Elliott Wave Theory Explained

The Elliott Wave Theory has always been one of the most controversial methods of market analysis. Despite its centuries-old history, the theory is still heavily disputed in the scientific community.

Elliott Wave pattern is a complex structure that defines financial market behavior. It is a mathematical interpretation of the chart with the help of basic wave patterns and without considering additional fundamental or technical factors.

Elliott Wave Theory is highly influenced by the Dow Theory that describes phases of movement of each market trend, considering corrections. Ralph Elliott’s theory only expresses the Dow Theory in a mathematical way, using wave calculations.

How does it work?

According to the Elliott Wave Theory, a market move is cyclical. The cycles that repeat are called waves. A wave of a major trend consists of five small waves. Each of these waves can further be decomposed into separate five waves. When a trend appears, there are three impulse waves that move in the direction of the trend and two corrective waves.

At first glance, the mathematical concept behind Elliott Wave rules seems far-fetched and it does not correspond to real market behavior. But if you look at it in terms of early Dow Jones market research, you will see that within the trend, there are at least two major corrections that move in the opposite direction of the trend. And sooner or later, each trend loses its momentum, turning flat or reversing back.

Please note: While Elliott identified five trending waves; nowadays, wave theory researchers speak about 8-13 wave patterns that describe the behavior of the market more accurately and consider the side movements of cryptocurrency quotes.
Wavelength calculation, in relation to the chart of cryptocurrency quotes, is regulated by strict mathematical formulas. The table below clearly shows the wavelength patterns. But, at the same time, you should understand that significant weight coefficient deviations are possible when it comes to real-time Elliott wave trading.

The Elliott Wave Theory, just like other methods of technical analysis, has not only mathematical but also psychological roots. Market psychology states that after each uptrend, there is a downtrend which is associated with a change in the market sentiment and has nothing to do with the market overheating.

This statement is particularly true for cryptocurrencies because, unlike fiat assets, they do not depend greatly on fundamental supportive factors that can anchor the price and therefore reduce the amplitude of the waves.

Description of waves

According to the Elliott Wave theory, waves are divided into two types:

1. Impulse waves that move with the trend.
2. Corrective waves that move against the trend.

The first wave is impulsive. It forms the basis of the trend and is characterised by an almost complete absence of corrective noise. It represents a bear or bull market. It has low volatility in an individual candlestick, with a sharp increase in the amplitude of closed deals. However, there can also be breakouts of key levels and gaps between opening and closing candles.

The second wave is a sharp corrective wave. It has a large amplitude and occurs when the market retreats from the “conquered” positions. The pullback can be so strong that it will return cryptocurrency quotes back to previous key levels. However, this pullback is not able to break through the resistance levels that have previously acted as support levels for the trend. From a psychological point of view, the second wave reflects the desire of investors and conservative Elliott wave traders to take profits.

The third wave is an impulsive wave, demonstrating the greatest trend strength (both in amplitude and in duration). Remember that this wave can never be the shortest one! There are no gaps in the candlestick chart. Motion accelerates exponentially. The third wave may be almost one and a half times larger than the first. From a psychological aspect, it is a manifestation of trend sentiments among the majority of market players.

The fourth wave is a sideways correction (up to 30% of the size of the third wave). Considering the psychological background, this wave shows that those players who predict the end of the trend early and wish to take profits are leaving. This movement includes a large number of small movements in both directions, which are sometimes interpreted as the beginning of a sideways trend.

The fifth wave (impulsive) represents a significant change in quotes with small volume levels. The psychological explanation behind this movement is that most players (buyers) have already closed their positions, but the market is still optimistic.

Five trending waves are followed by the ABC correction pattern that is typical for market stagnation:

A-Wave (impulsive): small volumes; the characteristics of this wave are similar to those of the first wave, but in the opposite direction (showing downtrend).

B-Wave (corrective): small corrective moves with high trading volumes, defining the fight between bulls and bears.

C-Wave (impulsive): similar in characteristics to the third wave, but again in the opposite direction.

Benefits

• Unlike classic Trend Following theory, Elliott Wave theory has a number of undeniable advantages.
• When identifying the “third wave”, you can not only determine the movement but also its entry point.
• Using the Elliott wave oscillator, you can easily find where the 5th wave ends and the A wave begins.
• The theory is easily scalable to any timeframe. But when using the Elliott Wave theory, we recommend that you start from a one hour time frame.

And on top of this, Elliott Wave theory is the perfect way to determine not only the existence of the trend, but also its strength (when a stable movement is formed).

Disadvantages

• Opponents offer a number of serious arguments why you should avoid using this theory.
• Wave theory is easy to observe from a historical perspective but it can hardly be applied to today’s live markets.
• Impulse waves can be extended in time, which means some players will leave before the movement ends.
• Within a large wave, there are several small ones, which may lead to incorrect interpretation of the chart.

In addition, you should not forget that obtained results can be difficult to interpret and the general analysis can also be complicated due to market noise.

Confirmations on Bitcoin Chart

Elliott Wave theory is easy to observe from a historical perspective. The 2013-2020 Bitcoin/USD chart proves that this theory is really working. When scaling the chart to week timeframes, several 8-wave patterns can be clearly identified.

Elliott wave theory proved to be effective for Bitcoin analysis because all main attempts to predict price movements were accurate. But it is worth mentioning that traders who use Elliott waves to predict price were wrong with time intervals.

Outcome

Elliott waves have a complex mathematical structure where great precision is of vital importance. That’s why it’s better to use Elliott Wave theory in combination with other technical analysis tools.

Unfortunately, just like with any other early developments in the technical analysis of the market, when using Elliott’s theory, you need to consider the phenomenon of “unrepeatability”. It means that under similar conditions, the results of the analysis may differ completely from a historical perspective.