Elliot Wave Theory

The Elliott wave principle is a form of technical analysis that finance traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. He proposed that market prices unfold in specific patterns, which practitioners today call “Elliott waves”, or simply “waves”.

Ralph Nelson Elliott developed the Elliott Wave Theory in the late 1920s. Elliott believed that stock markets, thought to behave in a somewhat chaotic manner, in fact traded in repetitive cycles. In this article, we’ll take a look at the history behind Elliott Wave Theory and how it is applied to trading.

Cycles and Waves
Elliott proposed that market cycles resulted from investors’ reactions to outside influences, or predominant psychology of the masses at the time. He found that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided further into patterns he termed “waves”. (For more on the history of technical analysis, check out The Pioneers of Technical Analysis.)

Elliott’s theory is somewhat based on the Dow theory in that stock prices move in waves. Because of the “fractal” nature of markets, however, Elliott was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. Elliott discovered stock-trading patterns were structured in the same way. He then took the next obvious step and began to look at how these repeating patterns could be used as predictive indicators of future market moves.

Market Predictions Based on Wave Patterns
Elliott made detailed stock market predictions based on unique characteristics he discovered in the wave patterns. An impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves, five waves can again be found. In this smaller pattern, the same pattern repeats itself ad infinitum. These ever-smaller patterns are labeled as different wave degrees in the Elliott Wave Principle. Only much later were fractals recognized by scientists.

In the financial markets we know that “every action creates an equal and opposite reaction” as a price movement up or down must be followed by a contrary movement. Price action is divided into trends and corrections or sideways movements. Trends show the main direction of prices while corrections move against the trend. Elliott labeled these “impulsive” and “corrective” waves.