How Elliott Wave Theory Predicts Crypto Trends

Introduction

When it comes to investing in cryptocurrencies, ample study and analysis is something indispensable. You can do technical analysis as well as fundamental analysis. Technical analysis is a charting method that you can use to study historical data of a particular asset and on the basis of the study, you can somewhat foresee what is going to happen. Fundamental analysis is different. It involves looking into the token’s use cases, strength and weaknesses of a project, its team, technology and market demand. Elliot wave is a principle or theory that helps drive your technical analysis.

What is Elliot Wave Theory?

Elliot wave theory is a technical analysis framework that asserts markets tend to follow a wave-like pattern regardless of the time frame we choose. We know that market sentiment keeps on oscillating between bearish and bullish. Elliot wave theory suggests that price action of financial markets also accompanies crows psychology. It implies that when most of the people are bearish, markets start falling. Similarly, markets rise when most of the investors and analysts feel confident.

Origin of Elliot Wave Theory

An American accountant and author Ralph Nelson Elliott is credited with expounding this idea in 1930s. However, the idea did not rise to eminence till 1978 when a book titled “Elliott Wave Principle: Key to Market Behavior” written by Robert R. Prechter and A. J. Frost refined and popularized the idea. The authors used modern examples, statistical observations, and detailed charts to show how Elliot wave principle applied to the markets. Prechter become more popular when he made bold and accurate predictions in 1980 using the ideas propounded in the book.

Originally, Elliot himself called use the term “Wave Theory” in tune with human emotional behavior. People tend to turn fearful when market has had a bullish run for a few months. More and more people start anticipating correction or even a crash. Similarly, when red candles abound, people turn confident that market will take a reversal. You can observe a graphic representation of this idea on $BTC chart.

Investors’ Psychology: Bitcoin Example

At the start of 2023, when crypto market had already had a bearish run of over a year, volume of green candles started skyrocketing. If you zoom out, you will find that in January, February and March of 2023, Bitcoin was bought more than in any following month, even more than when it made new ATHs of $73,000 or $126,000. This behavior is indicative of the fact that investors’ confidence is directly proportional to the duration of a bear market. In the same vein, fear is also directly proportional to the duration of a bull market.

Now a days, the most prominent use of Elliot wave theory is in spotting market cycles like optimism, greed, fear, and panic. However, experts hesitate in regarding the theory as a trading guide or as a technical analysis tool. It is too broad to be either. Warren Buffett once said, “The market is a device for transferring money from the impatient to the patient.” This simple statement highlights just how much emotions and psychology drive market behavior.

Elliot Wave Pattern

The theory suggests that one cycle of an asset consists of 8-wave pattern. Five of these are Motive Waves and three are Corrective Waves. Motive Waves move in the favour of the main trend whereas Corrective Waves move in the opposite direction. For example, in a bullish trend, Motive Waves move upwards and Corrective Waves move downwards. Contrarily, Motive Waves in a bear market move downwards and Corrective Waves move upwards.

As mentioned earlier, the wave-like movement exists regardless of the time frame we choose. If you have identified an 8-wave pattern on daily time frame and then you zoon out to weekly time frame, you find that 3 or 4 wave together form one large motive wave. If you zoom in from daily to 4H time frame, you find that one daily wave can be divided into 3 or 4 small waves.

Motive Waves

A Motive Wave is the one that moves in tune with the trend. The theory stipulates that every motive wave can be subdivided into five waves. Elliot himself formulated three rules for these five waves:

• Wave two cannot retrace more than 100% of the preceding wave one move.
• Wave four cannot retrace more than 100% of the preceding wave three move.
• Among waves 1, 3, and 5, wave three cannot be the shortest and is often the longest one. Also, Wave 3 always moves past the end of Wave 1.

Corrective Waves

Unlike Motive Waves, subcategorization of Corrective Waves is possible only in three waves. Out of these three, only one is corrective in itself. The other two are Motive Waves. Prechter claims that most distinctive feature of Corrective Waves is that they can never be divided into five sub-waves.

Since Corrective Waves move against the main trend, they tend to be smaller than the Motive Waves. Due to this reason, they are also smaller. They can also be harder to identify as compared to Motive Waves.

Validity and Applicability of Elliot Wave Theory

Subjectivity is the main concern of critics, especially when they talk about drawing the wave patterns. Different analysts draw the patterns differently, so there seems to be no universality. Interestingly, even when different persons draw the patten differently, none of them breaks the rules stipulated by Elliot Wave theory.

Due to subjectivity, critics even dismiss the idea as a theory on the basis of loose set of principles. The rejection of its theoretical nature also on account of the absence of the strict rules and empirical consistency found in scientific models. This flexibility makes the theory difficult to test objectively. However, supporters maintain that with sufficient experience and discipline, traders can use its principles to recognize repeating market patterns and improve their timing in buying or selling decisions.

Conclusion

Elliot Wave Theory is a framework for carrying out technical analysis by giving some space to crowd psychology and sentiments. It claims that markets tend to move in cyclical patterns than can be drawn in the form of Motive waves and Corrective Waves. Despite being criticized heavily due to its subjective nature, many investors claim to have earned hefty profits by following Elliot Wave principle.