Developed by Ralph Nelson Elliott in the 1930s and pushed to popularity by Robert Prechter in the 1970s, the Elliott wave Theory implies that, irrespective of the timeframe, the market trends always move in similar, repetitive patterns. And since these trends follow a common pattern, the stock market is very much predictable in terms of direction and investors’ behaviour. The patterns in the trading data are represented in the form of repetitive waves, based on which a trader can make an informed investment, and also know when to retract the funds. Since similar kinds of data are available for both stock and cryptocurrency trading markets, Elliott wave Theory is quite useful in cryptocurrency markets.
The theory quickly gained popularity as it helped institutional investors and traders see that stock trading is not entirely a matter of luck, and is indeed driven by patterns and signals. Along with Dow, Elliott Wave Theory is also among the most recommended chapters in the books of Technical Analysis; a similarity between the two being their focus on predicting the future of the market with the help of historical data.
Elements of Elliott Wave Theory
In Elliott’s analysis model, there are two types of waves: Impulse Waves and Corrective Waves, which are fractal in nature. Fractal is when something occurs inside itself. So when we say these waves are fractal in nature, it means they are composed of smaller sub-waves, which are also impulsive and corrective.
According to the theory, the whole market in any timeframe is structured into these two major types of waves. Often, it is confusing for people to differentiate between the two waves, which alleviates their probability to succeed in the cryptocurrency market. Let us not be confused about that and look at the definitions and stark differences between the two types of waves in the Elliott’s model.
Types of Waves
Waves that move with the trend are called Impulsive Waves. It is composed of 5 sub-waves.
Waves that move against the trend are called Corrective Waves. It is composed of 3 sub-waves.
Hence, impulse waves travel along the trend and corrective waves travel against the trend in 5-3 fashion, where 5 are the number of impulse waves, and 3 are the number of corrective waves. This brings us to the conclusion that any wave in Elliott’s Wave Theory consists of 8 sub-waves.
Just like any wave could be made up of sub-waves, an impulse wave is also made of 5 sub-waves, out of which 3 move in the direction of the next larger degree trend, and the remaining 2 move against the direction of the next larger degree trend. Similarly, a corrective wave is also made up of 3 sub-waves, out of which 2 move along with the next larger degree trend and ‘1’ moves against the next larger degree trend.
The reason why they are called Impulsive and Corrective Waves is quite easy to understand. The literal meaning of impulse is something that forces or urges something to happen, and an impulsive wave does just that. It represents the force that is pushing the market with the trend. Do not assume that impulsive waves actually move the market; they only illustrate the force that is being created by traders.
A corrective wave, on the other hand, represents the force that is correcting the price movement by not allowing the trend to continue indefinitely. Corrective waves usually depict the temporary exhaustion that comes after a rally or plunge, and means that traders trading along with the trend were exhausted pushing the market in the same direction, and that is when the traders trading against the market bring the market down by some degree to keep the equation in balance.
Degree of Waves
Each wave in Elliott’s model is made up of smaller waves called Sub-waves, except the highest and lowest degree waves. And multiple smaller degree waves together form a larger degree wave.
Before I explain further, have a look at this table showing degrees of wave:
|Degree||Labels for Impulse Waves||Labels for Corrective Waves|
|Grand Supercycle||[I] [II] [III] [IV] [V]||[A] [B] [C]|
|Supercycle||(I) (II) (III) (IV) (V)||(A) (B) (C)|
|Cycle||I II III IV V||A B C|
|Primary||    ||[a] [b] [c]|
|Intermediate||(1) (2) (3) (4) (5)||(a) (b) (c)|
|Minor||1 2 3 4 5||a b c|
|Minute||[i] [ii] [iii] [iv] [v]||[a0] [b0] [c0]|
|Minuette||(i) (ii) (iii) (iv) (v)||(a0) (b0) (c0)|
|Subminuette||i ii iii iv v||a0 b0 c0|
Structure of a Wave in Elliott’s Wave Model
As we can see in this chart, each peak and trough have been labeled with either a number or a letter. Take a glance at the wave degree chart and you will know that this chart displays only three degrees of waves – Primary, Intermediate, and Minor. All the waves with labels enclosed in square brackets [ ] are of primary degree, the ones enclosed in round brackets ( ) are of intermediate degree, and the ones without brackets are of minor degree. Although all degrees can fit in a chart, it would be impossible for someone to see all degrees as the smallest degree wave would be too small to be visible to the naked eye. So we have expanded the timeframe and will try to learn with these three degrees.
Now let’s dissect and learn the structure and formation of an Elliott’s wave.
Notice the first minor wave labeled 1. No wonder it’s an impulse wave as it moves along the larger trend i.e uptrend. Apart from that, it also makes it obvious that 4 more such waves will complete one impulse wave of the next larger degree i.e (1). The direction of trend for (1) is also upwards as it is in turn a sub-wave that belongs to the wave of the next larger degree wave i.e , which signifies that there will be three corrective waves of the same degree as (1), completing the formation of the next larger degree wave . Wave 1 also indicates that after the formation of wave 2, 3, 4, 5, there will be a corrective wave sequence labeled wave (2). The one larger degree wave  will be completed when wave (3), (4), (5) will complete after wave (2).
A corrective wave itself can be made up of smaller degree waves or sub-waves. Notice that wave A and C are part of the corrective sequence (2), but are actually impulsive waves with 5 sub-waves because they show the movement of price along with the trend of the next larger degree wave (2) i.e downtrend. Wave B, in this case, moves against the trend of the next larger degree wave (2) i.e downtrend. Hence, it is a corrective wave, which is actually a sub-wave of the next larger degree corrective wave (2).
Rules regarding formation of an Elliott wave
There are few rules embedded in the structure of an Elliott wave, which can never fail. The rules that have been mentioned below apply to all types of Elliott wave patterns.
- Wave “TWO” never retraces more than 100% of wave “ONE” of the same degree.
- Wave “THREE” can never be the shortest among the impulse waves of the same degree.
- Wave “FOUR” can never enter the territory of wave “ONE” of the same degree except in one condition, where we are talking highly liquid markets with a very high leverage, which may happen during intraday trades.
The primary goal for a trader practising Elliott Wave Theory should be minimising the loss and maximising the profits, for which, spotting the right patterns with utmost patience is a necessity.
Traders across the globe find it quite hard to form a consensus on what the theory is indicating at any particular point in the chart because its subjectivity varies from trader to trader.
Although a large number of traders, in the present day, find this theory reliable, of course those with the right amount of experience, something to be kept in mind is that the cryptocurrency market moves according to how masses trade.
Hence, the theory may fail at times because you cannot predict the psychology of masses with 100% accuracy. But that still doesn’t provide us with a scale to measure how often the theory may succeed or fail.
So, in conclusion, let us both agree on the fact that Elliott Wave Theory is all about practice, perseverance, and observational skills of the trader, and if you have what it requires, in the right proportions, nothing can stop you from making money in cryptocurrency markets using EWT.