The Elliot Wave Theory is one of the most known and studied in the world of technical analysis.
This theory was developed no less than almost a century ago by the accountant, Ralph Nelson Elliot, who discovered – or thought he discovered – the principles that govern the cyclical changes that mark the behaviour of the stock market.
The beginning of this theory was summarized in a series of articles published in 1938 in the book “The Wave Principle”.
Later, near the end of his life, this came to join a more complete work that also went on the subject of cyclology, in his book “The secrets of nature: The secret of the Universe.”
With this latest work you can already see where the shots go in Elliot’s work.
That is to say, Elliot thought to find some patterns of operation of the rhythms of this world; patterns that not only worked for stock markets, but for all human activities and phenomena in the world.
Surely this seemed really novel to many people, blind believers, already at that time, of the Theory of Evolution.
However, this theme is as old as the world, belonging to all the ancient traditions that refer to how the world “evolves”.
But before you talk about cosmic cycles and weird things, we’re going to continue with Elliot’s Cycle Theory.
What is the Elliot Wave Theory?
As the name says, the operation is based on advances by waves, which Elliot discovered to see that the stock markets do not behave randomly, but following the laws of nature with Fibonacci ratios.
According to what Elliot discovered, the stocks follow a kind of sequence of ups and downs in waves, not too different from the waves of the sea, spirals of the snails or galaxies, for example.
If that was the case then the logic is that such behaviour could be the basis for creating a system capable of making money on Wall Street: the dream of every stock speculator.
What is more, with that idea Elliot deduced that these waves, or stock market cycles were accompanied by the stock market mood, that is, by determining the psychology of the masses we could foresee future movements.
The basic Elliot model consists of 8 waves, of which the first five belong to the bullish phase, with 1, 3 and 5 forming the peaks of the bullish advance and 2 and 4, the increasing minimums of the previous one.
Points 6 and 8 would be the decreasing minima corresponding to the bearish phase, and 7 would be the rebound that would occur in it.
Well, the point is that according to this theory we should expect this type of waves not only in short-term movements, such as intraday, but also, and perhaps, more eminently, in long-term movements, such as secular markets.
In general, the theorists of this theory argue that the periods that we can find, and in which are included those of lower rank, from highest to lowest, are:
- The Great Supercycle that lasts for centuries
- The decades-old supercycle, from 30 to 70 years old
- Cycle from one to several years, depending on the circumstances
- Primary, which goes from a couple of months to a couple of years
- Intermediate, ranging from weeks to months
- Minor, which goes for weeks
- Minute, which goes for days
- Minutete, which goes by hours
- Sub-minutete, which goes by minutes
As we see, we have for all tastes, from those who invest based on guessing the “end of capitalism” or not, to those who want to make intraday aggressive algorithmic trading.
Of course, the practical applications in Technical Analysis are endless.
Does the Elliot Wave Theory really work?
This is the really important point of the matter, because it is of no use to us that they have a theoretical base that sounds very good, like Fibonacci and the psychological theories of the masses, with classic books like those of Gustave Le Bon.
This is the crux of the matter, because if the issue does not work in practice, it is worth applying that theory to our investments or speculations, since we will lose money.
In principle, what we have to be clear is that this theory at least is correct that markets move in a wave species of climbs followed by drops, and so on.
But not for that reason, we can think that we are going to find a sacred pattern with which we are going to win the dealers in the short term, because in that short term it is where the aforementioned theory works worst.
However, it is in the long term where it can give us more interesting approaches and on which there are many similar theories, such as that of the Kondratiev cycles and the like.
That is to say, what the study of the markets teaches us is that the upward phases of the last 200 years on Wall Street – at least in that stock market – last on average considerably more than the bearish phases.
To see this, we only need to look at the long-term chart of the Dow Jones to see that the bullish phases last a lot longer than those that are bearish and so, to bounce soon, we could say that these phases last longer than the 5/8 ratio. The upward phase of the Elliot Theory.
Moreover, it is not that they can last longer, but that they can also last less, and so it is with all the smaller cycles of all the great cycles.
And if that were not enough, we can also find terrible side markets that, in a way, almost completely disable the foundations of the theory, but before which the defenders of the same will say that these markets are also subject to the laws of Waves.
So what is left with this?
Well, a very complicated system to predict and from which we can hardly even draw definitive long-term conclusions, beyond knowing that when we have been in the bear market for two years, it is likely that we will not miss a lot for a bullish phase, or vice versa.
Much less try to make algorithmic automatic trading applications, because what we can see from these market cyclical movements is that they are not constant and that all the waves are different from each other in a way that is practically impossible to predict.
However, we can see that despite not being movements and cycles or even waves, we are in the presence of movements that are reactive with each other: rises preceded by descents and a kind of behavior of a similar nature in the bearish or bullish markets.
With that we already have something interesting; that can even help us make better investment decisions.
For example, you see the following graph of the IBEX:
Well, it is the long-term chart of the late 90’s and early 80’s of the Spanish index.
There we can see a kind of Elliot waves that occurred in those successive years with a bullish market in 5 waves and a bearish 3.
What happens is that, as I said before, the behavior of these waves is completely irregular, so that trying to make predictions would probably result in committing quite expensive errors.
However, also as I said before, the mere fact of knowing that we are going to have a “point 2”, or that it is probable, this can help us to make speculative decisions when we “suspect” that we are at that point, which It would always be advantageous.
What’s more, if we suspect, again, that we could be at a point 8, as we see in that bear market, it would not be too imprudent to start taking bullish positions, or at least take them soon, because in those cases, then of three bearish waves thus, it is very probable that this phase finishes, with the consequent possibility of facing a new upward phase.
What happens is that as we can see in subsequent years of the IBEX, the following phases of it have been much more complicated to measure with “waves”.
For example, in the next phase to the 8 previous waves that I mentioned, it is difficult to find the first five waves of the bullish phase, and it is also difficult to determine which are the three waves of the bearish phase, without knowing, also, if we are in a bullish phase now or starting a bearish.
As we can see, this subject of “waves”, “cycles”, and so on, is quite confusing.
And there is, perhaps, the key to the matter.
The waves exist, yes, but they are extremely confusing and difficult to predict in a quantified way, without which we can also expect perfect formations of 8 waves continuously, but of 8 followed by 3, 9 or 15, to say the least.
Do Elliot Waves work in markets other than the stock market?
This wave theme should work for all markets. This is what we should understand if we understand the theoretical foundations of the idea.
The waves have to affect the movements of oil, various raw materials, currencies, and of course, cryptocurrencies, in phases of euphoria followed by phases of depression.
Yes, surely all markets have these phases of euphoria followed by moments of darkness, but finding the key moment of these waves is still very complicated.
Of course, sometimes, when you hit one of the inflection points, like 5 or 8, you hit the spot and you’ll see good benefits in the coming times.
But do not see how difficult it is to come up with one of these points without ruining us before, especially with the “5”, which marks the end of the bullish phase.
There are few who try to find that fantastic 5, to end up crashing again and again against the terrible wall that are the bull markets of an inflationary world by nature.
For example, one of the best known cases in this regard is Robert Pretcher, undoubtedly the best known proponent of Elliot Theory in recent decades, which has been trying to predict the market cap for 20 years, at least, predicting on many occasions that the stock market was about to enter a “supercyle” phase as bad as the Great Depression of the 30s, and making calls for a Dow fall of more than 80%.
Unfortunately for Pretcher and his followers, these predictions have been unsuccessful, because in the last 20 years they have lost some of the most important bull markets in history, not to mention the terrible losses they will have accumulated trying to “sell short”.
And that we are talking about a deep scholar of the subject, not being easy to find someone with more knowledge of the subject than Pretcher; and yet, all that study has not been worth anything when making predictions on the stock market.
The truth, and this is something we must understand to the letter, is that the world of the stock market is very complicated and extremely complex dynamics, which requires even more things than Elliot waves.
Not by much studying the cycles of life, Fibonacci, the Golden Number, the phases of the moon, astrology, etc., it will be easy for us to defeat the Beast of the Stock Exchange, capricious as few others.
Greetings and good trading
Original article: ¿Funciona de verdad la Teoría de las Ondas de Elliot?