What is Elliott Wave Theory?

Elliott wave theory is a technical analysis technique used by investors. It is used with other technical analysis techniques to predict market movements and trading opportunities.

Nov 26, 2021 01:11 IST India Infoline News Service

Stock Market Trader, Stock Trader, Trading
As with any action and its execution, stock market trading, too, requires comprehensive planning. Professional investors simply don’t buy and sell stocks based on instincts and hope for a price increase. Speculation is the core reason for investors to incur losses in the stock market. If you talk to any experienced investor, they will always press on the importance of prior research before entering or exiting a trade.

They analyze past price patterns of the financial market to understand how it was then and how these factors can affect the price movements in the future. These factors are all part of the extended technical analysis process, which you will be learning about below, along with one of its integral parts known as Elliott Wave Theory. The Elliott Waves help in understanding price movements and trade efficiently using the information. But before diving into this theory, let’s start with technical analysis.

What is Technical Analysis?
Technical analysis is the study of chart patterns, graphs, and diagrams on a screen. The idea is to understand price and volume trends and pick stocks accordingly. Technical analysis believes that whether you talk about fundamentals, news flows, or earnings surprises, they are all in trice and volume.

Technical analysis is based on the premise that historical price trends tend to repeat over time. In technical analysis, you sit with historical stock charts, look at price and volume data, and then plot various trends. Based on past wisdom, you find patterns to trade for the future.

With this knowledge about technical analysis, let’s move on to understand the Elliott Wave Theory and why it is an effective technique in the process.

What is Elliott Wave Theory?
The Elliott Wave Theory is a technique that helps investors define price movements within the financial market. The Elliott Wave Theory is named after its founder Ralph Nelson Elliot, an American accountant, who analyzed 75 years of stock data to create the theory. It was later popularized by Robert Prechter.

The main belief behind the Elliott Wave Theory is that the market tends to repeat itself, meaning that the trades occur based on a repetitive cycle, mainly attributed to the sentiments of the investors. Apart from the investor sentiments, the Elliott Wave Theory also accounts for the effects of outside influences.

How does Elliott Wave Theory work?
Elliot created the Elliott Wave Theory after observing that the financial markets always move in a zigzag formation. He termed these zigzag formations as Elliott Waves. These Elliott Waves help investors analyze the markets deeply and identify the individual characteristics of wave patterns. After analyzing results, investors are equipped to make detailed market predictions about the trends and the price movement. Overall, the Elliott Wave Theory works on the principle that the investors’ collective psychology is responsible for bringing an uptrend or downtrend which is predictable as it repeats itself.

The Elliott Wave Theory, through its deep analysis of past data, empowers investors to spot a precise price point where the market is probably going to reverse. This price point helps identify the ideal entry and exit point. It also allows them to adjust their portfolio to realize gains or mitigate losses.

The Elliott Wave Theory operates by analyzing two types of Elliott Waves: Motive Waves and Corrective Waves. The use and interpretation of the Elliott Wave Theory differ from one investor to the next as they use various other technical indicators to create a hypothesis.

While providing the Elliott Wave Theory definition, Elliot maintained that the theory does not provide any certainty while predicting future price movements. However, the Elliott Wave Theory is just a way to help investors order the possibility of future price action.

How to trade using Elliott Wave Theory?
As per the Elliott Wave Theory, price movement that occurs towards the main trend is called the motive ways, and it occurs in five different ways.
  • The first, third, and fifth Elliott waves move towards the direction of the underlying trend.
  • The remaining two Elliott Waves, the second and fourth, act as minor retracement points or counter-trends within the underlying trend.
The motive waves may have a chance of being extended over the original period. This means that the three waves can last longer than the remaining two reactionary waves. However, the extension of the time frame entirely depends on the market sentiment and psychology.

According to the Elliott Wave Theory, there are roughly 21 wave patterns that illustrate the price movements. In this scenario, the results depend on the strength and sharpness of each wave and pullback. Generally, the wave’s fifth up move is followed by a correction 3. The traders usually level these as A, B, and C, and the 5-3 wave pattern can be identified across all the time frames.

Under the Elliott Wave Theory, the corrective phases that can initiate a trend reversal consist of two waves: A and C. These waves tend to move in the opposite direction of the motive or impulse waves that are heading towards the underlying trend. Furthermore, the Elliott Wave Theory also identifies nine degrees of waves ranging from short-term intraday movements to a multi-century time frame. The hierarchy of the nine degrees is as follows:
  • A Grand Supercycle is made up of Supercycle waves
  • Intermediate waves are made up of Minor waves
  • Minor waves are made up of Minute waves
  • Primary waves are made up of Intermediate waves
  • Supercycle waves are made up of Cycle waves
  • Cycle waves are made up of Primary waves
  • Minute waves are made up of Minuette waves, and
  • Minuette waves are made up of Subminuette waves
Final Words
Elliott Wave Theory is a simple yet effective technique to gain valuable insights into trend dynamics and understand comprehensive price movements. Knowing how and when the market will repeat itself makes it easier for investors to make informed investment decisions. However, it is advised that you use the theory along with other technical indicators to mitigate any false signals.

FAQs
Q.1: How successful is Elliott Wave Theory?
Ans:
Elliott Wave Theory can prove to be highly successful in analyzing past stock data to predict future price movements. However, you must use it in conjunction with other technical indicators.

Q.2: How to spot Elliott Waves?
Ans:
An impulse wave is made up of smaller waves that are heading in the same direction as the underlying trend. Corrective waves will be heading in the opposite direction of the impulse waves.

Q.3: Which time frame is best for Elliott waves?
Ans:
The best time frame for Elliott Waves would depend on your comfort zone and trading style. For example, if you are an intraday trader, you can use one minute, five minute, or hourly candles.

Q.4: Can Elliott Wave be used for day trading?
Ans:
Yes, you can use the Elliott Wave for intraday by utilizing shorter time frames such as minutes or hours.

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