession. The first set of 5 waves, known as impulse waves or motive waves, strengthen the existing trend. The next set of 3 waves, known as corrective waves, move in the opposite direction to the previous trend — indicating a reversal.
That said, these Elliott waves are nested within one another to create broad patterns. So, the direction of price movement may be different when you look at charts with different time frames. For instance, in a weekly chart, you may notice a building impulse wave, with share prices rising. However, the monthly chart may reveal a corrective wave, with share prices falling.
This essentially means that you need to adopt a bullish outlook over the ultra-short-term and a bearish outlook over the medium-term.
Impulse waves
Let us examine the 5-wave pattern that makes up the impulse wave segment in the Elliott Wave Theory — which furthers the ongoing trend. Impulse waves can indicate bullish or bearish movement. Here is what each wave entails in a bullish phase (the direction is the opposite in bearish markets).
- Wave 1: This wave begins the bullish trend. So, say the price of a stock goes from Rs. 10 to Rs. 17.
- Wave 2: Wave 2 corrects the ongoing momentum slightly, leading to a fall in the price. The Elliott Wave Theory suggests that the end of Wave 2 must always be above the start of Wave 1. So, in our example, say the price of the stock falls from Rs. 17 to Rs. 15 (it cannot go below Rs. 10).
- Wave 3: Wave 3 is an impulse wave in the direction of the ongoing trend. This is generally the longest motive wave, where the existing trend is the strongest. So, in our example, say the price of the stock rises from Rs. 15 to Rs. 25 (it has to rise more than Rs. 7, which is the length of Wave 1).
- Wave 4: Wave 4 again indicates a small correction. As a rule, Wave 1 and Wave 4 must not overlap at all. This means that the end of Wave 4 must always be higher than the end of Wave 1. In our case, this means that in this pullback wave, the share price may fall from Rs. 25 to Rs. 21 (it must remain above Rs. 17, which is the peak of Wave 1).
- Wave 5: The last impulse wave is also a trend follower. It is the final push in the current direction before the corrective phase begins. Wave 5 is also shorter than Wave 3. So, continuing our example, the share price may rise from Rs. 21 to Rs. 29 (it cannot rise by Rs. 10 or more, which is the length of Wave 3).
Corrective waves
Three corrective waves labelled A, B and C in the stock market typically follow the impulse segment. If the impulse phase is bullish, the corrective phase is bearish (and vice versa). Continuing our example from above, here is what the corrective waves mean when they follow a bull market.
- Wave A: Wave A is the start of the bearish trend, where the price falls below the peak of Wave 5. So, in the example, the price may fall from Rs. 29 to Rs. 23.
- Wave B: Wave B is when the price moves slightly upward to retrace a portion of Wave A. However, it does not hit the same high as Wave 5. For instance, the price may move from Rs. 23 to Rs. 25.
- Wave C: This is the final wave in the corrective phase, which further pushes the price in the direction of the counter-trend. In our example, the price may fall again from Rs. 25 to 18.
Trading opportunities using Elliott waves
In the 5-3 wave pattern suggested by the Elliott Wave Theory, you may be able to identify the following trading opportunities. The details of a bullish market have been explained. In a bearish market, the positions will be the opposite.
- End of Wave 2: The end of Wave 2 may be a buying opportunity as Wave 3 is generally the strongest.
- End of Wave 4: Similarly, at the end of Wave 2, you may have another buying opportunity before the price moves up in Wave 5.
- End of Wave 5: The end of Wave 5 may be the ideal time to enter short positions and trade against the trend.
Conclusion
This sums up what the Elliott Wave Theory is and how you can use the fractal wave patterns to identify trading opportunities in the market. That said, although the Elliott Wave Theory may be highly popular, remember to set stop-losses for your trades and have a target price before you enter the market. This will help you limit the upside and determine your potential gains with more certainty.
