What is the Elliott Wave Theory?
In the 1930s, American accountant and novelist Ralph Nelson Elliott created a method for doing technical analysis that came to be known as the Elliott Wave Theory. Elliott was the first person to accurately forecast the bottom of the stock market in 1935 after doing research spanning many years and multiple stock market indexes. At that time, the idea developed into a trustworthy instrument that is used by numerous portfolio managers all around the globe. In combination with other methods of technical analysis, the prediction of market movements and chances for trading may be accomplished using Elliott waves.
Fig.1: Elliott Waves – Bull Market (left to center). Bear Market (right to center).
Since the markets move in wave-like patterns driven by investor emotion, the Elliott Wave Theory proposes that stock price changes may be adequately forecasted by analyzing price history. This is due to the fact that the markets move in wave-like patterns. The motions are repeated, rhythmic, and perfectly timed, much like the waves of an ocean. In addition, the wave patterns are not considered to be a guarantee that they will take place in the markets; rather, they just present a possible scenario of how stock prices may behave.
Summary
- In technical analysis, determining price changes using Elliott waves is one of the most used applications. Elliott’s Wave Theory focuses primarily on two distinct types of waves: corrective waves and motive waves (also known as impulse waves).
- There are a total of five waves that make up a motive wave: three impulse waves and two retrace waves.
- The three waves that make up a corrective wave are denoted by the letters A, B, and C. Waves A and C are both considered to be impulse waves, however, Wave B is considered to be a retrace wave.
- The five-wave motive patterns seen in theoretical markets are uncommon in real-world markets, which often display three-wave motive trends.
Motive and Corrective Waves
Elliott’s Wave Theory focuses primarily on two distinct types of waves: corrective waves and motive waves (also known as impulse waves). Impulse waves, also known as motive waves, are movements that take place in the same direction as an existing trend. On the other hand, corrective waves go in the opposite direction of the wave that is currently in progress. The motions of Elliott waves are shown quite well in the figure that can be seen below.
Fig. 2: Elliott Wave Forecast.
Let’s say that a bull market exists. In other words, a single motive wave is driving the uptrend in the stock price. One motive wave is composed of five waves, numbered 1, 2, 3, 4, and 5. Waves 1, 3, and 5 are impulsive because they cause the stock price to move in a certain direction (here, upwards, but even downward stock movement can constitute an impulse wave). Wave 2 is a lesser decline after Wave 1, and Wave 4 is a smaller decline following Wave 3. Retrace waves are minor downward movements that follow impulse waves.
In addition, each of the impulse waves (1, 3, and 5) may be broken down into a total of five waves. Waves 1, 3, and 5 may be broken down into a series of smaller upward and downward motions, which when added together result in a total of five waves when seen closely enough. The five motions are denoted by the numerals I (ii), (iii), and (iv), respectively.
On the other hand, retrace waves 2 and 4 are decomposed into uphill and downward motions of three waves, which are shown by (a), (b), and (c), respectively.
Waves 1, 2, 3, 4, and 5 combine to form a single motive wave when considered as a whole.
The stock price is going to see a correction wave soon. The correction may be broken down into three distinct waves: A, B, and C. Waves A and C are composed of five waves that may be broken down into the following categories: I (ii), (iii), and (v). Wave B, on the other hand, is composed of three waves, which may be designated as (a), (b), and (c), respectively.
In a bull market, a motive wave drives the price of the stock upward, while a corrective wave causes the price to move in the other direction. In contrast, during a bear market, a motive wave will cause a decline in the stock price, while a corrective wave would cause a rise in the price of the company. As a result, the Elliott waves diagram that was shown before will be flipped when a bear market is present. It will include five waves (numbered 1, 2, 3, 4, and 5) that drive the price down, and it will include three waves (numbered A, B, and C) that drive the price higher.
Deconstructing Motive Waves
In order to recognize a motive wave, below are some broad principles that may be followed:
- Wave 2 cannot include more than one hundred percent of Wave 1.
- There is no way that Wave 3 could be the shortest of the three impulse waves (1, 3, and 5).
- Waves 1 and 4 are not allowed to have price ranges that overlap with one another.
Elliott Wave Theory Applied to Markets
It was discovered that a motive wave in real-time markets might consist of three waves rather than the usual five waves. In point of fact, the majority of the time, a motive wave on the market will seem like it is formed of three waves. Also, there is a chance that the market may continue to move in corrective waves. As a consequence of this, three-wave trends are far more prevalent than five-wave trends.
Use of Fibonacci Ratios in Elliott Wave Theory
The number 0 serves as the starting point for the Fibonacci summation sequence. Just adding one to zero gives you the following number. After that, the next number in the sequence may be arrived at by taking the sum of the two numbers that came before it and arriving at that sum. The sequence of numbers that make up the Fibonacci summation looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on till infinity. Fibonacci ratios are generated by dividing two Fibonacci numbers. The ratios are used to predict levels of support and resistance in the markets.
In Elliott Wave Theory, the Fibonacci retracement refers to the use of the Fibonacci ratios in order to pinpoint the point at which a correction is completed and the principal trend is able to resume. The extent of a downturn in a trend may be determined using Fibonacci retracements. As an example, the duration of Wave 2 may be half that of Wave 1.
The Fibonacci extensions are another instrument that sees widespread usage. Extensions of the Fibonacci sequence are used in order to locate the inflection points in a major trend. They show where a motive wave in a bull market may reach before the market begins to correct itself. They may be used to identify support levels in the event of a bear market. The levels of the stock price at which gains may be achieved are measured using extensions of the Fibonacci sequence.
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