Elliott Wave Theory
Introduction
Elliott Wave Theory is named after Ralph Nelson Elliott (1871 – 1948), an American accountant. Drawing inspiration from the Dow Theory and patterns observed in nature, Elliott proposed that stock market movements follow a repetitive and predictable wave structure. He observed that market price action is not random but instead unfolds in cyclical patterns that mirror the fractal nature of many natural phenomena.
Elliott Wave Theory is one of the most powerful methods used in technical analysis to predict financial market cycles and trends. By identifying extremes in investor psychology, it offers a structured way to analyze the market. Elliott Wave Theory has a pattern for nearly every conceivable price structure, giving traders a unique tool for identifying opportunities. However, learning all the different patterns can take months or even years. But as with any great journey, it all begins with a single step. So, let’s get started.
The Five Waves Pattern
In Elliott’s model, market prices alternate between impulsive (motive) and corrective phases on all time scales. Impulse waves consist of five smaller waves, with waves 1, 3, and 5 being motive waves, and waves 2 and 4 being corrective retracements.
Waves 1, 3, and 5 are subdivided into five smaller-degree impulses, labeled ((i)), ((ii)), ((iii)), ((iv)), and ((v)), while waves 2 and 4 are corrective, subdivided into three waves: ((a)), ((b)), and ((c)). These waves form a larger motive wave (1).
Corrective waves consist of three smaller-degree waves: A, B, and C. Wave A is a counter-trend impulse, wave B is a retracement, and wave C is another impulse. Together, these form a larger corrective wave (2).
In a bear market, the pattern is reversed—five waves move down, and three waves move up.
Fibonacci
Leonardo Fibonacci da Pisa was a thirteenth-century mathematician who discovered the Fibonacci sequence.
Various Fibonacci ratios are derived by dividing numbers within the Fibonacci sequence. These ratios, along with others based on them, are prevalent in nature and financial markets, often marking significant resistance and support levels. Fibonacci proportions can be seen in natural patterns (such as seashell spirals, flower petals, and tree branch formations), as well as in art, geometry, architecture, and music.
Key Fibonacci ratios include:
0.618 – Found by dividing a Fibonacci number by the next one in the sequence
0.382 – Obtained by dividing a Fibonacci number by another two places to the right in the sequence
1.618 (Golden Ratio) – Calculated by dividing a Fibonacci number by the one before it in the sequence
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