In the 1920s to 1930s, a genius accountant named Ralph Nelson Elliot. He studied stock data accounting for 75 years, and he found out that contrary to everyone’s belief that the stock market is chaotic, it actually is not. He wrote a book entitled “The wave Principle” where he explained “The Elliot Wave Theory.” He said that the upward and downward swings in price he calls waves are because of collective psychology, which constantly shows similar repetitive patterns. He thinks that you can predict the next price direction if you can correctly point out these repeating patterns. Many traders are interested in Elliot waves because they can pinpoint possible price reversal points. It made a system that can catch tops and bottoms.
What are fractals?
Fractals are anything that can be split into parts. And these split parts should be a close copy of the whole thing. Fractals are seen anywhere. Elliot waves are also fractals which we can subdivide into more petite Elliot waves.
In Mr. Elliot’s theory, he said a trending market moves in a 5-3 wave pattern.
- The impulse waves = The first five-wave pattern
- The corrective waves = The last three-wave pattern
Explaining the waves in detail
This pattern’s waves 1, 3, 5 are motives that go along the whole trend, and waves 2 and 4 are corrective. The Elliot wave theory is applicable in the forex market, and we are about to explain in detail what happens in every wave.
- Wave 1. The stock is starting to make its move upwards. A few people suddenly feel like it is a great time to buy stock since it is cheap. This makes the price rise.
- Wave 2. Those few people in wave 1 think that the stock became overvalued that they are now taking their profits. As a result, the stocks will decline but not to the point that it will go back to its previous lows before calling that stock again as a bargain.
- Wave 3. In this period, the stock already gained the interest of massive people, making it the longest and most potent of all the waves. The continuously goes up because more people find out about it and want to buy it. It goes so high that it even breaks wave 1’s end of the high record.
- Wave 4. The trading will now start to retake their profits because the stock became expensive once more. Some people still think that they can still buy on the dips and feel bullish about it. This reason makes this wave a weak one.
- Wave 5. At this point, people will only buy the stock because of some psychological factors that can be unreasonable sometimes. The stock is too expensive for its worth, and the people who do not think it is worth the price will start to sell, triggering the start of the ABC pattern.
The extended impulse waves
Among waves 1, 3, and 5, one of them will most probably get extended. In short, one of the three waves will be longer than the others. Elliot mentioned that wave five usually gets extended, but as time went by, people now usually call wave three the extended one.
Interesting, isn’t it?
Who would ever think that someone can interpret many years’ worth of stock data like this way? Thanks to this data and Mr. Elliot, we saw how market trading is relative to repetitive cycles and investor emotions!