The Emergence and Basic Principles of Elliott Wave Theory

By March 23, 2019 22:40
Elliott (1)

We are starting a series of short tutorial articles on one of the most popular tools for predicting market movement – the Elliott Wave Theory. This article will describe the history of creation and basic assumptions of the theory of waves.

Wave Theory was introduced in 1934 by Ralph Nelson Elliott, an American financier. The theory is based on the fact that stock markets, which, as usual, are considered to behave in a somewhat chaotic way, are actually traded in repetitive patterns or patterns.

The market is not a separate structure, developing by itself, the market is a crowd of people interacting with each other, and the graph displays its behavior. Where there is a person, there is always a psychology. Elliott was one of the first to make the assumption that psychological factors may prevail in the tendencies of trade price movements. He also suggested that people actually act systemically, without even realizing it. For the further development of his assumptions, Elliott began to observe the behavior of prices in the stock market, systematize the data and give them a graphic display. The result of such observations was the discovery of its wave models.

Read also – Types of stock charts 

Since Elliott was also an adherent of the fractal theory, he broke the price charts into smaller components and analyzed them in more detail (fractals are some mathematical structures that repeat infinitely at smaller scales). He found that price models of stock indices also have fractal properties, and suggested that these repetitive models could be used to predict price movements in stock markets.

Elliott described in detail how these models can be interconnected, as well as how they can form other models of larger sizes. Based on this, the main task of the “Wave Law” is an explanation of how the market is currently moving (to determine which model corresponds to market behavior), and to determine how most likely it will behave in the future.

With proper use of this theory, the accuracy of forecasts can be amazing. It provides for the analyst not only with knowledge of finding entry and exit points, but also provides a certain basis for disciplined thinking that allows you to successfully predict the future movement of the market.

Basic principles

The wave theory assumes that all market operations are the consequences of entering the market significant information and in themselves generate significant information. Each operation in the market is both a consequence and a cause.

The five-wave model

Price movement in the market adopts a special structure, which consists of five waves. Waves 1, 3 and 5 are waves of directional motion, waves 2 and 3 are recoiling or corrective. Corrective waves are part of a general movement. The five-wave model is the base figure from which all other models can be built. At any time and in any condition, the market can be assessed as being within the five-wave model.

The development of waves can be of two types: moving and corrective. The waves of the moving type have a five-wave structure, while the waves of the corrective type have a three-wave structure.

Driving waves are the basis of the five-wave structure, they set the direction of the market trend (waves 1, 2 and 3). Corrective waves are the basis of recoiling movements. They are called corrective for the reason that they make only a partial rollback from the full movement of the previous driving wave.

In the next article, we will look at the Elliott full cycle.

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By March 23, 2019 22:40