The Elliott Wave Theory is one of the most popular technical tools to determine market trends. This article will explain how this tool works, discuss its pros and cons, and give real-world examples.
Psychology plays a vital role in investing, but it can be challenging to understand the motivations behind other investors’ behaviors. The Elliott Wave Theory uses patterns that are somewhat easy to follow because they are based on human emotion. On the downside, people’s behavior may change over time, invalidating any analysis done using the theory.
It maps out price points and creates correlations between the past and the future. It’s an easy task for most forex markets where history tends to repeat itself without fail, but what about stocks?
The stock market has a personality all its own. For one thing, it changes every second of every day in almost every country around the world, so how can anyone be sure that they have found a pattern worth following? That’s where Elliot Wave Theory comes into play. The theory was created in 1938 by R.N. Elliott, who claimed that there was order within what appeared to be random movements on the stock charts.
The three-day stock market crash of October 19, 1987, was a momentous event in the history of markets and traders alike. The Dow Jones Industrial Average (DJIA) dropped by 508 points or 22.6% during this day alone. It would be hard for anyone to understand that such a dramatic downturn could lead to any order, but as you can see from the wave scale, if it wasn’t for those three days, we may not have seen such a dramatic run-up as investors started getting back into the market.
You can see how we had massive rallies and then equally as dramatic declines during these times, only to rebound again.
Elliott’s Wave Theory is a means of understanding mass psychology within the market context. The theory is based on the idea that people base their decisions primarily on emotion and create a sort of social trend. It happens because groups tend to have similar feelings, fears and worries that they need to overcome to push forward when traditional technical analysis fails or isn’t enough for them psychologically.
In essence, Elliot discovered three main rules about human behavior:
- People act in threes
- The movements from left to right are composed of 5 waves (rally)
- Each rally is organised of 3 smaller waves (corrective)
- Each corrective is composed of 5 waves (consolidation)
- The moves from right to left are made up of 3 large waves
It might be helpful to take a look at this example below, which shows what it looks like in practice:
As you can see, the market moved down to create the first three-wave move; then, five smaller corrective waves were created before moving down again. When doing your homework while looking for patterns within these moves, make sure that you only look at one currency pair or stock at a time because trying to compare them with each other will give you incomplete information.
Please note that wave one and wave three should not exceed the length of wave five; it is also recommended that you take more time to plot your wave scales. Once you master planning your charts using Elliot’s theory, then you can be assured that you will always have a clear picture of what is going on in any market at any given moment.
Hopefully, this article has been helpful and informative to those who wanted to understand better how Elliott Wave Theory can help them trade smarter. Remember that nothing replaces practice, so try looking for these patterns within the markets and seeing if they match what we discussed today.
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