The Elliott Wave theory is an investment strategy and a form of technical analysis used to forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. It claims to be able to forecast market turning points (referred to as “crashes” or “major reversals”) based on the actions of various participants: retail traders (also referred to as “sentiment”), fund managers, and institutional investors.
The key concepts behind the Elliot wave theory were primarily derived from observations surrounding the cause and effects of crowd behaviour. Sir Charles Mackay and William Hurst described this in their classic texts Extraordinary Popular Delusions and The Madness of Crowds, first published in 1841 and 1849, respectively.
This theory is based on beliefs that mass psychology, or herd behaviour, influences the market and that crowd sentiment swings from pessimism to optimism and back naturally.
The Elliott Wave Theory is used by many traders when trading stocks in Australia. Many believe that you can apply this theory to any investment, not just stocks. To be successful with this theory, you must keep an open mind and look for new opportunities while also having patience.
Determine your time frame
The time frame you use to apply the principles of the theory will depend on your investment goals. If you are looking for short-term trading opportunities, then a 5-minute chart is appropriate, whereas managing a long-term portfolio over months or years may be better to use daily or weekly charts.
Determine the current sentiment
To determine the present sentiment of the market you want to follow, look at volume and price action. Switch off all volume indicators but note down how many times prices rose above their moving averages (e.g., 200 days) during this time frame. These are called “higher highs”, which reflect optimism in the marketplace. The more frequent they become, the stronger is your indication that optimism has overtaken pessimism.
Determine the “extremes” of the crowd
To determine the extremes of the crowd, you need to look at volume and price action from a different perspective. If you notice that prices do not rise above their moving averages (e.g., 200 days) for a long time, this indicates that pessimism has overtaken optimism in the marketplace. The longer it takes, the stronger is your indication of this sentiment shift.
Wait
When applying these principles regarding assessing an investment opportunity, it is essential to be patient, as some theory purists suggest waiting until all three conditions have been met before determining whether or not one should invest. However, this can be a laborious task, given the fast-changing nature of financial markets and current events. Therefore, many pro traders only apply the principles when two conditions have been met:
1. that there is a high number of rises above moving averages, and
2. that there is a long time between these highs.
Look for clues in price action
After ascertaining this mindset through volume and price action, you would look for clues in future price action to determine whether your sentiment is correct. For example, if you believe the crowd has become pessimistic and you see another fall below moving averages on low volume, pessimism has overtaken optimism again, which may lead to a further fall.
However, if you see another fall on higher volume than the previous fall, this indicates further pessimism, which may lead to a reversal back to optimism.
Determine whether or not there is a trend
The Elliot Wave Theory states that mass psychology swings from pessimism to optimism and back again in repeating patterns of five waves (three up followed by two down). If the market is trending, then only three waves are required; but if it is range-bound, the five waves are required.
Once you have discovered that you are in the third (down) wave of a sequence, look for clues as to where prices might reverse. For example, if you believe pessimism has overtaken optimism and low volume leads to a wave four high, then look for clues as to what the next fall might do. E.g., if there is a five-wave sequence up with no retracement below moving averages followed by three waves down on low volume, this may be your clue that countertrend rallies will fail, and prices will continue further downwards.
