What is Elliott Wave?
The Elliott Wave principle was created in the '30s by Ralph Nelson Elliott – an American accountant and author. However, the theory only rose in popularity in the '70s, thanks to the efforts of Robert R. Prechter and A. J. Frost.
Initially, the EWT was called the Wave Principle, which is a description of human behavior. Elliott's creation was based on his extensive study of market data, with a focus on stock markets. His systematic research included at least 75 years’ worth of information.
[...] the Wave Principle is not primarily a forecasting tool; it is a detailed description of how markets behave.
– Prechter, R. R. The Elliott Wave Principle (p.19).
The basic Elliott Wave pattern
Note that, in the first example, we have five Motive Waves: three in the upward move (1, 3, and 5), plus two in the downward move (A and C). Simply put, any move that is in accordance with the major trend may be considered a Motive Wave. This means that 2, 4, and B are the three Corrective Waves.
Also, if we zoom in to lower timeframes, a single Motive Wave (such as 3) can be further divided into five smaller waves, as illustrated in the next section.
In contrast, an Elliott Wave cycle in a bearish market would look like this:
As defined by Prechter, Motive Waves always move in the same direction as the bigger trend.
Wave 2 can't retrace more than 100% of the preceding wave 1 move.
Wave 4 can't retrace more than 100% of the preceding wave 3 move.
Among waves 1, 3, and 5, wave 3 can't be the shortest and is often the longest one. Also, Wave 3 always moves past the end of Wave 1.
Unlike Motive Waves, Corrective Waves are typically made of a three-wave structure. They are often formed by a smaller Corrective Wave occurring between two larger Motive Waves. The three waves are often named A, B, and C.
When compared to Motive Waves, Corrective Waves tend to be smaller because they move against the bigger trend. In some cases, such a counter-trend struggle can also make Corrective Waves much harder to identify as they can vary significantly in length and complexity.
According to Prechter, the most important rule to keep in mind regarding Corrective Waves is that they are never made of five waves.
Does Elliott Wave work?
There is an ongoing debate regarding the efficiency of the Elliott waves. Some say that the success rate of the Elliott Wave principle is heavily dependent on the traders' ability to precisely divide the market movements into trends and corrections.
In practice, the waves may be drawn in several ways, without necessarily breaking Elliot's rules. This means that drawing the waves correctly is far from a simple task. Not only because it requires practice, but also due to the high level of subjectivity involved.
Accordingly, critics argue that the Elliott Wave Theory isn't a legitimate theory due to its highly subjective nature, and relies on a loosely defined set of rules. Still, there are thousands of successful investors and traders that have managed to apply Elliott's principles in a profitable manner.
According to Prechter, Elliott never really speculated on why markets tend to present a 5-3 wave structure. Instead, he simply analyzed the market data and came to this conclusion. Elliott's principle is simply a result of the inevitable market cycles created by human nature and crowd psychology.