Elliott Wave Theory, created in the 1930s by Ralph Nelson Elliott, uses the natural rhythm of waves to explain price movements in financial markets. He believed that market fluctuations follow repetitive patterns, much like waves in the sea. By identifying these "waves" in stock prices and investor behavior, traders can predict market trends.
Elliott's theory gained fame in 1935 when he accurately predicted a stock market bottom. Even though market price movements can still puzzle scientists today, Elliott's approach linked financial markets to nature, introducing the concept of "biomimicry.".
The Elliott Wave Principle
Elliott is often regarded as a key figure in market analysis, following in the footsteps of Charles Dow. He expanded on Dow's work by adding more specific market definitions and, importantly, a way to forecast price levels. Elliott's theory suggests that stock price movements mirror natural laws, where human emotions drive recurring bullish and bearish waves.
At its core, the Elliott Wave principle assumes that markets are influenced by economic trends, psychological shifts, and natural cycles. The constant ebb and flow of human emotions—optimism, fear, greed—shape market prices, and these emotions create the wave-like patterns in the markets.
How Elliott Waves Work?
Elliott Waves are an essential tool in technical analysis and are particularly useful for trading forex and other financial markets. The theory is broken down into two main types of waves: impulse waves (5-wave structure) and corrective waves (3-wave structure).
Together, they form an 8-wave cycle, where the first five waves are an upward "impulse," followed by a correction made up of three sub-waves. These cycles are endless and can occur in smaller or larger timeframes.
Impulse waves:
These are five waves moving in the direction of the main trend. Waves 1, 3, and 5 follow the trend, while waves 2 and 4 briefly reverse direction. The third wave tends to be the longest, as it's driven by the masses.
- Wave 1: Small group of investors buy at a low price, causing an initial rise.
- Wave 2: Profit-taking happens, leading to a slight price dip.
- Wave 3: Public joins in, driving the price higher.
- Wave 4: More profit-taking as prices peak.
- Wave 5: A small group of traders pushes the price even higher.
Corrective waves
These three waves (A, B, and C) move against the main trend. They can form different patterns: zigzag (sharp reversals), flat (sideways movement), or triangles (sideways, contracting formations).
Elliott Wave Fractals: Patterns Within Patterns
Elliott waves are fractal in nature, meaning each wave can be broken down into smaller cycles. Depending on the time frame you're observing, these waves are categorized into:
- Grand super-cycle (centuries)
- Super-cycle (decades)
- Cycle (years)
- Primary wave (a year)
- Intermediate wave (months)
- Minor wave (weeks)
- Minute wave (days)
- Minuette (hours
- Subminuette (minutes)
Trading with Elliott Wave
The real value of Elliott Wave theory lies in its ability to help traders identify trends and manage gains and losses. By spotting these wave patterns, traders can take advantage of market movements, open positions at the right time, and exit at optimal points.
For example, during an impulse wave, traders can enter a long position at the start of the wave, setting a stop-loss at the origin of the movement and aiming to profit from waves 3 or 5. In corrective phases, traders can also identify sell positions or prepare for a new buy when the correction ends.
Three Core Rules for Elliott Waves:
- Wave 2 cannot retrace more than the beginning of Wave 1.
- Wave 3 cannot be the shortest of the impulse waves.
- Wave 4 cannot overlap the price territory of Wave 1.
There are also some guidelines, such as waves 2 and 4 often bouncing off Fibonacci retracement levels, or Wave 5 not extending beyond the end of Wave 3.
Supporters and Critics
Elliott believed that financial markets reflect human psychology, which remains consistent over time. However, while the theory looks great on paper, applying it in real-world markets can be challenging. Counting the waves correctly without breaking the strict rules can be difficult, leading some traders to adopt a more flexible approach.
The book "Elliott Wave Principle: Key to Stock Market Profits" by AJ Frost and Robert Prechter popularized the theory even further, especially after they predicted the 1987 market crash.
Summary
Elliott Wave Theory connects investor psychology—shifts between optimism and pessimism—to the wave patterns seen on price charts. By following this theory, traders can estimate price movements, set stop-losses, and identify entry and exit points. Combining Elliott Wave with other analysis techniques can provide traders with a well-rounded strategy for navigating the financial markets.
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