The Elliott Wave Theory is an approach used to analyze financial market cycles and thus be able to predict how their prices will move in the future. The theory was first advanced by Ralph Nelson Elliott, a professional accountant argued that financial markets operate in predictable patterns. These patterns are now known as Elliott Waves and form the basis of this theory.
Basis of the Theory
According to Elliott, market prices are driven by investors’ collective psychology. These waves of optimism and pessimism in the market underlie the behavior of the market and occur in predictable patterns. In a financial market, the theory says that there will be a series of impulses and corrective actions. These patterns hold regardless of whether the market is moving upwards or downwards.
Nature of Waves
According to Elliott, all these waves have their own unique characteristics that are based on the stage of the cycle. For example, the first wave is usually hard to notice and traders use indicators such as increased trading volume to know that they are in the middle of the first wave. By the time the cycle is in wave three, the cycle is at its strongest and at this stage corrective waves are small and short-lived. By wave five, the market has peaked and volumes traded are often lower than they were in wave 3.
For the Elliott Wave Theory to be useful to a trader, it is critical for an investor to be able to understand at what stage a bull or bear market is at as that allows them to know what the next wave will be. Investors can do this by observing price movements and to some extent, the volume of trade.
There are a number of rules that guide the application of this theory. These are as follows:
- The second wave (corrective) never retraces all of wave one (impulse).
- Of the three impulse movements, wave three can never be the shortest
It is important to remember that Elliott waves can have smaller waves within larger waves. However, the sub waves will still follow the same wave pattern as the larger waves.
Application of Elliott Wave Theory
After Elliott first postulated the theory, there was a period of time in which the theory was pushed to the peripherals of market analysis. The revival of the theory came with its use by Robert Prechter who was a financial forecaster in the eighties. Since then, the theory has gained widespread use and candidates working to attain the Chartered Market Technician title must first pass an exam in Elliott Wave Theory before getting their license. Many other market analysts have built on the theory to come up with their own market analysis concepts. The Elliott Wave Theory is one of the most widely used techniques in calculating stock price movements.
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