According to Elliot Wave Theory, developed by Ralph Nelson Elliott, a professional accountant, and a stock market trader. He realised stock markets to a moderate extent, act in an arbitrary manner, but with the same recurring patterns that are represented in the form of waves. However, these repetitive patterns are not seen all the time. To a moderate extent, it resembles the Dow Theory that also recognizes stock price movements. In addition to this, the Elliot Wave Theory found out the fractal nature of the market. Elliot used this concept as projecting indicators of the movements in the future market.
How Are Markets Predicted Based on Wave Patterns?
The Elliot Wave Principle is primarily based on the impulsive phase (five-wave structure) and corrective phase (three-wave structure), which are the two distinct ways of looking at the chart. Impulse and correction are the heartbeats of the market that helps in looking at the different patterns and understanding the market structure. In other words, it helps to analyze the market price.
If you know about impulsive and corrective waves, you are half done in understanding the entire wave analysis, which helps in trading and everyone with even little knowledge of the Elliott Wave Theory will be familiar with impulsive and corrective waves.
The impulse waves have a five-wave pattern, as shown in the above diagram, in which waves 1, 3, and 5 determine the direction of the market while waves 2 and 4 are counter waves to the waves 1, 3, and 5.
Three Golden Rules in The Elliot Wave Theory
If there is a diversion in any of the rules, suggested in this theory, you are probably following some other theory.
- Rule 1: The trough of Wave 2 is never below the trough of Wave 1
- Rule 2: Wave 3 is never the shortest wave
- Rule 3: The crest of wave 1 is always below Wave 4
The above diagram is the basic structure of The Elliott Wave Theory. The Waves 1 through 5 represent Impulse Wave and waves a, b, and c represents Corrective Waves. Corrective waves constitute a set of financial asset price movements in the Elliott Wave Theory which move in the opposite direction.
You might feel the Elliott Wave Theory is a very hard principle, but once you master it, your predictions can be accurate.