Wave Theory

Elliot Wave Theory is one of the most popular technical analysis tool available. Here is how it works

Having introduced the concept of Fibonacci retracement levels in an earlier piece, we can now proceed to a basic introduction of Elliot Wave Theory (EWT). This is the most popular and also the most controversial technical analysis tool available.

Technical analysts tend to be either complete believers in Elliot or they tend to be complete sceptics. EWT does provide a complete framework for studying repetitive phenomena (not just stock market moves) across any given timeframe.

Ralph Nelson Elliot achieved prominence because he made a series of uncanny predictions about the Great Depression of 1929-1937. He used the mathematical basis of the Fibonacci Ratios of 0.618 and 1.61 that are evident in a Fibonacci Series.

Long after Elliot's death, the development of modern Chaos theory suggests that there was also underlying fractal logic in some of his broader interpretations. Various followers of Elliot have since modified his methods to yield more sophisticated interpretations of the basic theory.

Here's the EWT in a nutshell. Elliot believed that stock market actions occurred in waves. He believed that those waves usually come in predictable patterns of five up (Action) followed by 3 down (reaction).

Occasionally the 5-wave trend will be down and followed by a 3-wave uptrend. The Fibonacci ratios apply in determining the relationships between the waves. Depending on the way in which the wave count is categorised, EWT can make predictions about the direction, amplitude and duration of the next wave. These relationships are independent of scale and hence EWT can make predictions ranging over centuries! It can also, given sufficiently detailed data, make predictions about price moves in the next minute.

The basic pattern of a complete Elliot cycle is thus eight waves split into 5-3. This 5-3 cycle is itself two subdivisions of a larger cycle. Starting from minutes, the waves cycles have been decoded up to grand-super-cycles ranging literally through centuries. The time span of a given wave may vary but this fractal pattern of 5-3 will repeat across all scales and dimensions according to classic Elliot theory.

The action waves are conventionally numbered 1-5 while the reaction waves are usually labelled a,b,c. Obviously there is subjectivity in the picking of the scale and interpretation of the pattern. This causes much confusion since two EW Theorists will frequently differ violently on the interpretation of the same pattern. Deciding where one wave starts and ends is the basic issue.

There is general agreement about a few things. Inside the 5-3 pattern itself, some of the waves will be impulse (strong vertical moves) while others will be failures or reactions (flat). For example, 1,3,5 may be impulse waves when 2 and 4 will be corrections.

The second reaction wave "b" will usually be a "correction within a correction" and this could move in the basic direction of the previous 5-wave trend. Take a look at the "Elliot Wave Count" chart to understand the basic pattern.

Projections for the next wave's duration and magnitude are made according to the Fibonacci Ratios. If it's a reaction phase, the likeliest pattern is down until some Fibonacci retracement level of the previous move while in an impulse wave the move will rise to some Fibonacci multiple.

Typically the EW theorist will attempt to superimpose the wave pattern on a stock that he is interested in and then derive likely projections. In practice, wave counts are rarely clear cut and this is where the problems arise. For example, take the weekly Sensex between 1999-2001.

How exactly do we take the wave counts on this chart? I have attached three possible interpretations. In the first interpretation, we saw a fifth wave failure in July 2000. The fifth wave ought to have been an impulse that drove the market up further than the third wave peak of 6151 in February 2000. Going further with this interpretation, we are now in the fifth wave of an downtrend and could expect a three-wave corrective uptrend when this current wave 5 ends.

The next 3-wave reaction will be a weak upmove that will not take the market back to its peak 6151 levels although it would definitely be a bull market. According to the second interpretation, we are in the second "b" wave of the 3-wave corrective after a 5-wave impulse that also ended with a failure.

In this case, we can expect another downtrend when the b wave ends and the "c" wave starts. Here the expectations would be a continuing bear market after this (temporary) b-wave uptrend concludes. A third interpretation is possible.

In this case, we are in the fourth wave of a 5-wave cycle and a strong upmove should come if the fifth wave is an impulsive uptrend. Obviously this would mean a totally different outlook from the first two interpretations.

The subjectivity of the wave count is what makes EWT difficult to handle. Unlike other technical tools, it is possible to make huge errors in interpretation. It is true that experienced users can come up with very accurate projections that hold good over the long-term.

The above explanation will only give the analyst a nodding acquaintance with EWT. It should be enough to highlight the dangers of casual use without understanding of the basic principles. If the reader wishes to use EWT, he will have to invest a lot of time and trouble in studying this system.