While fundamental analysis focuses on a company’s business operations and financial health, technical analysis focuses on price patterns and trends on a stock’s price chart.
Within these two methods of analysis, numerous theories exist regarding how investors approach stock investing. No matter how you approach stock-picking, the end goal for all investors remains the same, i.e. to create wealth.
Today, let’s study one of the famous theories in technical analysis: Elliott Wave Theory.
This theory uses wave patterns to help investors understand market trends.
What is Elliott Wave Theory?
The Elliott Wave theory is focused on identifying a trend in financial market values and is based on the assumption that market patterns that have prevailed in the past might extrapolate in the future. This theory was developed by Ralph Nelson Elliott in 1930. The theory still finds relevance among traders/investors and financial institutions.
The theory proposes that market price movements follow a repetitive pattern of waves, both upwards and downwards, driven by investor behaviour and sentiment. According to the theory, these distinct patterns formed by the waves can be a useful tool to understand movements in stock prices.
As per this theory, market cycles are made up of five wave patterns that provide direction to the primary trend (impulse waves), followed by three wave patterns against the main trend. These waves are fractal, meaning they occur in multiple time frames, from minutes to months or even years.
This theory uses various supplementing tools and techniques, such as Fibonacci ratios, trend lines, and momentum indicators. However, it is subjective and can be differently interpreted by various analysts, and not all investors agree on its validity and effectiveness.
What is the basic structure of the Elliott Wave Theory?
The structure of Elliott Wave Theory includes:
Impulse Waves (5 waves): These are five waves that move in the direction of the primary trend and are labelled as, 1,2,3,4, and 5. Amongst these, waves that move in the direction of the main trend are 1, 3, and 5. Waves 2 and 4 are correcting waves against the trend.
Corrective Waves (3 waves): These waves move against the main trend and are labelled A, B, and C. These waves typically retrace a portion of the preceding impulse waves.
What are the Rules of the Elliott Wave Theory?
The rules of this theory are as follows:
Wave counting:
The identification and counting of waves is the foundation of this theory. A complete cycle consists of eight waves, five impulsive and three corrective waves. These waves form larger degrees of waves within waves, creating a fractal-like pattern.
Wave proportions:
The theory suggests that waves within the same degree exhibit proportional relationships. For instance, the strongest and longest wave in the impulsive sequence is wave 3, which typically extends beyond the price territory reached by wave 1. Also, wave 2 retraces under the range of 100 percent of wave 1, and wave 4 retraces to a lesser degree than wave 2.
Wave relationships:
Waves exhibit specific relationships with one another. For example, wave 3 is never the shortest among waves 1, 3, and 5 within an impulsive sequence. Moreover, wave 4 usually does not overlap with the price territory covered by wave 1, ensuring that the impulsive structure remains intact.
Wave alternation:
The Elliott Wave Theory emphasises the concept of alternation between waves of similar degrees. This means that if wave 2 is a sharp and swift correction, wave 4 is likely to be more complex and time-consuming. Similarly, if wave A is a simple correction, wave B is likely to be more complex or vice versa.
Wave extension:
In certain cases, one of the impulsive waves within a sequence may extend significantly beyond its expected length. This phenomenon, known as wave extension, often occurs in strong trending markets where one of the impulsive waves experiences rapid price expansion.
Wave failure:
While the Elliott Wave Theory provides guidelines for wave patterns, it also acknowledges the possibility of wave failure. Wave failure occurs when a wave violates one of the fundamental rules, such as Wave 4 overlapping with Wave 1 or Wave 2 retracing more than 100 per cent of Wave 1. In such cases, the wave count may need to be reassessed.
Fibonacci ratios:
Although not a strict rule, Fibonacci ratios often play a significant role in Elliott Wave analysis. These ratios, such as 0.618 (golden ratio) and its derivatives, frequently appear in the relationships between wave lengths and retracements, adding another layer of confluence to wave analysis.
Investors must practice and implement adequate risk management tools like setting up a stop-loss order to minimise losses if the trade does not pan out as expected.
Another aspect which needs to be taken care of is positing sizing. Investors must size their bets based on their faith in the theory and the overall risk-reward ratio of the trade. As the markets continuously evolve, investors must monitor the price movements and adjust their trading strategies accordingly.
Note: The article is for information purposes only. This is not an investment advice.
(The author is Vice President of Research, TejiMandi)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)