The Elliott Wave Theory is used to predict market behavior by looking at market patterns. The theory was formulated by Ralph Nelson Elliot and holds that market movements follow predictable waves based on the collective psychology of investors. The theory has some basic tenets and we are going to explain them to you.
This is the foundation of the Elliott Wave Theory and holds that market movement is characterized by five ‘waves’ or movements which drive the direction that the market takes. Wave 1, 3 and 5 are directional movements (known sometimes as impulses). The other two labeled 2 and 4 are counter directional (opposite of the first three) and shape the overall movement of the market.
Impulse Waves vs. Corrective Waves
The Elliott Wave Theory identifies two basic types of waves namely impulse waves (also known as motive waves) and corrective waves. The two sets of waves travel in opposite directions and collectively guide the direction of the market. corrective waves reverse the impulse waves although they should never go beyond 100%.
In the Elliott Wave theory, a full market cycle consists of eight waves where five waves are impulses and three are corrective waves. Within each major wave could lie a series of sub-waves. It is important to remember that these sub-waves follow the same impulse-corrective wave cycle as the larger wave.
Beyond the categorization of waves as either impulse or corrective, one can further categorize waves in terms of degree. Below are the nine categories of waves based on degree. The period next to each category denotes the period of time the cycle takes.
- Grand Supercycle: Takes place over several centuries
- Supercycle: Runs across several decades
- Cycle: Typically, one to three years
- Primary: Couple of months
- Intermediate: Four weeks to two months
- Minor: This runs over a week or two
- Minute: This spans a few days
- Minuette: This cycle runs in the space of a few hours
- Subminuette: This cycle runs in the space of a few minutes
Rules and Guidelines
The Elliott Wave Theory follows a set of rules that help traders discern between motive waves and corrective waves. These rules are as follows:
- The second wave (corrective) never retraces all of wave one (impulse). If it did, it would change the direction of the stock price movement and would mean that it no longer a corrective wave but a motive wave
- Of the three impulse movements, wave three can never be the shortest of them
- The theory allows for wave 2 and 4 to diverge in direction. Wave 2 can be zigzag while wave 4 can be flat.
The Elliott Wave move in patterns that closely mirror the Fibonacci sequence. Out of this, traders developed the Fibonacci analysis tool which calculates the extent of a price retracement.
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