Elliot Wave Theory- Understanding Technical Analysis And Market Behaviour

Elliott wave theory is a core principle for truly understanding the stock market behavior in depth. It is basically a form of technical analysis that allows traders to analyze the financial market cycles. With the help of this wave principle, traders will be able to identify price extremes and investor psychology and forecast market trends.

Usually, the Elliot waves are created based on the ongoing market sentiment, alternating every now and then between bearish and bullish cycles. The theory suggests that the market movement follows a specific sequence of crowd psychology cycles.

Even though it is recommended not to consider the theory as a technical indicator, it helps to predict the market behavior in detail. Let’s get a thorough idea of the Elliott wave principle and its importance in the stock market today.

Elliott wave theory– An Overview

The Elliott wave theory is essentially a technical analysis technique that describes the price movements in the financial market. It was developed by the American author and accountant Ralph Nelson Elliot during the 1930s.

He studied the stock market data for several years across different indices and was the first to predict a stock market bottom in 1935. Ever since, this principle has been a reliable tool for portfolio managers, investors and traders across the globe.

It is used in conjunction with other technical analysis theories to predict trading opportunities and market movements. The theory suggests that stock price movements can be predicted reasonably through the study of price history. This is because the market keeps moving in a wave-like pattern, repetitive, timely and rhythmic, driven by investor sentiment.

Working of the Elliot Wave Principle

Using the Elliott wave theory, technical analysts try to gain profits from the wave patterns available in the stock market. According to this hypothesis, the price movements in stock trading can be easily predicted through the repeatedly moving in up and down wave patterns formed by investor sentiment or psychology.

What makes Elliott wave principle stand out is that its idea of wave analysis does not equate to a regular blueprint formation, where the aim is to simply follow the given instructions. It is quite different from other price formations.

A wave analysis provides insights into the trend dynamics and offers a better and in-depth understanding of the price movements.

Common types of Elliott wave theory

The Elliott wave principle can be categorized into the following types: Motive or Impulse waves and Corrective waves. However, this wave category is entirely subjective. In other words, the theory may not be interpreted equally by all traders for them to agree on it being a successful trading strategy.

The motive or impulse waves are movements occurring in the direction of a trend. Corrective waves, on the other hand, occur in the opposite direction of the ongoing market trends.

Let’s understand the impulse and corrective waves in detail.

• Impulse waves:

As mentioned before, these motive or impulse waves move in the direction of the trends at hand. It makes up the net movement in the same direction as the trend of the next-largest degree. That being said, it is one of the most common motive waves and easily spotted in the market.

Motive waves can be sub-divided into five sub-waves, in which two of them are corrective waves and will be discussed next.

The motive waves come in two specific types – the impulse waves and the diagonal waves.

1. Impulse – Speaking of the five motive waves, they are labeled in the structure of 5-3-5-3-5 or as wave 1, wave 2, wave 3, wave 4 and wave 5. However, the formation of the waves is based on a certain set of rules.

Upon violation of any of the rules, the impulse wave will not be formed. In the worst case, the suspected impulse wave has to be re-labeled. The prime rules for the formation of an impulse wave are –

1. It is not possible for wave 2 to retrace over 100% of wave 1.
2. Wave 3 could never be the shortest wave amongst the waves 1, 3 and 5.
3. It is not possible for wave 4 to overlap wave 1.

The main aim of a motive wave to shift the stock trading market. Here, impulse waves are the best type to accomplish this.

1. Diagonal – Like all other motive waves, the diagonal wave consists of another set of five sub-waves that also moves in the direction of the trend.

These waves resemble a wedge-like pattern that could either be contracting or expanding. Besides, the sub-waves may not always have a count of five at times. It depends on the type of diagonal wave under observation.

Like any other wave, the sub-waves of each diagonal wave may not completely retrace the previous sub-wave. Not to mention, the sub-wave 3 in this type is not the shortest wave, unlike impulse waves.

Diagonal waves can be divided further into the leading and ending diagonals.

Speaking of the ending diagonals, they usually occur in the last wave of the corrective waves or in wave 5 of an impulse wave.

The leading waves can either be found in wave 1 of nay impulse or the wave position of a zigzag correction wave, which will be discussed later in the article.

• Corrective waves

Corrective waves consist of three waves or a combination of three sub-waves that make up the waves’ net movement in a direction opposite to the direction of the market trends.

The corrective waves are quite similar to the diagonal waves are often pronounced as so. However, what distinguishes it from diagonal waves is that the latter looks like a contracting or expanding wedge. The sub-wave count for diagonal waves is five depending on the diagonal in question. The corrective waves are nested in a self-similar fractal that is used to create larger patterns. The common sub-waves under the corrective wave can be categorized as follows.

1. Zigzag wave – It is a corrective that comprises waves labeled as wave A, wave B, and wave C, respectively, strongly moving up or down.

Essentially, the waves A and C are motive waves whereas, wave B is a corrective wave, often subdivided into three waves. The zigzag patterns generally resemble sharp declines in a bull rally or an advancement in a near rally. Nonetheless. The aim is to substantially correct the price level of the previously made impulse patterns.

These patterns are usually formed in a combination called the triple or double zigzag. In these cases, two or three zigzags get connected by an additional corrective wave between them.

1. Flat wave – This type consists of a three-wave correction where the sib-waves are formed in the following structure, 3-3-5, labeled as an A-B-C structure.

In this wave type, wave A and wave B are corrective, whereas the third wave, wave C, is a motive wave having five sub-waves. This type is considered flat since the wave movement is sideways. Generally speaking, the fourth wave is flat within an impulse wave, unlike the second wave.

In most technical charts, the flats don’t give a clear look as there are different variations to the structures formed.

One such variation is the expanded flat wave. In this case, the flat may have wave B that is terminated beyond the beginning of wave A. Besides, wave C may be terminated beyond the starting point of wave B.

1. Triangle wave

This pattern consists of five waves that form a 3-3-3-3-3 structure, usually labeled as A-B-C-D-E. Such a corrective wave pattern shows a balance of forces that travels sideways.

The triangle could be either expanding, where every sub-wave gets bigger over time. Or, the triangle could also be contracting to form a wedge. They are usually symmetrical, ascending or descending, depending on whether they are pointed sideways, up with a flat top, or downwards with a flat bottom. It is a complex combination of sub-waves that can be theoretically easy to spot but may take a while to identify in a practical market.

Application of the Elliott wave principle in the stock trading market

In real-time, it could be observed that a motive wave comprises three waves instead of five waves. Most of the time, a stock trading market will get to see a motive wave that is composed of three waves.

It could also be possible for the market to keep shifting in corrective waves. Hence, the three-wave trend is common in comparison to the five-wave trends. Elearnmarkets offers an excellent course on the Elliott wave theory. To know more, head over to their website.

Elearnmarkets also offers online technical analysis course certification, which is jointly certified by the Elearnmarkets and NSE Academy. It is a great trading course tailored to meet the robust trading market. It offers good insights into the profitable technical strategies and patterns supported by statistical market analysis.

Besides, another course offered is the “Complete Foundation Technical Analysis Course” offers a deeper insight into the theory and philosophy behind price action. It offers good insight into the candlestick patterns, chart patterns, and reversal candlestick patterns to predict specific market movements.

Bottom Line

The Elliott wave principle is open to interpretations in several ways based on the traders and investors and their viewpoints regarding the stock trading market. Hence, traders and investors must ensure it when identifying the patterns. To gain better knowledge in technical analysis and the Elliott wave theory, head over to the Elearnmarkets website and join their courses today.