What is the Elliott Wave Theory

The Elliott Wave Theory was developed by Ralph Nelson Elliott to describe price movements in financial markets, in which he observed and identified recurring, fractal wave patterns. 


Elliott Wave Theory Basics

Origins of the Elliott Wave Theory

The Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1930s. After being forced into retirement due to an illness, Elliott needed something to occupy his time and began studying 75 years worth of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across various indexes. The theory gained notoriety in 1935 when Elliott made an uncanny prediction of a stock market bottom and has since become a staple for thousands of portfolio managers, traders, and private investors.

R.N. Elliott described specific rules governing how to identify, predict and capitalize on these wave patterns. These books, articles, and letters are covered in R.N. Elliott's Masterworks, published in 1994. Elliott Wave International is the largest independent financial analysis and market forecasting firm in the world whose market analysis and forecasting are based on Elliott’s model..

R.N. Elliott was careful to note that these patterns do not provide any kind of certainty about future price movement, but rather, serve in helping to order the probabilities for future market action. They can be used in conjunction with other forms of technical analysis, including technical indicators, to identify specific opportunities. Traders may have differing interpretations of a market's Elliott Wave structure at a given time.

How Elliott Waves Work

The Elliott Wave principle consists of impulse and corrective waves at its core:

  • Impulse Waves - Impulse waves consist of five sub-waves that make net movement in the same direction as the trend of the next-largest degree.
  • Corrective Waves - Corrective waves consist of three, or a combination of three, sub-waves that make net movement in the direction opposite to the trend of the next-largest degree.

These impulse and corrective waves are nested in a self-similar fractal to create larger patterns. For example, a one-year chart may be in the midst of a corrective wave, but a 30-day chart may show a developing impulse wave. A trader with this Elliott wave interpretation might therefore have a long-term bearish outlook with a short-term bullish outlook.

Elliott recognized that the Fibonacci sequence denotes the number of waves in impulses and corrections. Wave relationships in price and time also commonly exhibit Fibonacci ratios, such as ~38% and 62%. For example, a corrective wave may have a retrace of 38% of the preceding impulse.

Elliott Wave Oscillator Chart

Other analysts have developed indicators inspired by the Elliott Wave principle, including the Elliott Wave Oscillator, which is pictured in the image above. The oscillator provides a computerized method of predicting

future price direction based on the difference between a five-period and 34-period moving average. Elliott Wave International’s artificial intelligence system, EWAVES, applies all Elliott wave rules and guidelines to data to generate automated Elliott wave analysis.