Ralph Nelson Elliott developed the Elliot wave theory during the Great Depression because public sentiment drives market trends.
He asserts that collective investor psychology swings from pessimism to optimism and back in a natural sequence, creating identifiable price patterns.
In other words, investors’ general bias (toward greed or fear) shows up as specific price patterns that can then be identified and used for market timing and trading purposes.
The more people gather around each new concept, the more likely it seems to become self-fulfilling.
This is why there are so many holy wars over different techniques – trend following vs contrarian investing, fundamental analysis vs technical analysis, etcetera – regardless of how much empirical evidence exists suggesting that all these approaches are nothing more than self-fulfilling prophecies.
The Elliott wave theory is no different. Most investors now know about this theory, so they either play along and join the crowd – and therefore create the very thing they’re trying to avoid: a self-fulfilling prophecy – or they don’t buy into the theory and label it as nonsense, which also creates a self-fulfilling prophecy of sorts.
The truth, as always, is somewhere in between.
Most traders use the Elliott wave theory as many tools for market timing and trading purposes.
Its main strength lies in its simplicity: There are only five basic patterns, so you can quickly learn and apply them without much effort.
The possible downsides of using the Elliott wave theory as a standalone trading tool are:
- Its complexity and
- The fact that most traders now also use this approach, creating larger crowds and, therefore, harder-to-predict market behaviour.
Another point worth mentioning is that there is no such thing as “Elliott Wave predictions” or “Elliot wave forecasts”.
An analyst can only make educated guesses and assumptions based on past price data – which inevitably makes it look like he knows what he’s doing when he gets his timing right by pure luck… but don’t be fooled!
That being said, Elliot waves are still one helpful tool to add to your market timing and trading toolbox.
The most popular way to trade the Elliot wave theory is by looking for 5-wave price patterns (i.e., impulsive waves) in a more significant trend that can be sold using standard trend-following or contrarian methods.
This idea is that every impulse (5 waves) should be followed by a corrective structure (3 waves).
These corrections are expected to end either at the 0% line – where they started –, at the 38.2% retracement, or the 50% retracement, which very roughly corresponds with support and resistance levels as well as areas of former tops and bottoms.
Here is an example of a trading strategy based on the Elliot wave theory to better illustrate what we’re talking about.
We’re about to enter a rising market with five impulse waves that are part of a more significant trend.
The Elliott wave analysis suggests that this rally will be followed by at least one pullback, which might have ended when it reached the 38.2% retracement after wave 3
As mentioned before, markets are complex systems and not predictable in the long term, so don’t use any technique as if your life depends on it – because it doesn’t!
There’s no holy grail in trading. All you need to remember is what you already know: Making money in financial markets takes hard work, dedication, and lots and lots of practice.
In other words: If you want to be a successful trader, always keep in mind that trading is hard work but also fun and challenging when done right!
In addition, there are several other advantages to applying this theory when trading, including:
- The Elliott Wave Theory helps traders identify turns in an ongoing trend, increasing their profitability.
- According to Wright (1977), “the best way to make sure we don’t miss important turning points is by using a method which gives us entry signals at those times.” The application itself does not require any mathematical or statistical expertise; as such, novices can apply it and experienced traders.
- The ElliottWave Theory can also help traders identify support and resistance levels. This is important because security will often reverse course as it reaches vital support or resistance areas.
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