The Elliott Wave Theory is a technique that is used by traders to analyze stock price movement and to predict its future movements. The Elliott Wave Theory is founded on the belief that market prices move in predictable patterns over any given period of time. Here is everything a trader needs to know about this theory.
History of the Elliott Wave Theory
The theory was first put out in the 1930s by Ralph Nelson Elliott and he argued that stock prices move in predictable patterns. These patterns, if understood, could help predict the future movement of the stock and even when this movement could happen. The theory was relatively obscure for decades until the eighties when it became popular. Today, the principles of this theory are used by traders across the world to predict stock price movements.
Motive and Corrective Waves
The foundation of this theory lies in the dynamics of the motive and corrective waves. The theory holds that stock prices move in a series of directional movements called motive waves and counter-directional waves known as corrective waves. Understanding if a stock price movement is a motive or corrective wave helps market analysts predict the next movement. The theory holds that in a typical cycle, there will be 8 waves consisting of 5 motive waves and 3 corrective waves.
Rule Governing Motive and Corrective Waves
To help traders distinguish between corrective and motive waves, the theory has developed several rules that govern the analysis of stock price trends. These rules are as follows:
- The first corrective wave can never go below the preceding motive vote. It may correct it up to 100% but it can never exceed it.
- The second motive vote (labeled wave 3) can never be the shortest in the 5-wave cycle.
- The theory allows for wave 2 and 4 to diverge in direction. Wave 2 can be zigzag while wave 4 can be flat.
Elliott Wave Cycles
Apart from looking at the direction of a stock price, the Elliott Wave Theory can also help market analysts understand the length or degree of the wave. Elliott identified nine cycles namely:
- Subminuette – this is a cycle that takes place in the space of a few minutes
- Minuette – these cycles take place in the space of a couple of hours
- Minute – takes place across a few days
- Minor – this cycle spans a few weeks
- Intermediate – this cycle takes place across a few months
- Primary – spans several years typically 1 or 2
- Cycle – cycle also runs across a number of years. Typically, 5-7 years.
- Supercycle – this cycle spans one or two decades
- Supercycle: This cycle spans several decades
- Grand Supercycle: This cycle covers several centuries.
How the Theory Helps Traders
You can use the Elliott Wave Theory to understand when to enter a particular market and when to leave. For example, it is recommended to enter at the beginning of the first wave but since these often go unnoticed, most traders enter at the low end of the second wave.
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