Elliott Wave Theory is a popular method of analysis that applies a technical approach with a fundamental analysis interpretation. Elliott Wave Theorists also concentrate on the price action strictly, and agree to the notion that the price is the beginning and end of all analysis, but they recognise that there exists an important relationship between liquidity, credit, and economic robustness which underlies the existing price patterns in the market.
The Wave Theory was first proposed by Ralph Nelson Elliott, an accountant, in the 1930s. Elliott’s approach was condensed into its definitive form in his 1938 book “Nature’s Laws – The Secret of the Universe” in 1946. Since then, the theory has been regarded both as pseudo-science, and as an effective method for dealing with the uncertainties of the market. Academics tend to disregard it in general, while some famous trading personalities, such as Robert Prechter, and Paul Tudor Jones claim to have attained success by using it.
The Elliott Wave Theory is based on the cyclical nature of market events. Most traders are familiar with the fact that market events, and economical conditions tend to recur in time with a varying frequency. A growth phase may be exceptionally long, or a recession (and a bear market may surprised to be exceptionally harsh and deep, but the nature of trading and economic activity ensures that sooner or later the existing conditions will revert to the opposite, and the market
Trading with the Elliott Wave
A wave theorist will divide the price pattern into several sub-patterns and consider trade opportunities on the basis of trends that exist at lower levels. Although Elliott Wave Theory is often discussed in the context of decades or years, the fractal nature of the price action enables the application of the theory at any timeframe.
Wave theory divides price action into five main phases. At the first phase, the trend is barely obvious as only a small number of traders are aware of its emerging potential. At phase two, there is a small correction, but it never brings prices below the inception point of the trend. Phase three is the strongest and most powerful, and also drives a large number of bystanders into the price action. Phase four is the ensuing corrective phase, and phase five is the final, bubbling phase of the trend where everyone is bullish and massive amounts of capital enter the market. Phase five is followed by a collapse which ends the trend.
Deciding where each of these phases begins or ends is mostly a matter of intuition. As such, there are no generally accepted methods, and each trader will sooner or later improvise his own techniques for determining the time frame of a trend. This is not necessarily a problem, since the best way of coping with the resultant failures and losses is choosing a strategy that will accommodate your risk tolerance and mental resilience in trading. Since each person is different, interpretation of Wave Theory also varies from person to person.
The main advantage of the Elliott Wave Theory lies in the organisation and compactness that it grants to the chaotic and price action. By reorganising the market patterns into an easily understood hierarchy, the Wave Theory allows greater precision in trade decisions, increasing the trader’s confidence, and widens his horizon by stretching the field beyond the randomness of short-term market events. All these make it possible to formulate more sophisticated and advanced strategies in trading while still keeping the necessities and implications of the immediate market action in mind.
The weakness of the Elliott Wave Theory is its arbitrariness. It is rare to have two analysts examine the same chart part pattern and reach the same conclusions or draw the same wave patterns as a result. Indeed, it is almost possible to imagine a complex price pattern on which a large number of analysts will reach consensus.
The main reason of this problem is the intuitive, fluid formulation of the theory itself. By attempting to place market dynamics into the strict formalism of a deterministic theory, the analyst deprives himself of the benefit of the insight that prices will and often do move for reasons which do not in any way accept explanation by referencing the past. In other words, it is possible that the market will create recurring patterns that appear to be cyclical without any simplistic underlying causality based on patterns and visual analysis. And when the wave theorists try to disregard this fact and confine the price into an arbitrary structure devised on very strict rules, the outcome is a rainbow pattern of scenarios that have little relationship to actual market dynamics, or the realized future market trends.
In summary, we can say that the Wave Theory is useful as a tool for organising one’s opinion about the markets, but it has very little predictive power in the storm of real market action. One could certainly use the theory to generate entry/exit points for trades, but success is only possible if the notion of precision is discarded, and the data is evaluated with strategies suitable to a chance game.