Markets can also be simply structured. This proves the approach of the Elliot wave theory, which goes back to the exchange trader Ralph Nelson Elliot. At the beginning of the 20th century, he observed that markets move in wave-like structures. He justified these structures with the fact that the psychology of market participants as a whole drives the markets in certain directions. He established a set of rules that is still very popular among advocates and has only been slightly developed.
What is the Elliot Wave Theory?
The Elliot Wave Theory is based on the Assumption that market participants fluctuate between pessimism and optimism. The whole thing is of course understood as a collective. Different periods can be considered. The so-called waves are called cycles and can last minutes, but also centuries.
Numbers 1, 3 and 5 are used to mark so-called drive and motif waves. The numbers 2 and 4 are correction waves. The wave theory usually tries to describe the market behavior and makes less of a statement about the future price behavior.
"Then why the theory?", Some will ask themselves. Quite simply: the better traders understand the current situation, the more precisely they can estimate the probability of future developments. This is how market technology works. The decisive factor is the here and now.
The upper illustration is of course greatly simplified. Everyone knows that courses are irregular. However, based on his observations, Elliot has established the rule that trends run in five waves up and three waves down. The so-called 5-3 sequence. The downside applies to downward trends; five waves down and three waves up.
How can this help in retail? One could build a trading system or a set of rules based on the Elliot wave theory. While it is clear that this theory should not be understood as a 100 percent functioning system, this cannot be said of any technical indicator or system. The feasibility and the probability that the system works in about 53% of all cases are important.
This is how a system can look like
In the first step, it would make sense to look for a tradable value to search. According to experienced analysts, broad equity market indices are particularly suitable for this. So let's look for waves that are as even as possible and an index that shows stable trends.
The US S&P 500 contains 500 stocks and can truly be called a broad index. Our rules are as follows:
- The trend must be initiated by a dynamic first wave.
- A correction wave must continue to confirm the Elliot wave theory.
- Entry begins when the second pulse wave starts.
Noob or pro?
How does the whole thing look in practice?
Between 2012 and 2014 the index had a strong upward trend report, which was partly due to the Fed's monetary policy measures. The example above makes it clear that the Elliot wave theory can work on a long-term as well as a short-term basis. The reason for this is not necessarily the predictive power of the theory, but rather the fact that it can make sense to take advantage of fixed structures.
The structures in which the market runs allow retailers to find meaningful entrances and exits. However, it should be noted that the example above is very simplified. Elliot also defined the individual waves in their structures. Anyone who takes a closer look at this could gain further advantages and clearly avoid false signals.
The Elliot wave theory is particularly popular with long-term analysts, as it contains cyclical structures in shows the markets. These structures reflect the mood of market participants. Elliot has discovered that the collective mood runs in recurring patterns, that is, in mood swings. Optimism and pessimism take place in waves, and there are certain indications of when moods are exhausted and lead to a change.
However, the effect of the rules behind it is more advantageous for the dealer. On the one hand, the theory helps to define a trend and on the other hand it can signal entries and exits.