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Understanding the Elliot Wave theory in stock trading

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The Elliot wave theory assesses the stock market and makes predictions based on investor behaviour. Although the theory was first published in 1936, it wasn’t until the late 1970s and early 1980s that financial markets started using this concept for trading strategy purposes.

The Elliott Wave theory in Stock Trading

Basic Concepts

According to the Elliott wave theory, market prices alternate between an impulsive phase (the trend) and a corrective phase (the countertrend). Impulses move toward the primary trend while corrections move against it. In other words, when sentiment moves from optimism to pessimism or vice versa, prices will react accordingly.

 

When investors become euphoric about stock prices, they will keep pushing them higher without thought for an extended period, and corrections will be shorter. Conversely, when investors are pessimistic about stock prices, they will not sell or sell short in droves until the price has reached a low point, after which it may reverse its direction forming another correction.

How does the Elliott wave theory work?

Generally, the Elliott wave theory uses specific rules to judge investor mentality during an impulse movement for traders to ascertain what is likely to happen next. Two of these rules are that “five waves have no more than three waves which oppose them” and that “the trend cannot end with three swings.” According to the theory, many moves are combinations of five impulses followed by two corrections

Five waves in trends

Investor psychology moves in five waves within a trend. These waves are impulsive and corrective, making this a form of Elliott wave theory known as motive-wave progression.

Later on, other rules were added to these basic principles, such as those developed by A.J. Frost and Robert Prechter.

 

They published their ideas about how investor psychology moves in three distinct waves within a trend. In this version of the Elliott wave theory, they called it a “three-wave correction.” It is often mistaken as the only way an impulse moves on Wall Street. Still, it is simply one variation of market behaviour using the more significant idea of the Elliot wave theory.

 

One essential aspect of the Elliot Wave Theory is that once five sub-waves are complete within an impulse movement, investors will likely see another correction or a trend continuation. This five-wave movement is the only one in the theory that does not have either of these options since it was already completed when we started another impulse.

Subwaves of the Elliott Wave theory

An Elliot wave pattern consists of 5 waves followed by three waves and so on, in an alternating fashion. To find out how long this process takes, we can apply Fibonacci ratios to the structure, which will lead us to our expected timeframes for future market movements: 1-1-2-3-5-8 (and 9) and 2-4-8 (and 10).

 

This pattern repeats itself throughout all stages of investment behaviour because human beings are very predictable in their reaction to stimuli. When the market moves higher, it will likely stop at three impulse waves before continuing. It creates support at 38.2% and 61.8

 

If we take our two fundamental principles, the Elliott Wave Theory of investor psychology and the price retracement Fibonacci ratios, we can put them together to make some very accurate predictions about market movement. To adapt this method for use on your own, you need to know how many times the larger Elliot wave pattern repeats itself to find where you are within it at any given time.

 

Let’s take our two fundamental principles, the Elliott Wave Theory of investor psychology and the price retracement Fibonacci ratios. We can put them together to make very accurate market movement predictions. To adapt this method for use on your own, you need to know how many times the larger Elliot wave pattern repeats itself to find where you are within it at any given time.

 

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