|Elliott Wave Theory||
About Elliott Waves Theory Basics
The Elliott Wave Theory is named after Ralph Nelson Elliott. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves. In fact, Elliott believed that all of man's activities, not just the stock market, were influenced by these identifiable series of waves.
Elliott based part his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Thus Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns he had identified.
Definition of Elliott Waves
In the 1930s, Ralph Nelson Elliott found that the markets exhibited certain repeated patterns. His primary research was with stock market data for the Dow Jones Industrial Average. This research identified patterns or waves that recur in the markets. Very simply, in the direction of the trend, expect five waves. Any corrections against the trend are in three waves. Three wave corrections are lettered as "a, b, c." These patterns can be seen in long-term as well as in short-term charts. Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. This information (about smaller patterns fitting into bigger patterns), coupled with the Fibonacci relationships between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid reward/risk ratios.
There have been many theories about the origin and the meaning of the patterns that Elliott discovered, including human behavior and harmony in nature. These rules, though, as applied to technical analysis of the markets (stocks, commodities, futures, etc.), can be very useful regardless of their meaning and origin.
Simplifying Elliott Wave
When the analysis is not clear, why not find another market conforming to an Elliott Wave pattern that is easier to identify?
From years of fighting this battle, we have come up with the following practical approach to using Elliott Wave principles in trading.
The whole theory of Elliott Wave can be classified into two parts:
Elliott Wave Basics —
Wave 3 rally picks up steam and takes the top of Wave 1. As soon as the
Wave 1 high is exceeded, the stops are taken out. Depending on the
number of stops, gaps are left open. Gaps are a good indication of a
Wave 3 in progress. After taking the stops out, the Wave 3 rally has
caught the attention of traders.
The next sequence of events
are as follows: Traders who were initially long from the bottom finally
have something to cheer about. They might even decide to add positions.
traders who were stopped out (after being upset for a while) decide the
trend is up, and they decide to buy into the rally. All this sudden
interest fuels the Wave 3 rally.
the time when the majority of the traders have decided that the trend is
Finally, all the buying
frenzy dies down; Wave 3 comes to a halt.
Profit taking now begins to
set in. Traders who were long from the lows decide to take profits. They
have a good trade and start to protect profits.This causes a pullback in
the prices that is called Wave 4.
Wave 2 was a vicious
sell-off; Wave 4 is an orderly profit-taking decline.
While profit-taking is in
progress, the majority of traders are still convinced the trend is up.
They were either late in getting in on this rally, or they have been on
They consider this profit-taking decline an excellent place to buy in and get even.
On the end of Wave 4, more buying sets in and the prices start to rally again.
The Wave 5 rally lacks the
huge enthusiasm and strength found in the Wave 3 rally. The Wave 5
advance is caused by a small group of traders.
Although the prices make a
new high above the top of Wave 3, the rate of power, or strength, inside
the Wave 5 advance is very small when compared to the Wave 3 advance.
Finally, when this lackluster buying interest dies out, the market tops out and enters a new phase.
An impulse pattern consists of five waves. With the exception of the triangle, corrective patterns consist of 3 waves. An impulse pattern is always followed by a corrective pattern. Corrective patterns can be grouped into two different categories:
Ratios inside a Zig-Zag Correction
A simple correction is commonly called a Zig-Zag correction.
Complex Corrections (Flat,
Triangles, by far,
most commonly occur as fourth waves. One can sometimes see a triangle as
the Wave B of a three-wave correction. Triangles are very tricky and
confusing. One must study the pattern very carefully prior to taking
action. Prices tend to shoot out of the triangle formation in a swift
When triangles occur in the
fourth wave, the market thrusts out of the triangle in the same
direction as Wave 3. When triangles occur in Wave Bs, the market thrusts
out of the triangle in the same direction as the Wave A.
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