Elliott Wave Theory – Know the basics

The elliott wave theory is predominantly at work in the financial markets. The ever changing psychology of the investors is usually seen as patterns in the form of price movements. The Elliott Wave theory, is in effect a principle that was drafted by Ralph Nelson Elliott. The Elliott Wave theory is a princple that details how certain groups of people tend to behave.

The Elliott Wave Theory suggests the mass psychological swings from pessimism to optimism and back as a form of a natural sequence, thus creating very specific and measurable patterns.

The elliott wave theory is based on the fact that by identify the repeating natural patterns in prices, from a financial aspect, investors can figure out where they are in those repeating patterns today and can therefore predict the future trends.

In effect, the Elliott Wave Theory is used to measure the investor psychology. This is the real engine that drives the stock markets as the markets are purely driven by speculation and human emotions.

As obvious, when investor optimism is high, on the future of a given stock or a even a currency pair, the bid price of the asset goes up proportionately.

In order to fully grasp the Elliott Wave Theory, there are two observations that need to be made:

Firstly, for many years, investors noticed that the events which are external to the stock markets don’t have consistent effect on the the stock’s progress. In other words, the very news, which in the present day seems to drive the markets are less likely to drive them down the preeceding day. The only reasonable conclusion from this first observation is that the financial markets do not simply react consistently to outside events.

Secondly, when investors study the historical charts, it is often noticed that the markets continuously unfold in wave patterns.

The Elliott Wave theory is a probability exercise. When investors understand the markets and the resulting wave patterns generated, investors would know how the markets reactive in the next instance. A person who can manage to identify market patterns and thus confidently anticipate the next likely move based on the previous positions within those structures is refered to as an Elliottician.

Using the Elliott Wave theory, investors can identify the highest probable movements in the markets with the least risk.

Understanding the Elliott Wave Theory

Ralph Nelson Elliott’s discovery about the trends in social, or crowd behavior and the reverses in recognizable patterns is what forms the basis of the Elliott Wave Theory. Ralph Elliott noticed that the ever changing pattern of the market prices revealed a very distinctive design which infact reflected the basic harmony that can be found in the nature. From this discovery, Ralph Elliott developed a rational system of market analysis by isolating 13 patterns of movement, or “waves,” that keep occurring at regular intervals in market price data which are repetitive only in form but not necessarily in time or amplitude. The name given to these patterns were called Elliott Waves.

Subsequently, these patterns, or Elliott waves join together and form larger versions of the patterns which in turn, link to form further identical patterns of the next larger set, and so on resulting in the “Elliott Wave” as can be seen in the illustration below.

Elliott Wave Theory
Elliott Wave - The Basic Patterns

Generally speaking, the Elliott Wave can be identified by directional movements of the wave structure and are interrupted by the counter trends. The counter trends are a requisite for the overall movement of the patterns to occur.

While there exists many variations of the Elliott wave theory, they all fit into the basic structure as displayed above. The markets are usually located within the basic five-wave pattern at the largest degree of trend, as it overrides the form of market progress, all other wave patterns are absorbed by it.