Elliott Wave Theory Definition Explained Types Example

Elliott Wave Theory Definition

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Its application helps in making stock market predictions. The theory suggests that price moves in waves, which can be recognized by studying historical stock market price data and long-term price patterns that are rhythmic, regular, and repetitive. The waves are categorized as impulse and corrective waves.

Key Takeaways

Elliott wave theory explains how a security’s price changes over time by identifying recurring eight-wave patterns in return data. The eight-wave pattern is usually five waves up and three waves down.Ralph Nelson Elliott introduced it in the 1930s and was famous for predicting the 1935 stock market bottom after studying long indices and historical data.The Elliott wave theory is a technical analysis tool that claims and predicts that stock price movements are primarily in waves rather than simple patterns. It is said to be quite similar to the Dow theory on the common grounds that price movements occur in waves and not just line patterns.There are many books on Elliott wave theory that analysts can read and understand how to apply in prevailing market conditions to make sound investment decisions.

Elliott Wave Theory Explained

Elliott wave theory is used to predict price variations primarily in the stock market; the creator of Elliott wave theory is Ralph Nelson Elliott, an American accountant, and author; hence the theory is named after him. He introduced it in 1930. Typically, the wave theory suggests that the price movements are repetitive and historic, and when looked at from a broader perspective, they look like ocean waves in long patterns.

It is essential to identify where one wave segment finishes and another starts and analyze whether a significant correction is the completion of a wave or merely a deviation from the general trend. As a result, it is one of the most popular forms of technical analysis used by many portfolio managers globally.

Elliott believed that every action would give a reaction; he studied long-form and historical data patterns and introduced the wave theory based on this. It is often compared to the Dow theory. He proposed that the investors’ sentiment and psychological behavior can make waves in price movements rather than just straight lines. When he studied long-form historical data, he concluded that these waves are repetitive.

Traders use the theory for trading as it helps in predicting future price movements; based on that information, traders take a position in the market. Elliott wave theory with Fibonacci retracement is a typical example among traders and analysts. Though typically employed in the stock market, it can also be used in other financial markets.

Types of Elliott Waves

Impulse Waves: These consist of five waves, generally named Wave 1, Wave 2, Wave 3, Wave 4, and Wave 5. All these waves move in the primary trend direction, but Wave 2 and Wave 4 move in the opposite direction. It has often been sighted that the motive waves are only three and not five in a real-time market. There are three inevitable Elliott wave theory rules regarding motive waves.Corrective Waves: The corrective waves, also called diagonal waves, move opposite to motive waves. These waves are more complex and elemental than motive waves, and thus, they are time-consuming to comprehend. The waves are in triangles, diagonals, and zig-zag. Generally, a motive wave is the upward trend in a bull market, and corrective waves alter the tendency. This same scenario is reversed, as in a bearish market, the corrective waves will show an upward trend in stock price, and the motive will decrease it.

Example

The analysis of the stock price movement of Gamestop starts from a significant low, which is at $2.57, seen on 3 April 2020. The evaluation and interpretation based on the theory explain that wave 1 of the five waves of the bull cycle went from $2.57 to a peak of $159.18, seen on 25 January 2021.

It should be observed that wave 2 corrected wave 1, a 61.8% retracement, and the third wave reached 200% of wave 1. Again another wave, wave 4, brought a correction which presented another chance to buy, as the stock dropped to close to the 38.2% retracement of wave 3. Finally, wave 5 finished at $483.

Traders holding the company’s shares should have intended to sell them when the price got closer to this objective. When the fifth wave finished, the chances of a correction rose, and given the already irrational swings that had occurred, the chances of traders trying to buy from a point beyond the wave 5 level may decrease. As expected, a correction quickly decreased the price to almost a 78.6% retracement of the bull cycle.