Elliot Wave Theory is one of the most popular strategies applied by traders. This theory works exceptionally well if read correctly. In the early 1930s, there was this professional accountant named Ralph Nelson Elliot. He was a stock market expert who analyzed the data of stocks closely for 75 years’ timeframe. He thought that markets move in random chaotic directions but later realized that they don’t. After years of analysis and research, he published a book titled The Wave Principle. This book explained in detail about the theory he had proposed.
Elliot Wave Theory
According to Elliot, the market moves in repetitive cycles. The cause for these cycles is the emotions of mass retail investors, primarily due to psychological factors. It was seen that the upward and downward swings in prices caused by the collective psychology of traders always showed a repetition in the same manner. These swings were referred to as ‘waves.’
So, if traders have a clear understanding of these repetitive cycles, one can predict future price movements. In fact, traders can identify points precisely where the market is going to reverse.
There quite a lot of terms involved in the Elliot Wave Theory. For now, we shall the two most fundamental terms and understand others in the later lessons.
Elliot proposed that trends are formed as a result of the psychology of investors. He proved that swings formed by this mass psychology were a recurring pattern. And these swings were termed as waves. Elliot’s theory, to an extent, resembles the Dow theory, which also mentions that prices move in ‘waves.’
Generally speaking, fractals are structuring whose split parts are like a similar copy of the whole. These structures repeat themselves even on an infinite scale. Apart from individual stocks, Elliot discovered that stock indices showed the same recurring structures. So, he moved to the futures market to analyze if the theory worked there as well.
Predicting the Market with Elliot Waves
Elliot studied the stocks in detail and concluded that predictions could be made using the characteristics of wave patterns. It is known that for a trending market, there is a pullback or correction for it. It is usually said that “what goes up, must come down.” That is, price action is divided into trends and corrections. Trends represent the main direction of the market, while corrections are against the trend.
The Elliot wave theory also uses a similar principle. There is an Impulsive wave that moves in the same directions as the larger/main trend. It always shows five waves in its pattern. Then there is a corrective wave that travels in the opposite direction of the larger trend. On a smaller scale, under each impulsive wave, five other waves can be found again. And such a pattern repeats by going into smaller and smaller scales.
Wondering what the above figure represents? To interpret it, stay tuned for the next lesson.