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Originally Posted On: https://www.tramlinetraders.com/secrets-of-the-elliott-wave-theory/
Back in the 1920s and 1930s when technical analysis was in its infancy, most pro traders located in or near the stock exchanges and plotted their charts using point and figure, not the usual bar charts we use today.
But one man in the 1930s, Ralph Nelson Elliott (a corporate accountant), studied price movements on bar charts and observed that certain patterns repeated time and again. After a time, he was able to make stunningly accurate predictions for future stock movements.
What appeared as random moves to others, to Elliott they were making recognizable patterns that he used to predict future movements. He observed the various set of swings that were being traced out and often he was able to label them with the numbers and letters that we use today. Elliott discovered that within the stock market behavior, there was a five wave pattern visible in these swings, with three waves in one direction, and two corrective waves in the other. He also noticed that the third wave in these wave structures was a stronger impulse wave than any of the others.
Elliott’s wave theory made a huge splash (if you’ll pardon the pun) in the trading community as a means of market analysis and trading strategy, and Elliott wave principle is still a relevant theory and tool in any trader’s arsenal.
And today, many technical analysts rely on aspects of the Elliott Wave Theory in their professional trading strategies, as does this writer.
So what are Elliott Waves?
The most important discovery Elliott made was that when the price of a freely traded market (such as the Dow Jones Industrial Average or Gold) moves from a high to a low (or vice versa) in a swing, it does so in five waves we label 1,2,3,4,5. This is the basic Elliott Wave structure.
Waves 1,3 and 5 move with the main trend and waves 2 and 4 move against it in a corrective fashion.
This basic pattern is repeated in most markets and in all time frames.
Then, when the final fifth wave has completed, that terminates the ‘impulse’ wave and a corrective pattern begins in three waves (or variation).
That is the basic 5/3 pattern that applies to all markets.
In an impulse swing, there are five waves with the trend and then three corrective waves against it.
The existence of this pattern shows that investor behavior is patterned universally. And it shows that the various stages of bullish and bearish sentiment sweeping over markets are patterned in an orderly way that reflects the various stages of human behavior.
These patterns have not changed in many years, if at all.
And this basic 5/3 pattern applies in all time frames.
At the time, Elliott’s crucial insight went unrecognized until the 1970s but today, many analysts use it. Here is an example of a complete impulse and correction in the 5/3 pattern
When we analyze these wave patterns, we can see that there are three impulse waves and two corrective waves. In waves 1,3 and 5, (the impulse waves) investor behavior is bullish. But in waves 2 and 4 (the corrective waves), they are clearly bearish.
Of course, in the real world and in real-time, the wave labels are not as much written in stone as subject to several options.
The objective of correct wave analysis is to judge the most likely ‘wave count’ and we have several inputs that can help us. One of these is to observe the extent of investor bullishness or bearishness.
Monitoring the levels of Elliot Waves
Most chart platforms have an array of technical indicators for this and the simplest is the much-established 12-period Momentum oscillator.
And another very useful aid is the Fibonacci levels.
These are the fractions that determine the growth (or decay) of organisms (such as the human-constructed financial markets).
My own Tramline Trading Method incorporates the Elliott Wave Theory and Fibonacci ratios.
And if your thoroughly professional trading strategy of the financial markets includes the Elliott Wave analysis of the price charts, you have a significant advantage.
Possibly uniquely, using the Elliott Wave Theory, you can sometimes set reliable price targets, support and resistance levels and importantly, the direction of travel.
Thus, my chart above of Crude Oil (taken in March 2023) indicates a probability that prices will rise if the A-B-C correction has completed as seems likely.
But if the correction is not over, the C wave will make a new low and the uptrend can resume from there.
How to apply Elliott Wave Theory in more specific situations
If you’re reading this and are asking yourself “This is all very interesting, but there must be more to it“, then you’d be correct. Elliott wave theory is a deep and complex topic, with many nuances and details within the Elliott wave patterns to discover and learn about. While I am only able to give a cursory introduction to the concept here, I have a more in-depth look at Elliott Wave theory here.
Delving more into the wave structures and financial market theory behind the waves, this piece should prove an excellent follow-up to this introduction to Elliott Waves. And for those who want even more practical and nuanced information, the knowledgeable community in my VIP and Phoenix Trader’s Clubs are a wealth of experience and information for you to draw from.
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