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The Elliott Wave Theory is a complex method that can take months and even years to master. It is a method that may be suitable only for traders who approach the market seriously and strive to achieve professional competency. Today we will look at the basics of this approach and see how it may be applied in trading. The method is fully and extensively described by the author in the book “The Wave Principle”, which was published back in 1938.
The history of the Elliott Wave Theory
Back in 1930-s an American economist Ralph Elliott, in an attempt to keep himself busy and distracted from his illness, started analyzing hourly, daily, weekly, monthly and yearly price charts of various indices in order to find out whether there is any similarity in patterns. He believed that there was a reason for every movement and he went through charts covering 75 years of stock market data.
In May 1934, the results of Elliott’s observations began to form a general set of principles of the stock market behavior. Elliott stated that even though the market activity may seem random and scattered, in reality it follows predictable laws and can be measured using Fibonacci numbers.
Motive and corrective waves
Ralph Elliott suggested that trends in financial prices result directly from investors’ psychology and the swings in mass psychology always showed up in the same patterns. Elliott found out that prices move in impulsive (motive) and corrective ways. The price movements that repeat one after another are called waves. They can be split in two types.
Motive waves consist of 5 waves: 3 large price movements in the direction of the uptrend and 2 corrections. These waves are labeled waves 1, 2, 3, 4 and 5 respectively. There are several rules to note when finding these waves:
- The third wave (second impulsive wave) is usually the largest of the sequence. Waves 1 or 5 cannot be longer than wave 3.
- When the wave 3 is the longer impulse wave, wave 5 will be almost equal to wave 1 in length.
- The structure for waves 2 and 4 will alternate: if one is a sharp correction, the other one will be a flat correction and vice versa.
- The high of wave 3 must be higher than the high of wave 1 (otherwise it is necessary to start the wave count again). The waves should be making progress.
Corrective waves consist of 3 waves: an impulse down, a correction to the upside and another impulse down. These waves are labeled A, B and C. As a rule, corrective waves A, B and C usually end in the area of the prior wave 4 low.
Both motive and corrective waves can be seen in the picture above. It is important to note the length of the waves as well as their proportions. Wave 2 is typically 60% the length of the first one. Wave 3 is usually much bigger than wave 1 and wave 4 that comes next is usually 30% or 40% of wave 3. The same rules are applied for a downtrend.
How to use this theory in practice?
There are many ways to take advantage of the Wave Theory. However, applying the theory in practice can be quite challenging. It is important to remember the rules of the waves sequence in order to build them on the chart correctly.
The wave structure suggests that the price moves in cycles. For instance, after three big moves to the upside, the upturn trend is likely to be near its end and that the prices are likely to move lower. For a downtrend, it would be the opposite: after three big moves down, the downtrend is likely to be over and the prices might start moving higher.
These movements are fractal, which means that they can be found both on larger and smaller chart types. The waves help to determine the trend direction and a possible moment for an entry.
For example, such a structure can be found on a monthly chart on the Amazon stock. It is clearly visible that the price first climbed upwards in a cycle of 5 waves, followed by the 3 corrective waves.
Finding the waves and analyzing the chart in this way may assist the trader with making decisions regarding the future deals. The possible method a trader may utilize is to enter Buying positions during the pullbacks (corrective waves) during uptrends, for example. This, if done correctly, may allow a trader to “ride” the next uptrend as the price rises to the next high.
Selling deals may be executed during corrective waves in a downtrend to possibly benefit from the market trending down.
Understanding the Elliott Wave Theory may improve your market analysis skills and help time the trade entries better. However, it is a complex method that requires plenty of research and it cannot guarantee 100% accurate results. This approach is better suited for experienced traders who already have above average technical analysis skills.