Elliott Wave Theory is an effective technical analysis tool for understanding the big picture of the Forex market and forecasting future scenarios.
This article focuses not on the technical “when to trade” aspects, but rather on the fundamental knowledge you need to understand in order to properly utilize Elliott Wave Theory.
To use Elliott Wave Theory correctly, it’s important to understand its origins and core principles!
That means if you hold onto a misunderstanding, there’s a risk you’ll keep making incorrect analyses and forecasts.
Specifically, this article covers the following topics:
- What is Elliott Wave Theory? What kind of technical analysis is it?
- The waves in Elliott Wave Theory and its three important principles
I hope this article will serve as a helpful introduction for learning Elliott Wave Theory and applying it to your trading.
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What Is Elliott Wave Theory?
The Origin of Elliott Wave Theory
Ralph Nelson Elliott, a former accountant and investor, discovered recurring patterns in price movements through extensive market observation.
He introduced this principle of stock price fluctuations as the “Wave Principle” (1946, Nature’s Law: The Secret of the Universe (Elliott Wave)).
Later, Hamilton Bolton and Robert Prechter took notice of this “Wave Principle.”
They accumulated further insights and refinements, leading to the formation of the modern “Elliott Wave Theory.”
- Ralph Nelson Elliott, a former accountant and investor, discovered recurring patterns in price movements.
- He compiled his findings into a paper titled The Wave Principle.
- After Elliott’s death, Hamilton Bolton and Robert Prechter took interest in his work and expanded upon it with additional insights and revisions.
- This led to the development of what is now known as modern Elliott Wave Theory.
In simple terms:
The market follows certain patterns and moves in cycles.
These patterns and cycles are based on human behavioral psychology.
“That theory dates back to 1946 — that’s quite a long time ago. Does it still hold up today?”
I understand why you’d think that. The key to this theory is that it’s based on human behavioral psychology!
Why Elliott Wave Theory Works in the Market
The reason Elliott Wave patterns hold true across different markets and eras is believed to be linked to the following three facts about markets and human nature:
- Markets are driven by human psychology.
- In similar situations or environments, individuals tend to exhibit similar behaviors and mindsets.
- Human psychology has common characteristics that transcend time.
Markets Are Driven by Human Psychology
Rises, falls, and sideways movements in the market reflect human emotions such as hope and fear, and the thoughts of “this might happen” or “I want this to happen.”
In similar situations or environments, individuals tend to exhibit similar behaviors and mindsets.
Behavioral psychology concepts such as the bandwagon effect and prospect theory are well-known.
Not only in markets but in general, people acting in groups tend to feel the same way and behave similarly.
Human psychology has common traits that transcend time.
Fear of a market crash, the pain of unrealized losses, and the desire to win or avoid losing—these fundamental emotions like fear and pleasure are universal across time.
There has never been an era when people were happy to lose their wealth.
[Side Note] Are Market Participants Only Humans?
Elliott Wave Theory is based on the premise that market patterns reflect human psychology. It observes, classifies, and systematizes these patterns.
This framework is what we now know as modern Elliott Wave Theory.
It’s humans who gather all kinds of information, make predictions, feel hope or disappointment, and participate in the market.
That’s true, but nowadays AI and robots also participate in the market, don’t they?
That’s right. But even those are ultimately driven by human intentions and psychology, aren’t they?
As he said, trading technologies like AI, robots, and automated systems have advanced significantly today.
However, they are developed based on human desires and knowledge, operate according to human theories, and are controlled by humans who have hopes and fears.
Therefore, as long as AI does not trade on its own independent will, all market participants can still be considered human.
If AI were to start acting with its own will, then who knows what would happen to this theory…
The development of generative AI like ChatGPT is amazing these days.
In other words, it’s fair to say that Elliott Wave Theory analyzes the human psychology hidden behind the market.
As long as humans remain the driving force shaping the market, Elliott Wave Theory will remain valid.
Elliott Wave Theory as Technical Analysis
Elliott Wave Theory is a type of technical analysis.
It views market price movements as waves and analyzes them based on wave patterns to forecast future price actions.
The advantage of using Elliott Wave Theory is that it allows you to analyze market conditions and effectively predict future scenarios.
Specific analysis methods similar to Elliott Wave Theory include drawing lines based on price, such as “line analysis” and “Fibonacci retracement.”
I’m familiar with channel lines and Fibonacci—they were also mentioned earlier in the Elliott Wave Theory explanation.
Also, it’s similar to “pattern analysis,” which uses common patterns like double tops and head and shoulders to predict market price movements.
For those who use these kinds of analysis methods, Elliott Wave Theory might be easier to get into!
[Very Important] What Are the “Waves” and “Wave Patterns” in Elliott Wave Theory?
What exactly are the “waves” and “wave patterns” often mentioned in Elliott Wave Theory?
“Waves” and “wave patterns” refer to price movements and market shapes! Let me explain in detail.
The Concepts of “Waves” and “Wave Patterns” in Elliott Wave Theory
When analyzing with Elliott Wave Theory, it’s important to have a clear understanding of the concepts of “waves” and “wave patterns.”
Their definitions are as follows:
- A “wave pattern” refers to a specific shape of price movement.
- A “wave” refers to a series of upward and downward price movements.
In other words, a “wave pattern” is made up of multiple individual “waves” combined together.
The “Size of a Wave” in Elliott Wave Theory Refers to the “Magnitude of Price Movement”
In Elliott Wave Theory, a “wave” is said to include both price and time elements. (Think of it like a mathematical vector = magnitude + direction.)
However, when evaluating the “size of a wave” during analysis, only the price movement is taken into account.
Be careful not to misunderstand “wave size” as “price + time length,” as some people do.
Such misunderstandings can affect the accuracy of your Elliott Wave analysis.
Let’s take a look at a wave pattern composed of waves 1 through 5.
Wave 1: Price movement ❶ is 500 pips, duration ❶ is 4 hours
Wave 3: Price movement ❸ is 800 pips, duration ❸ is 2 hours
Wave 5: Price movement ❺ is 500 pips, duration ❺ is 2 hours
If you look at the chart based on “price + time” (black lines), Wave 1 and Wave 3 may appear to be roughly the same size.
However, if you focus only on “price movement” (red arrows), it’s clear that Wave 3 is significantly larger.
In Elliott Wave Theory, “wave size” is defined by the magnitude of the price movement, so the correct conclusion is that Wave 3 is larger than Wave 1.
This wave pattern can be defined as an “impulse”, but if you mistakenly evaluate it using wave + time,
you might fail to recognize it as an impulse. So be careful!
Even small misunderstandings can add up, leading to a misread of the market → trading mistakes (losses).
That’s right—make sure there’s no misunderstanding when it comes to “waves”!
Now, let’s go over the three core principles of Elliott Wave Theory.
The Three Core Principles of Elliott Wave Theory
In Elliott Wave Theory, the market is analyzed based on the following three principles:
- The market moves forward in 5 waves and corrects in 3 waves
- The market has a fractal structure
- Wave patterns that appear in the market can generally be classified into 5 categories
Some people or websites refer to the following as “rules” of Elliott Wave Theory:
- Wave 2 does not retrace beyond the start of Wave 1
- Wave 3 is never the shortest
- Wave 4 does not overlap with Wave 1
However, these are actually conditions specific to the Impulse wave pattern—
so be careful not to misunderstand them as universal rules of Elliott Wave Theory.
Principle 1: The market moves forward in 5 waves and corrects in 3 waves
In Elliott Wave Theory, the market advances in 5 waves numbered 1 through 5, pushing the price in the direction of the trend.
Then, it corrects in 3 waves labeled A through C, adjusting the price against the trend.
- Impulse waves: Waves that push the price in the trend direction, composed of 5 waves
- Corrective waves: Waves that move the price against the trend, composed of 3 waves
In an uptrend, the price moves upward in 5 waves, followed by a correction in 3 waves downward.
Conversely, in a downtrend, the price moves downward in 5 waves, followed by a correction in 3 waves upward.
The fundamental idea of Elliott Wave Theory is that all market movements are made up of impulse waves and corrective waves.
One complete cycle is counted as five impulse waves plus three corrective waves.
Principle 2: The market has a fractal structure
A fractal structure is a mathematical term referring to a shape where parts of the figure resemble the whole.
This is a concept from geometry.
Hmm… that sounds complicated.
Think of it like a matryoshka doll!
A large doll contains a smaller doll inside it, and inside that smaller doll is an even smaller one, and so on.
In Elliott Wave Theory, the market is also believed to have this fractal structure.
The idea that “the market is fractal” can be understood as follows:
- Regardless of whether it’s a long-term, medium-term, or short-term timeframe, the market always follows the pattern of “5 waves impulsive + 3 waves corrective.”
- Elliott Waves themselves are made up of smaller Elliott Waves.
For example, one wave on the monthly chart (long-term) is made up of 5 or 3 waves on the daily chart (medium-term).
Similarly, the daily chart (medium-term) is composed of 5 or 3 waves on the 4-hour chart (shorter-term).
From the perspective of the fractal structure, the “impulse waves” and “corrective waves” can be seen as composed of “action waves” and “reaction waves.”
- Action Waves: Waves moving in the same direction as the next larger wave.
- Reaction Waves: Waves moving in the opposite direction to the next larger wave.
These action waves and reaction waves are collectively called subwaves.
Because the market has a fractal structure, there are even smaller subwaves within these subwaves.
Because the Elliott Wave Theory is based on the concept of fractal structure, it is very compatible with multi-time frame analysis!
That’s the method where you analyze multiple timeframes in order from long-term to medium-term to short-term, right?
Exactly! Elliott Wave Theory’s strength lies in its ability to analyze not only a single timeframe but multiple timeframes to understand the trend direction and entry points.
Principle 3: The patterns that appear in the market can be classified into five basic wave forms.
In Elliott Wave Theory, market movements are classified into five basic wave patterns.
- Impulse waves: Two patterns — Impulse and Diagonal
- Corrective waves: Three patterns — Zigzag, Flat, and Triangle
These five wave patterns are considered the fundamental building blocks of the market structure.
Note that especially the Diagonal, Flat, and Triangle patterns have various variations.
There is also a pattern called the Complex Correction, which consists of multiple consecutive corrective waves, but we will not go into detail here.
The Impulse, Diagonal, and Zigzag patterns are characterized by large price movements and often present opportunities for significant profits in trading.
On the other hand, the Flat and Triangle patterns indicate sideways or consolidating price action. After these patterns complete, the price typically resumes movement in the direction of the original trend.
It helps in scenario analysis such as identifying which wave of which pattern the current market movement is in, and predicting which pattern is likely to form next.
Summary
This concludes the overview of Elliott Wave Theory, including its fundamental waves and the three key principles.
Elliott Wave Theory is based on human behavioral psychology and serves as a form of technical analysis that predicts market patterns.
・The market moves forward in 5 waves and corrects in 3 waves.
・The market has a fractal structure.
・There are 5 main categories of wave patterns.
These are absolutely essential to remember!
Don’t forget that in Elliott Wave Theory, the “size of a wave” is determined solely by the magnitude of the price movement!
If You Want to Learn Elliott Wave Theory, This Book Is Recommended!
Needless to say, when you fail to predict any big movements of the market, trading is more or less a gamble, and things become much more dangerous.
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Elliott Waves Made Simple: Master Elliott Waves Techniques In Less Than 48 Hours
