What is the Elliott Wave Theory?
The Elliott Wave theory is the technical analysis of price patterns based on sequences, which are used to predict the path of the market over time.
Key Takeaways
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The Wave Principle by Ralph Nelson Elliott posits that crowd behavior trends and reverses happen in 13 patterns of price movements.
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An impulsive or motive wave consists of five linked subwaves and moves in the same direction as the trend, where the even-numbered waves tend to be shorter than the other three.
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A corrective or retracement wave comprises of three wubwaves and moves against the trend of the next larger size.
The complexities that pervade every seasoned trader’s price charts leaves most neophytes discouraged. This is to say, traders use common terminology to describe charts but it can appear as an assortment of numbers and letters splattered at random around a graph. The nomenclature devised by Ralph Nelson Elliott is one of the main causes of this confusion.
Ralph Nelson Elliott discovered that crowd behavior trends and reverses in recognizable patterns — known as the Wave Principle. Using 75 years’ worth of stock market data, Elliott isolated 13 patterns of price movements. He described how these “waves'' interlink to form larger versions of those same patterns, in an almost fractal manner. In expanding the time horizon, these basic structures form larger identical versions which, in turn, form larger versions of themselves, and so on. Essentially, the Wave Principle is a rolodex of price patterns that are used to predict the path of the market as time progresses.
Elliott Wave Theory (EWT) Fundamentals
To say that market movements are patterned, especially in the frenzied realm of crypto, is largely controversial. But, consistent systems of punctuated growth, which show periods of bullish tendencies with phases of bearish undertones, is similar to the price patterns exhibited by most cryptocurrencies. This is the pattern Ralph Nelson Elliott described. The pattern consists of impulsive (a.k.a. motive) or correction (a.k.a. retracement) waves. The former is denoted by numbers on a price chart and the latter by letters.
A single impulsive (or motive) wave consists of five subwaves and moves in the same direction as the trend of the next larger size. In the figure below, the impulsive wave is clearly constructed by five smaller subwaves, all of which concatenate into an upward movement of one degree larger — ending at (1). With impulsive waves, the even-numbered waves (i.e. 2 and 4) are often shorter than the other three.
The end of this impulsive movement signals the start of a corrective wave. A singular corrective (or retracement) wave comprises three subwaves and moves — as expected — against the trend of the next larger size. As one can notice, the three subwaves that construct the corrective wave (from (1) to (2)) are labeled by letters, ending at (2) in the image below. Together with the previous impulse wave, this basic pattern forms structures of recurring five and three wave patterns of increasingly larger degree. Variations in corrective patterns revolve around repetitions of this three-wave pattern, but they create more complex structures that have a variety of names, like triangle, flat, or double three.
Elliott categorized these waves by relative size and distinguished nine degrees of waves — varying from a shudder on an hourly chart to the largest wave of an asset over a century. From smallest to largest these names consist of:
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Subminuette
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Minuette
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Minute
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Minor
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Intermediate
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Primary
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Cycle
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Supercycle
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Grand Supercycle
To reassert, these labels refer to identifiable degrees of waves, which refer to their size (or degree). One example, as described in A Capsule Summary of the Elliott Wave Principle, is the rise of the US stock market from 1932 to the present day. Often talked about as a Supercycle, it has the following subdivisions: 1932-1937, first wave of Cycle degree (i.e. one degree lower than a Supercycle); 1937-1942, second wave of Cycle degree; 1942-1966, third wave of Cycle degree; 1966-1974, fourth wave of Cycle degree; 1974-present, the fifth wave of Cycle degree. Fractally, Cycle waves subdivide into Primary waves which break down into Intermediate waves that are constructed of Minor waves, and so on.
With this separation, each wave degree receives its own type of labels:
| Degree | Impulse with the Trend | Corrective Against the Trend |
|---|---|---|
| Subminuette | i ii iii iv v | a b c |
| Minuette | (i) (ii) (iii) (iv) (v) | (a) (b) (c) |
| Minute | [i] [ii] [iii] [iv] [v] | [a] [b] [c] |
| Minor | 1 2 3 4 5 | A B C |
| Intermediate | (1) (2) (3) (4) (5) | (A) (B) (C) |
| Primary | [1] [2] [3] [4] [5] | [A] [B] [C] |
| Cycle | I II III IV V | A B C |
| Supercycle | (I) (II) (III) (IV) (V) | (A) (B) (C) |
| Grand Supercycle | [I] [II] [III] [IV] [V] | [A] [B] [C] |
While seemingly convoluted, the alternative notation — preferred by most scientists — would be 11, 12, 13,14, etc. However, this further obfuscates a price chart, meaning the above table provides for easier readability. Alternatively, chartists also use color to discern wave degrees. One of the most difficult aspects of the Wave Principle is to decide what the initial smaller subdivision of a new wave in real time is. As waves are not based upon specific prices or time periods, they are dependent upon form, size, and position relative to adjacent, component, and overarching waves. Therefore, the Wave Principle is an intellectual challenge — permitting seasoned discretionary traders to establish a knowledge disparity.
Expanding Elliott Wave Theory
Utilizing the nomenclature established by Elliott, analysts are able to accurately identify the position of a wave in time. This can be paralleled to using longitude and latitude over general location, or temperature over weather conditions. By saying Ethereum is in Intermediate wave [1] of Primary wave [2] of Cycle Wave III, etc., places a specific point along the price action of Ethereum in history.
Source: A Capsule Summary of the Elliott Wave Theory Principle
The above image expands upon the previously shown impulse and corrective waves to demonstrate this point. If you notice, wave 1 of impulse wave (1) consists of 5 subwaves, as does wave (1), suggesting that the first subwave of impulse wave (1) is also an impulse wave with its own subwaves — alluding to the “degrees” Elliott distinguished. The first subwave of impulse wave (1) is followed by three corrective subwaves that make up 2. This is the same makeup as the larger corrective wave (2).
Below is a pertinent example of the 'geolocative' capabilities of EWT. This specific image is taken from the Trading on the Mark Substack, which offers a regular newsletter discussing an assortment of assets, including bitcoin future prices. It perfectly illustrates the wavering nature that chartists display as they deliberate upon the correct degree of the wave under discussion when utilizing EWT. The author vacillates among the possibilities of the displayed waves, considering them as Subminuette impulse waves (iii, iv, v,..., a, b, c), Minuette waves ((iii)), or even Minute degree waves ([iii]). Nevertheless, through the use of EWT, they can accurately disclose and deliberate on the stage and movement of the Bitcoin futures market. For example, as written below, the newly generated price data causes their confidence in disclosing the most recently shown wave as a Minuette impulse wave ((iv)) to waver.
Source: Trading on the Mark Substack
Elliott Wave Theory in Crypto
Despite the onerous process of identifying a wave and its correct degree, GeckoTerminal simplifies this task. For example, in identifying the current state of WETH/USDC; simply select the pool in the search bar at the top, move to the graph displayed and select the “text” tool to begin jotting on the graph. The resultant chart can be seen below. WETH recently displayed a noticeable Minor impulse wave with an extended 5 subwave, constructed by 5 Minute waves as the price action reached for 1980, before featuring a corrective wave built by 3 Minor corrective subwaves that moved down to 1430, assembling the second wave (2) in the Intermediate impulse wave. Assuming a trader followed this pattern, they would have been able to trace the impending corrective waves that followed the 5 Minute Waves, and profited off of a short position once the support of 2000 was tested (as indicated by the (1), 5, and [v]).
Elliott Wave Theory Technical Analysis
The contemporary overuse of the Elliott Wave Theory was a corollary of its precision. In essence, traders use it to define trends and timeframes with accuracy, simplifying price charts. Alternatively, some employ it as a form of technical analysis aimed at forecasting market movements by identifying recurring patterns.
Despite its applicability to various markets, including crypto, the theory fosters a number of pitfalls. This technical theory heavily relies on the analytical abilities of individual traders, leading to significant discrepancies in interpretation. Developed in the 1920s and 1930s, many consider its relevance today to be questionable, as it has not been updated to account for more recent market data.
Nevertheless, some traders still utilize the theory as a trading tool. One of the significant discoveries propagated by Elliott was the relation between the market and the sequences of five and three waves. The wave patterns resemble a Fibonacci sequence, as an additive sequence of 1, 1, 2, 3, 5, 8, 13, 21, 34, etc. is created throughout the theory. To clarify, 3 and 5 represent the three subwaves that construct a corrective wave, and the five subwaves that create an impulsive wave, resulting in a total of 8 waves — in correspondence with the Fibonacci sequence. This is continuously repeated as the successive waves are also constructed by this same pattern.
Fibonacci numbers occur widely in nature, suggesting that the progress of markets is not random or straight, but rather recur in three and five step patterns. Thus, the EWT is often interlinked with Fibonacci expansion and retracement levels, depending on the pattern displayed. More concretely, “Wave analysts” abide by the following rules:
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Wave 2 never retraces more than 100% of wave 1 of (1)
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Wave 3 cannot be the shortest of the three impulse waves (i.e. waves 1, 3, and 5) that construct (1)
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Wave 4 does not overlap with the price territory of wave 1
Similarly to the bases of the EWT, these rules have a number of sub-rules that are indicative of certain patterns that the impulse and corrective waves take. Chart analysis-based traders then apply these rules to Fibonacci extension and retracement levels, to identify potential profit and areas of support and resistance. Common Fibonacci extensions include 61.8%, 100%, 161.8%, 200%, and 261.8%. 61.8% is derived from dividing any Fibonacci number in the sequence by the number that immediately follows it, like 34 divided by 55. 161.8% is known as the “Golden Ratio” as it is derived by dividing any Fibonacci number in the sequence by another number that directly precedes it, like 144 divided by 89.
Elliott Wave Theory and Fibonnaci Levels
Fibonacci extension points are chosen based on the start of the move, the end of the move, and the end of the retracement against the move — hence the association with Elliott’s Wave Theory. Fibonacci retracement levels are established by multiplying the difference between a peak and a trough by the Fibonacci levels of 23.6%, 38.2%, 50%, 61.8%, and 100%. This product elicits the placement of support and resistance levels.
Fibonacci extension/retracement levels herald the target of a wave’s movement within an Elliott Wave structure. These targets vary as different waves arise, for example in an impulse wave:
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Wave 2 is 50%, 61.8%, 76.4%, or 85.4% of wave 1
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Wave 3 is 161.8% of wave 1
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Wave 4 is 14.6%, 23.6% or 38.2% of wave 3
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Wave 5 can be measured in 3 different waves: 1) inverse retracement of 123.6-161.8% of wave 4 2) equal to wave 1 or 3) 61.8% of wave 1 to 3
These rules only govern motive waves that are malleable given the nature of the impulse wave. For example, impulses can have periods of extension in one of its motive waves (either wave 1, 3, or 5). In the image below the third impulse wave of the Minor wave is elongated, highlighting its subwaves — the Minute waves [i], [ii], [iii], [iv], [v]. This elongation could occur in any of the odd number waves that construct the first intermediate impulse wave (1) as shown below.
This serves to reiterate the fractal nature of Elliott Waves and the variability of wave formation — hence the palpable skill-gap between new and seasoned traders. The rules that govern this example change when considering an impulse wave with a leading or ending diagonal, a zigzag, or regular and expanded flats. These patterns serve as the basis for judgment, gaining substance only when an obvious trend occurs. Despite this, as markets are deluged with participants and computing power, identifying these signals from Elliott Wave Theory and Fibonacci levels can help traders assume positions as the crowd joins in.
Returning to the previous WETH/USDC example, if one were to canonically follow the impulse wave rules stated above, their graph could look similar to the one illustrated below. The convoluted nature of using this technique in technical analysis is demonstrated below. Nevertheless, if one were to follow the laid out rules, they would notice the second wave is between 50% and 61.8% of wave 1, the third wave is 161.8% of wave 1, and the fourth wave is between 38.2% and 50% of wave 3 (as shown by the blue arrows). These four signals led up to a strong bullish trend in WETH/USDC, as shown by wave 5. While the locative capabilities of EWT in trading underscores its significance, incorporating it into technical analysis demands time and might seem arbitrary. Therefore, prudent practice suggests the utilization of additional indicators.
Conclusion
The true ingenuity of the EWT lies in the nomenclature Elliott developed to assist traders in accurately discussing the price action of an asset. It facilitates communication with other traders and the sharing of information. This methodology can be leveraged throughout trading to identify levels of support/resistance as impulse waves run their course and corrective waves begin. Moreover, it can be combined with other forms of chart analysis, such as Fibonacci levels, to form more concrete projections of the price action.
All content in this article does not address the circumstances of any particular individual or entity and is information of a general nature. Nothing in this article constitutes professional or financial advice, nor does any information in this article constitute a comprehensive or complete statement of the matters discussed.
Jackson Henning has a background in economics and has spent 3 years in crypto, primarily ensconced in NFTs and DeFi. He is especially intrigued by the perpetual ingenuity common to crypto trading, along with the employment of technical analysis and the ability of DeFi to push the bounds of traditional finance. Follow the author on Twitter @Henninng
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