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Support / Knowledge Emporium / Counting on the Waves

Counting on the Waves

A New Look on the Celebrated Trading Method

The Elliott Wave theory has been a major thing in trading for decades now and, undoubtedly, Mr. Ralph Nelson Elliott should be held in high esteem by all those who trade the markets these days. However, while some steadfast followers consider his theory to be a highly effective pattern recognition technique able to help predict market developments, others are prone to regard Elliott's creation as a commonly used methodology, a brilliantly created means of seeing the recent past of the market, rendering this past with stunning clarity. Who's right and who's wrong?

The Elliott approach construes market actions as recurrent phases, comprised of two major moves: a five-wave advance and a three- wave decline, customarily referred to as the Impulse Wave and Corrective Wave. According to the Elliott theory, the market phases are scalable and the same market actions can constitute the same but larger or smaller phases and be considered over time periods that differ in duration significantly. By identifying the current position in the phase, it is possible to predict the kind of market action that will follow. This is made easier by the following interpretation rules for the counting of the waves:
  1. Wave 2 should not end below the beginning of Wave 1;
  2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
  3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree;
  4. Rule of Alternation: Wave 2 and 4 should unfurl in two different wave forms.
One of the sub-waves 1, 3, 5 of the Impulsive Wave is supposed to be an extended wave. For a better understanding of the Corrective Wave phase, the Elliott theory delineates the following types of sub-waves that can make up the Corrective Wave: Zig-Zag, Flat, Irregular, Horizontal Triangle, Double Three, Triple Three. This stringently ordered, if a bit complicated in places, and revered by many theory seems to provide an effective means of analyzing market developments and only God knows what would happen if it worked completely as stated. Basically, all you have to do is determine which of the itemized wave forms is going to arise next. And here is where the pitfalls start. And God forbid we call into question the accuracy of Mr. Ellliott's concept, Fibonacci's Golden Ratio it is based on, or the laws of the Universe the latter claims to explain. The problems are a lot more trivial. How will you determine the starting point for your count of the waves? Out of five people who will look at the same chart two will most probably see the starting point differently. Right from the outset, the ticket for your journey to success seems to be hard to get hold of.

However, if you've been able to identify the starting point correctly, you will very soon understand that identifying waves as they are occurring is something altogether different from identifying waves when they have already occurred. And this is the second and biggest disadvantage of the Elliott theory. Unfortunately, there are several more. Is there going to be the fifth wave? Will the correction be flat or zigzag? Which of the waves will have the extension? All these are questions Elliott's theory has difficulty answering.

It is true that many experienced traders who have extensively dealt with the "bugs" the theory contains use the Elliott method as a predictive technique. However, all the above has caused many thinking traders to form a vision of the Elliott theory as of a methodology, rather than a predictive technique. In their opinion, this methodology has been extremely helpful in naming and identifying different states of the market: strong and week trends, complex and simple corrections. This can help gainfully use the other methods in your combination at the opportune time.

This view on the Elliott theory and the approach on which some of the thinking traders base their use of Elliott waves seems to be quite correct: the main value of the method is the possibility of determining the phase the market is currently in. And this is too valuable an addition to any thinking trader's arsenal to overlook or underestimate.

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