What is Elliott Wave Theory?

Elliott Wave Theory in technical analysis describes price movements in the financial market. Developed by Ralph Nelson Elliott, it observes recurring fractal wave patterns identified in stock price movements and consumer behavior. Investors who profit from a market trend are described as riding a wave. Elliott Wave theory is a technical analysis of price patterns related to changes in investor sentiment and psychology. The theory identifies impulse waves that establish a pattern and corrective waves that counteract the larger trend. Each set of waves is within another set of waves that follow the same impulse or corrective pattern, described as a fractal approach to investing.

Understanding Elliott Wave Theory

The Elliott Wave theory was developed by Ralph Nelson Elliott in the 1930s. He studied 75 years of annual, monthly, weekly, daily and self-made hourly and 30-minute charts of various indices. His theory became famous in 1935 when Elliott made an uncanny prediction of a stock market bottom and has become a staple for thousands of portfolio managers, traders and private investors. Elliott defined rules for identifying, predicting and profiting from wave patterns in books, articles and letters summarized in R.N. Elliott’s MasterworksElliott Wave International is the largest independent financial analysis and market forecasting firm whose market analysis and forecasts are based on Elliott’s model.

His patterns do not provide any certainty about future price movements but help to order the probabilities of future market action. They can be used with other forms of technical analysis, including technical indicators.

How Elliott Waves works

Some technical analysts profit from wave patterns in the stock market using the Elliott Wave Theory. The theory hypothesizes that stock price movements can be predicted because they move in repeated up-and-down patterns called waves created by investor psychology or sentiment. The theory is subjective and identifies two different types of waves: motive or impulse waves and corrective waves. Wave analysis is not equal to a template for following instructions. Wave analysis provides insights into trend dynamics and helps investors understand price movements. Impulse and corrective waves are nested in a self-similar fractal to create larger patterns. For example, a one-year chart may be in the middle of a corrective wave, but a 30-day chart may show a growing impulse wave. A trader with this Elliott wave interpretation may have a long-term bearish outlook with a short-term bullish outlook.

Impulse waves

Impulse waves consist of five sub-waves that make net movements in the same direction as the trend of the second largest degree. This pattern is the most common motive wave and the easiest to spot in a market. It consists of five sub-waves, three of which are motif waves. Two are corrective waves. – Wave 2 cannot trace more than the beginning of Wave 1 – Wave 3 cannot be the shortest wave of the three impulse waves, 1, 3 and 5 – Wave 4 does not overlap the price area of Wave 1 – Wave 5 must terminate with momentum divergence2 If a rule is broken, the structure is not an impulse wave. The trader would have to relabel the suspicious impulse wave.

Corrective waves

Corrective waves, called diagonal waves, consist of three, or a combination of three sub-waves that make net movements in the opposite direction to the trend of the second largest degree. Its goal is to move the market in the direction of the trend. – The corrective wave consists of 5 sub-waves – The diagonal looks like either an expanding or contracting wedge. – The sub-waves of the diagonal may not have a number of five, depending on the type of diagonal observed. – Each sub-wave of the diagonal never goes all the way back to the previous sub-wave, and sub-wave 3 of the diagonal may not be the shortest wave.

Elliot Wave Theory vs. other indicators

Elliott realized that the Fibonacci sequence denotes the number of waves in impulses and corrections. Wave ratios in price and time also typically exhibit Fibonacci ratios, such as 38% and 62%. For example, a corrective wave may have a 38% retracement of the previous impulse.

Elliott Wave Oscillator Chart.

Other analysts have developed indicators inspired by the Elliott Wave principle, including the Elliott Wave Oscillator Chart. The oscillator provides a computerized method for predicting future price direction based on the difference between a five-period and a 34-period moving average. Elliott Wave International’s artificial intelligence system, EWAVES, applies all Elliott Wave rules and guidelines to the data to generate automated Elliott Wave analysis.

What is Elliott Wave Theory?

In technical analysis, Elliott Wave theory looks at long-term trends in price patterns and how they align with investor psychology. These price patterns or ‘waves’ depend on rules developed by Ralph Nelson Elliott in the 1930s. They identify and predict wave patterns in stock markets and help predict future movements.

How does Elliott Waves work?

Based on Elliott’s Wave Theory, market prices will alternate between an impulsive phase and a corrective phase. Impulses are always divided into a set of 5 lower degree waves, which again alternate between a motivational and corrective nature, so that waves 1, 3 and 5 are impulses, and waves 2 and 4 are minor reversals of waves 1 and 3.

How do you trade with Elliott Wave Theory?

If a trader sees a stock moving up on an impulse wave, they may go long until it completes its fifth wave. Anticipating a reversal, the trader may go short on the stock. Behind this trading theory is the idea that fractal patterns recur in financial markets. In mathematics, fractal patterns repeat themselves on an infinite scale.

Summary

The Elliott Wave Theory was developed by Ralph Nelson Elliott. It provides a technical analysis of price patterns related to investor sentiment and psychology. The theory identifies impulse waves that establish a pattern and corrective waves that oppose the larger trend. It assumes that stock price movements can be predicted because they move in repeated up-and-down patterns.

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