The Elliott Wave principle was discovered in the late 1920s by Ralph Nelson Elliott. He discovered that stock markets do not behave in a chaotic manner, but that markets move in repetitive cycles, which reflect the actions and emotions of humans caused by exterior influences or mass psychology. Elliott contended, that the ebb and flow of mass psychology always revealed itself in the same repetitive patterns, which subdivide in so called waves. In part Elliott based his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Thus Elliott was able to analyse markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns he had identified. Fractals are mathematical structures, which on an ever smaller scale infinitely repeat themselves. The patterns that Elliott discovered are built in the same way. 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 of the before mentioned impulse, again five waves will 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 1980s the scientist Mandelbrot proved the existence of fractals in his book "the Fractal Geometry of Nature". He recognized the fractal structure in numerous objects and life forms, a phenomena Elliott already understood in the 1930s. In the 70s, the Wave Principle gained popularity through the work of Frost and Prechter. They published a legendary book ( a must for every wave student) on the Elliott Wave (Elliott Wave Principle...key to stock market profits, 1978), wherein they predicted, in the middle of the crisis of the 70s, the great bull market of the 1980s. Not only did they correctly forecast the bull market but Robert R. Prechter also predicted the crash of 1987 in time and pinpointed the high exactly. Only after years of study, did Elliott learn to detect these recurring patterns in the stock market. Apart from these patterns Elliott also based his market forecasts on Fibonacci numbers. Everything he knew has been published in several books, which laid the foundation for people like Bolton, Frost and Prechter, to make profitable forecasts, not only for stock markets, but for all financial markets. Next let¡¦s first examine the patterns Elliott identified. According to physical law: "Every action creates an equal and opposite reaction". The same goes for the financial markets. A price movement up or down must be followed by a contrary movement, as the saying goes: "What goes up must come down"( and vice versa). Price movements can be divided into trends on the one hand and corrections or sideways movements on the other hand. Trends show the main direction of prices, while corrections move against the trend. In Elliott terminology these are called Impulsive waves and Corrective waves. The Impulse wave formation has five distinct price movements, three in the direction of the trend (I, III, and V) and two against the trend ( II and IV).
Obviously the three waves in the direction of the trend are impulses and therefore these waves also have five waves. The waves against the trend are corrections and are composed of three waves.
Note that these waves A and C go in the direction of the shorter term trend, and therefore are impulsive and composed of five waves, which is shown in the picture above. An impulse wave formation followed by a corrective wave, form an Elliott wave degree, consisting of trend and counter trend. Although the patterns pictured above are bullish, the same applies for bear markets, where the main trend is down. The following example shows the difference between a trend (impulse wave) and a correction (sideways price movement with overlapping waves). It also shows that larger trends consists of (a lot of ) smaller trends and corrections, but the result is always the same.
Very
important in understanding the Elliott Wave Principle is the basic concept that
wave structures of the largest degree are composed of smaller sub waves, which
are in turn composed of even smaller sub waves, and so on, which all have more
or less the same structure ( impulsive or corrective) like the larger wave they
belong to.
In theory the number of wave degrees are infinite, in practice you can spot about four more wave degrees if you examine at tick charts. This indicates that you can trade the investment horizon, which is most suited for you, from very aggressive intra day trading to longer term investing. The same rules and patterns apply over and over again. Now we will take a look at the patterns...
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