Ralph Nelson Elliott developed his theory to describe price fluctuations in financial markets where he observed recurring wave movements in the graphs.
You often hear the expression ‘riding a wave’ the expression is based on this theory and the idea that investors try to profit from market trends.
For example, a wave might be a large collection of homeowners wanting to refinance their mortgages with better terms; this can be described as a ‘refinancing wave’.
The theory gained traction in the 1930s when it predicted a stock market bottom and has since become a must-have theory amongst investors globally across.
A book published in 1994 uses Elliott’s specific rules to outline the process in identifying, predicting and capitalizing on the wave patterns.
Like many other theories and equations used by traders they serve as a way to calculate the probability of a certain variable and not as a way of predicting a certain outcome.
Elliott noted this in his journal’s multiple times, reinforcing that they are just predictions.
Differing interpretations by investors can be taken from the theory at any given time and usually work in conjunction with other technical indicators.
The theory identifies different types of waves such as impulse and corrective waves.
The theory is highly subjective, and many traders consider it a nonviable way to profit off movements in the market. Others swear by it.
Impulse Waves
Impulse waves contain five sub-waves that make overall movement in the same direction as the trend of the next-greatest degree.
This form is the most collective motive wave and the simplest to identify in a market.
Similarly, to all motive waves, it contains five sub-waves – three of them are also motive waves, and two are corrective waves.
Nevertheless, it has two strict rules that outline its formation.
These rules are unbreakable.
If even one of them is violated, then the configuration is not an impulse wave and an investor would need to re-define the supposed impulse wave.
The two rules are:
- wave two cannot retrace more than 100 percent of wave one
- wave three can never be the shortest of waves one, three, and five.
Corrective Waves
Corrective Waves (occasionally referred to as Diagonal waves) contain three, or a combination of three, sub-waves that make clear movement in the direction opposite to the trend of the next-largest degree.
Like all motive waves, its objective is to transfer the market in the direction of the trend.
Furthermore, like all motive waves, it consists of five sub-waves. The differential feature is that the diagonal appears like either an expanding or contracting wedge.
Due to the popularity of the Elliot Wave Theory, many investors and analysts have developed indicators that have been motivated by it, such as the Elliott Wave Oscillator.
In addition, many artificial intelligence systems have applied the theory to their data in order to interpret it – there is clearly a bright future for this theory in all walks of life, not just interpreting market trends.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
