What is the Elliott Wave Theory?

Introduction to the Elliott Wave Theory

If you have never heard about the Elliott Wave Theory, chances are you are not alone. But fear not, the wonderful thing about life is that we get to learn new things every day, and with the Wave Theory, you will.  

Briefly, it’s a method of market analysis in finance. So, it ties into forex trading, traditional trading, and more. But further to this theory is that it uses several types of patterns to supply clues on what might happen in the market next. Some call it a predicting tool, while others call it exactly what it is: a wave theory. Let’s look at what the Elliott Wave Theory is. 

What is the Elliott Wave Theory?

It is a method of market analysis that is based on the idea that the market must form the same types of patterns on a small timeframe, also known as a lesser degree, as compared to a longer timeframe which is known as a higher degree. It’s these patterns that give us insight into what might happen in the market going forward. The theory also says that the market movements follow the same pattern every single time, so the timeframe you are analyzing does not directly affect those movements. While this might sound confusing right now, you will understand it shortly. Also, note analysts at Elliott Wave International have used trends to predict a number of things, most notably Russia’s invasion of Ukraine. 

This predictor was first developed by R.N. Elliott in 1930 and then later made popular some 40 years later during the 70s by Robert Prechter. The wave theory has an interesting outlook on behaviour. It claims that when it comes to crowd behaviour, patterns and trends in markets are only a physical manifestation of mass psychology in the world. That’s a lot to process. But further to this, the theory also highlights that this does not only apply to markets but to a broader life of humans, especially where decision-making is concerned. There are examples of this in our everyday lives, and these include housing prices, fashion trends, as well as the type of public transport (including the routes) people choose. Let’s look at some of the different wave patterns and how they are applied.  

Motive waves

This is a wave that continually advances in the direction of a trend. This trend is of one more significant degree. The wave is then broken down into five smaller waves, and if you create a wave chart, it will be displayed as 1, 2, 3, 4, and 5. 

Now let’s look at the waves within the motive wave. These are impulse and diagonal. Let’s go back to the 5 smaller waves. Picture a chart with 5 lines; waves 1, 3, and 5 are all moving upwards, while waves 2 and 4 are moving down. Waves 1, 3, and 5 are actionary sub-waves, while 2 and 4 are corrective sub-waves – since they move in the opposite direction of the larger trend. 

Corrective waves

We will have to picture another chart, but corrective waves are always shown as a three-wave structure before you do. Imagine the chart with three sub-waves labeled A, B, and C. There is always a concern with corrective waves since the wave structure isn’t always the same as with motive waves. Picture the chart showing wave A and wave C both in the direction of the trend of one higher degree, so this is a correction. Then wave B is seen traveling in the opposite direction of the larger correction.  

Cycle structures

This is where combining motive and correction waves comes into play. The combination of the two primary waves is known as the complete Elliott Wave cycle. This means there are eight waves; five motives are in the direction of the trend of one larger degree and three corrections against the higher degree trend. 

Here is another chart to think about. It is an eight-wave sequence with a rising five-wave motive and a falling three-wave correction. This sequence finishes higher than what it started. So why is that? Because the smallest requirement to reach progress in either an up or down direction is the 5-3 structure. Since markets fluctuate, meaning they rise and fall, they will advance either up or down in progress. This is where Elliott noticed that the markets follow the same 5-3 structure every single time, and the Elliott Wave Theory was born.

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