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What is Elliott Wave theory?
Elliott Wave theory was developed to describe price movements in financial markets that are related to investor sentiment and psychology. In particular, these price movements are described as fractal wave patterns.
The name Elliott Wave was given to the theory by its founder, Ralph Nelson Elliott. Elliott began his research in the 1930 by studying large quantities of yearly, monthly, weekly and daily charts, for numerous indexes. Elliott also created his own hourly and 30-minute charts.
The theory identifies impulse waves that setup a pattern as well as corrective waves that oppose the larger trend. These waves are grouped into sets and each set becomes a wave within a larger group.
The theory gained acclaim in 1935 when Elliott made a prediction of a stock market bottom using his approach. Since then it has gained a substantial and loyal following and remains core to many technical analysts.
The theory describes how to identify, predict and capitalise on these wave patterns.
The theory is sometimes referred to as the Elliott Wave principle or Elliott Wave cycle.
How does Elliott Wave theory work?
Elliott Wave theory states that prices move in predictable and repeated patterns. These patterns are called waves and are created by investor sentiment. The theory does not provide a precise mathematical formula that traders can use to identify waves. Instead they are subjective to each trader. Thankfully, there are rules that can be followed.
We can see from the image above that the Elliott Wave principle is broken down into two key wave types. When the price is moving with the trend the waves are called impulse waves. When the price is correcting the main trend the waves are called corrective waves.
Impulse waves consist of 5 sub waves. Corrective waves consist of 3 sub waves.
At this point we can identify some key rules that an Elliott Wave pattern must adhere to:
- Wave 2 cannot retrace more than 100% of wave 1
- Wave 3 can never be the smallest of waves 1,3 and 5
- Wave 4 cannot retrace more than 100% of wave 3
- Wave B cannot retrace more than 100% of wave A
An oscillator has been created that bears the name Elliott Wave, although that is where the similarity ends. The Elliott Wave oscillator is simply a histogram showing the difference between 2 moving averages. The oscillator can identify waves but it does not go into enough detail. It cannot identify impulse or corrective waves, or number individual waves.
How to trade using the Elliott Wave theory?
You may be wondering by this point whether it is possible to trade using Elliott Wave theory.
It is definitely possible to use the theory as part of your trading toolkit. It should not be used in isolation though.
The theory can assist in identifying a trade direction but it cannot tell you when to enter or exit a trade. The theory can also help identify and forecast when an asset may be reaching a top or bottom due to wave patterns and numbers. It could not though identify an absolute value for the top or bottom.
Elliott Wave theory is one of the oldest technical analysis tools available and has stood the test of time. Although highly subjective, there is no doubt that the theory exists. The theory is the basis of many trading strategies, with the most famous being swing trading.
Even if you don’t want to use Elliott Wave theory within your trading toolkit we strongly advise you become familiar with its principles. Once you understand the theory you will gain a valuable insight into the psychology and behaviour of traders.
If you would like to advance your knowledge of Elliott Wave theory even further then Trading AtoZ strongly recommend the following publication.
See the full selection of trading books recommended by Trading Atoz.
Elliott Wave International is the largest independent financial analysis and forecasting company in the world whose analysis is based upon the Elliott Wave theory.