Elliot Wave Theory
The Elliot Wave theory is typically used in technical analysis to predict the market trend or describe the price movements of financial markets. The Elliot wave theory was developed by an American accountant and author Ralph Nelson Elliot in the 1930s. The theory is inspired by dow theory where Elliot identified that the price movement in the stock market can be predicted as they create repetitive patterns like waves.
Traders could be described as riding the wave to profit from the fluctuations from the capital market which forms the basis for the Elliot Wave theory. The investors’ psychology or sentiment plays a huge role in this theory. Due to investors’ psychology or sentiments, the stock market patterns are repetitive up and down.
There are two different types of waves in Elliot Wave theory:
- Motive waves (or impulse waves)
- Corrective waves
The impulse wave indicates the trend of the next largest degree. It consists of 5 sub-waves that make the final movement in the trend direction of the upcoming largest degree. The impulse waves are direct towards up movements in uptrends and conversely direct towards the downside in the downtrends.
Impulse waves last for different timeframes. They may last for several hours or several months or several years or even decades. Impulse waves with five sub-waves are the most common in the market and are very powerful analytical tools. At any given period the price movements seem to alternate between an impulsive wave or motive wave and a corrective wave.
Impulsive waves of 5 sub-waves are again divided into motive waves and corrective waves. In an uptrend wave 1, wave 2 and wave 3 are motive waves and also impulse waves which show the direction towards the largest next degree in the upward direction. Similarly, wave 2 and wave 4 are retracement waves for wave 1 and wave 3. After wave 5, the corrective phase starts (corrective wave) namely wave A, wave B, and wave C the net momentum being in the opposite direction of the motive wave. In bullish trends, the wave pattern is 5 waves up and 3 waves down. In the bearish trend, the wave pattern is formed by 5 waves down and 3 waves up.
During the bearish market trend, the net momentum made by impulse waves is on the downside. The motive waves or the impulse waves from the dominant waves in the downward direction while the corrective waves are in the upward direction. In the bearish trend, the wave pattern is formed by 5 waves down and 3 waves up.
The formation of an impulse wave is only confirmed if it follows the following three rules.
- In any market trend or in any timeframe the second retracement wave must not retrace more than 100 percent of the first wave.
- The third wave must always be greater than either the first wave or the fifth wave. In other words, the third wave cannot be the shortest of the three motive waves.
- For any given timeframe the wave four must not exceed wave three.
These are the three golden rules that must be followed for an impulse wave along with the 5 – 3 – 5 – 3 – 5 structure of the impulse wave.
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Elliot Wave Principle with Fibonacci Retracements
Fibonacci retracements are based on Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144….).
Fibonacci retracements are drawn in the price charts to determine support and resistance levels. Effectively determining the support and the resistance levels is essential in making a profit from the market.
There are different levels in Fibonacci retracement which are created by dividing the vertical distance between the extreme points in the charts by the key Fibonacci ratios: 23.6%, 38.2%, 50%, 61.8%, and 100%.
These ratios are simply obtained by dividing any number in the Fibonacci series by the number following it in different positions. For example: 21 divided by 34 equals to 0.618 (i.e. 61.8%), 13 divided by 34 equals to 0.382 (i.e. 38.2%) and 8 divided by 34 is 0.236 (i.e. 23.6%).
The target of the waves in an Elliot wave structure can be determined using the Fibonacci retracements.
‘In impulse wave:
- Wave 2 is typically 50%, 61.8%, 76.4%, or 85.4% of wave 1
- Wave 3 is typically 161.8% of wave 1
- Wave 4 is typically 14.6%, 23.6%, or 38.2% of wave 3
- Wave 5 is typically inverse 1.236 – 1.618% of wave 4, equal to wave 1 or 61.8% of wave 1+3′.
The above-mentioned information can be used to predict the target of each wave of an impulse. Thus helping to find an appropriate entry and exit position in the market.
During an uptrend of the impulse wave, the buy positions are at the support levels of the second and fourth waves. Conversely, traders can sell or short the position when the five-wave pattern is completed as the reversal is definite.
Using Elliot wave theory, different types of waves can be categorized in the order of smallest to largest as:
Scenarios in an Uptrend for Elliot Waves
Wave 1: The stock prices move in a positive direction with buying pressure.
Wave 2: Traders try to take short-term profit resulting in the pullback.
Wave 3: Traders want to take the advantage of the market correction, thus increasing the number of buyers. Wave 3 is longer than wave 1 creating a new high.
Wave 4: Again the traders try to take short-term profit and create a small pullback than the previous. But the overall market is still on an uptrend.
Wave 5: The market attracts the most number of buyers at this stage and eventually the market becomes saturated with buyers. The market becomes overpriced and the sellers push the market towards a reversal or corrective phase.
Be it in planetary bodies or the capital market, what goes up must come down. Elliot wave theory gained huge popularity when the authors of the book ‘Elliott Wave Principle: Key to Market Behavior’, successfully predicted the bull market of the 1980s. Elliot wave principle is indeed an effective technical analysis tool to predict the forthcoming market trend. The theory though is hard to master and the time for the completion of the wave can be easily misinterpreted. The fractal Elliot waves interpret human psychology to predict the stock market trend making it a handy tool for traders and investors.
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