The theory based on the fact that the psychology and sensitivity of investors in technical analysis create repetitive patterns is called the Elliott Wave Theory. The Elliott Wave Theory was proposed by Ralph Nelson Elliott in the 1930s.
Analyzing 75-year data for various indices in different time frames such as yearly, monthly and daily, Elliott realized that the prices of the assets form certain patterns of rise and fall, which he calls waves in all time frames, and that these are due to investor psychology.
The theory is used to detect trends and cycles in many markets today. It should be noted, though, that the Elliott Wave Theory is not a technical indicator, but a theory used only to predict market sentiment.
Basic principles of the Elliott Wave Theory
The theory suggests that a market cycle consists of eight waves. Five of these waves move in the direction of the current market trend and are called “movement” or “impact” waves. The other three waves that move against the trend direction are “corrective” waves.
While the motion waves, which are the first five waves of the cycle, are indicated by the numbers “1,2,3,4,5”, the last three waves, the corrective waves, are indicated by the letters “A, B, C”.
Sample model of Elliott Wave waves. Source: Binance Academy
As seen in the example chart above, the numbers 1, 3 and 5 represent the movement waves moving in the direction of the trend, while the numbers 2 and 4 represent the retracements within a general upward trend. On the other hand, Ralph Elliott explained that he thinks these cycles in financial markets are in fractal structure. That is, the movement between waves 1 and 5 and waves A and C can also represent a single wave in a larger time frame. Similarly, a separate cycle within a single wave can be observed in a smaller time frame.
There are some fixed rules between motion waves in Elliott Wave Theory. The waves in question must obey these rules in order to be called motion waves. Wave 2, for example, cannot show a retracement that retraces the movement of wave 1 by more than 100 percent. The same rule applies to waves 3 and 4.
Between waves 1, 3, and 5, wave 3 can never be the shortest wave, which is usually the longest wave. The motion of wave number 3 always surpasses that of wave 1.
Correction waves are shorter compared to movement waves because they run against the direction of the trend. Corrective waves are never five, always three.
Fibonacci ratios and Elliott Wave Theory relation
Ratios based on the Fibonacci sequence put forward by the Italian mathematician Leonardo Fibonacci also have an important place in the Elliott Wave Theory. The Fibonacci retracement levels made up of these ratios refer to the support levels where the price may drop during the correction, and a reversal is expected from these levels and the initial trend is expected to continue from where it left off.
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Fibonacci extension levels represent the points where the price following the first trend can go and are considered by investors as profit-taking points. It has been observed that there is also a relationship between Elliott Wave waves based on Fibonacci ratios.
Fibonacci retracement (upper block) and extension (lower block) rates. Source: Elliott Wave Forecast
Wave 2, for example, usually shows a 50, 61.8, 76.4, or 85.4 percent retracement compared to wave 1. Wave number 3 generally increases by 161.8 percent compared to wave number 1. Retractions experienced by wave number 4 are usually 14.6, 23.6, or 38.2 percent of wave number 3.
Properties of Elliott Wave waves
Wave number 1
This first wave, which is the beginning of the bull market, is often unnoticeable and originates in a negative sentiment environment. Of the five movement waves, it is generally considered that the previous trend is still present during wave 1, which is the shortest. In the option markets, put options are predominant and volatility is high.
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Wave number 2
Overall market sentiment is still negative during this wave, which is the correction of wave 1. On the other hand, the volume is lower than wave 1. The correction experienced during this wave generally does not exceed 61.8 percent of wave # 1.
Wave number 3
In this wave, which is often the biggest wave of the cycle, market sentiment starts to improve and bullish expectation among investors increases. While prices are rising rapidly, corrections take an extremely short time. Traders waiting for a correction to enter during this wave are likely to miss the opportunity.
Wave number 4
During this wave of clear correction, there is usually a 38.2 percent retracement compared to wave 3. During wave 4, the price starts to rise again.
Wave number 5
This wave, the last wave of motion, is the last leg of the uptrend. Investors entering during this wave of positive market sentiment are at risk of buying at the peak price. Volume is mostly lower compared to wave # 3.
Corrective waves are generally more difficult to detect than motion waves. Volume increases in A wave, volatility in the options market increases and open positions of the futures market increase.
This wave, in which the price is rising again, is the last exit before the bridge for investors. The volume is low.
In this wave, when it is understood that the uptrend is over, the price decline continues.
Does the Elliott Wave Theory work?
One of the biggest debates about this theory is its high subjectivity. The theory is based on the ability of traders to properly classify market movements, and this can be done in many different ways without breaking the rules mentioned above.
Nevertheless, the success of this theory, which benefits investors, will increase when used in conjunction with other indicators.
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Reminding: No technical indicator alone is sufficient to predict prices. As with almost any indicator data, the Elliott Wave Theory makes sense when used in conjunction with other market data.
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