by Ross Ulbricht

The Elliot Wave Theory is a concept that describes how prices change over time in speculative markets. It combines mass psychology and an area of math called fractal geometry. For those of you afraid of numbers, don’t worry; we won’t be doing anything beyond counting and basic arithmetic. It’s worth taking a moment to understand because it provides an excellent framework with which to understand Bitcoin’s price history up to today and where it may be going next.

Elliot Wave posits that the driving force behind price movements in speculative markets is the expectations investors have about future prices. This makes sense because investors only buy if they think the price will go up so they can sell at a profit later, and when they buy, that pushes the market higher. So, optimism drives the prices higher.

Mass psychology comes into play when other investors see the price rise and it causes them to be optimistic, so they buy in too, pushing the price still higher. A feedback loop sets in between higher prices and higher optimism as more and more investors get drawn in. Eventually — at peak optimism — everyone who is going to buy in already has, and there is no money left to drive the price higher. Then, the few sellers left in the market start to push the price back down. As they do, optimism turns to pessimism and the reverse feedback loop takes hold. Pessimism drives prices lower which creates more pessimism.

Over and over these cycles of peak optimism and peak pessimism coincide with the major tops and bottoms in the price. Thus, buying when you — and everyone else — are most optimistic (high prices) and selling when you are most pessimistic (low prices) is a recipe for losses.

Elliot Wave therefore leads one to become contrarian. It is profitable — though not popular — to be pessimistic when everyone else is most convinced the future looks good for a given asset and to be optimistic when everyone has written it off.

Many look to the news to get an idea of why prices have been going up or down and to find the reasons for why they’ll be higher or lower in the future. This is counter productive because the news is caught up in the same cycles as investors, so you’ll see good news and rosy projections at price peaks, with bad news and projections near lows. It’s the blind leading the blind because no one knows the future. That’s not to say Elliot Wave is a magic bullet, but it can help you step back and not get caught up in popular opinion.

Elliot Wave also uses fractal geometry to track these waves of optimism and pessimism as they unfold. Fractals are shapes that have small features nested within larger ones, and the small features look similar to the large ones. Examples abound in nature such as ferns with leaves within leaves within leaves, or clouds with puffs within puffs within puffs. Fractal patterns often emerge from chaotic systems, and speculative markets — such as Bitcoin — are nothing if not chaotic.

In these markets, the fractal is waves within waves within waves of optimism and pessimism, pushing prices up and down on every scale, from years and decades down to hours and seconds. A wave is just a sustained movement in price, either up or down. The basic pattern is five waves up three waves down. (See Fig. 1)

Fig. 1

Waves moving in the direction of the next larger trend in prices are called impulse waves. They are labeled with numbers at their end points and subdivide into five smaller waves (1, 2, 3, 4 and 5 in Fig.1). Waves moving against the next larger trend are called corrections. They are labeled with letters and usually subdivide into three smaller waves (A, B and C in Fig. 1) This pattern is not arbitrary. It is the minimum number of waves necessary to allow for both cycles (ups and downs) and trends (sustained moves) within a fractal progression of prices. It can be seen as an efficient form, even elegant.

Fig. 2

Every wave is both part of a larger wave and composed of smaller waves as can be seen in Fig. 2. In this figure, the trend is up (the price ends higher than it starts), so wave (1) is an impulse because it moves up with the larger trend. Wave (2) is a correction because it moves down against the trend. Waves (1) and (2) subdivide the same as in Fig. 1 and then those waves subdivide one level further. Waves 1, 3 and 5 move in the same direction as wave (1), so they are impulse waves and thus subdivide into five smaller waves. Waves 2 and 4 move down, against the direction of wave (1), so they are corrections and subdivide into three waves. Waves A and C are subdivisions of wave (2). They move down, in the same direction as wave (2), so they are impulses and subdivide into five waves. And finally wave B is a correction, subdividing into three waves because it moves up, against wave (2). So, whether a wave subdivides into three or five does not depend on whether it moves up or down, but whether it moves with or against its parent wave.

There are a number of rules and guidelines governing how to correctly count these waves in actual markets. There is plenty of literature online and books covering Elliot Wave, so I won’t go into all the details here. I’ll only cover a few that I have found to be most important.

Rule 1: The end of wave 2 in an impulse can never extend beyond the beginning of wave 1.

Rule 2: The end of wave 4 in an impulse can never extend beyond the beginning of wave 2.

Rule 3: Wave 3 is never the smallest wave in an impulse.

Guideline 1: Corrections tend to be choppy, overlapping and hard to count.

Guideline 2: Impulses tend to be clear, dramatic and easier to identify than corrections.

There are many more details and subtleties to Elliot Wave than what I have covered in this post. As the need arises, I will delve into these details as we analyze the Bitcoin market in future posts.

Combining a sense of where investor psychology is (optimistic or pessimistic) with a clear wave count can yield a moment’s confidence in the future direction of prices, but it takes patience, humility (no one is right every time) and a willingness to be decisive.

In the next post, I describe the types of charts we’ll be using as we apply Elliot Wave to Bitcoin.