The Elliott Wave Theory is an approach that is used to predict stock price movements. The Elliott Wave theory holds that stock prices move in predictive waves that can be anticipated. The Elliot Wave Theory is used by traders to discern stock price movements and to predict their future movement.
Background of the Elliot Wave Theory
The Elliott Wave Theory was first postulated by a professional accountant named Nelson Elliott who observed stock price movement over a period of time. Elliott identified patterns in stock price movement that he labeled Elliott Waves. These waves consist of motive waves which drive the direction of the stock price and corrective waves that retract the motive waves. Elliott’s theory was based on the collective psychology of traders which Elliott argued could be understood and therefore could be predicted.
Principle 1: Motive and Corrective Waves
Motive and corrective waves are the basis of the Elliott Wave Theory and drive the price of the stocks. These waves work in a pattern that somewhat mirrors the Fibonacci sequence which is derived from the summation of the first two numbers of the sequence. The theory holds that a typical cycle has 5 waves. Motive waves are labeled 1, 3 and 5 and move prices up or down. In between the motive waves are corrective waves which counteract the motive waves. Corrective waves are labeled 2 and 4. It is important to remember that any one of these waves also has sub-waves that follow the same wave patterns as the larger waves.
Traders use these patterns to understand when to enter the market and when to exit. For example, it would be ideal to join the market at the beginning of the first wave but most traders miss it as it is hard to discern. Most traders enter the market at the bottom of the first corrective wave.
Principle 2: Market Cycles
The Elliott Theory identifies a series of cycles that prices go through. These are as follows:
- 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: In a week
- Minute: Days
- Minuette: hours
- Subminuette: minutes
Rules and Guidelines
For the theory to work, the Elliott Wave Theory follows a series of rules that help traders discern between motive and corrective waves:
- 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 be a corrective wave but a motive wave
- Of the three impulse movements, wave three can never be the shortest.
- The theory allows for wave 2 and 4 to diverge in direction. Wave 2 can be zigzag while wave 4 can be flat.
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