Elliott Waves Theory Definition: Patterns, Rules and Guidelines

The Elliott Wave Principle or Elliott Wave Theory is a form of technical analysis that financial traders use to analyze financial market cycles and predict market trends by identifying extremes in investor psychology and price levels, such as highs and lows, by looking for patterns. Price.

You should know that all the movements in the market and even the behaviour of traders follow a certain pattern, and it may make us want to know more about various aspects of the Forex market. People in financial markets know this subject as the Elliott waves theory.

The reason for the significance of this theory is that it investigates the market existing patterns together with time and price. Using this theory in addition to other technical analysis tools, we can find the best trading opportunities and find the changes in the market.

Who Developed the Theory of Elliott Waves?

The term Elliott waves refer to a technical analysis theory used to describe price movements in financial markets. Ralph Nelson Elliott is the father of this theory, who introduced it in 1930 after identifying numerous fractal patterns.

He ran his research based on the stock market, and after long studies, he understood that market movements do not occur randomly and without irregular activities. In fact, this market works based on a repetitive pattern. He figured that we could predict future prices by the correct investigation of these movements and patterns.

He also believed that the stock prices move on waves and his theory was similar to Dow theory. The only difference between his theory and Charles Dow’s theory was that Elliott, in contrast to Dow, investigated the fractal behaviour in financial markets.

Elliott explained everything about identifying and predicting the market movements based on these wave patterns. He published all his essays in a book entitled “R. N. Elliott’s Masterworks” in 1994.

How do Elliott Waves Work?

Some market analysts try to take advantage of wave patterns in stock markets using Elliott theory. Based on this theory, price movements in stock markets are predictable because they operate on a repetitive ascending and descending wave pattern created by emotions and based on investor psychology.

This theory identifies different types of waves, including motive waves, corrective waves and impulsive waves. However, this varies based on different thinking patterns, and not all traders interpret these moves in a similar way.

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In addition, unlike many pricing forms, all of these analyzes do not have a general order by themselves. Therefore, one cannot easily understand it by following the instructions. Instead, analyzing the waves provides insights into trend dynamics and helps you understand price actions.

Elliott Wave patterns

The market is generally in two phases:

impulsive wave

impulsive waves are made of 5 sub-waves which together form the net movement in a similar direction as the larger trend. This pattern can be easily found in the market because it is the most common motive wave. Three of these sub-waves are motive waves, and two of them are corrective waves.

The violation of any one of the following three rules will destroy impulsive wave structure:

• The second wave will never be lower than the beginning of the first wave.
• The third wave can never be the shortest wave among waves 1, 3 and 5.
• The fourth wave can never be higher than the third wave.

Corrective waves

These waves are also called diagonal waves. They are made of three sub-waves which their net movement is against the largest trend. The impulsive and corrective waves together in a similar fractal make larger patterns. For example, a one-year chart may be placed in a corrective wave. However, a 30-day chart may indicate a developing impulsive wave. So, by interpreting an Elliott wave, a trader may be able to identify a descending long-term viewpoint or an ascending short-term viewpoint.

Just like the impulsive waves, there are some rules for corrective waves:

As a rule, when the corrective wave is vertical in the second wave, the fourth wave will be elongated. If wave 2 corrects continuously, the fourth wave will be corrected. Also, based on similar rules and behaviours, the corrective waves of A and B have almost similar lengths.

The relation of Fibonacci with Elliott Waves

Elliott found that the Fibonacci sequence showed the number of waves in the corrective and motive waves. The relations of the wave with price and time indicate Fibonacci sequences. For example, a corrective wave might be 50% of the previous motive wave.

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Other analysts created some indicators using Elliott rules and they called them Elliott wave oscillators. An oscillator is a computer method for predicting future price directions which works by measuring the difference between a five-day moving average and a thirty-four-day moving average.

Conclusion

using analytical tools in the financial market can paint a fairly accurate picture of the future of a particular asset. Elliott wave principle is one of these tools, and due to its growing popularity among analysts, it has also become a business style. Although using it may seem complicated at first. However, it would be best to remember that tools such as Elliott waves need further study because of their comprehensiveness and sophistication. Also, this theory is more accurate and more reliable due to the inclusion of Fibonacci ratios, which are another tool in the technical analysis field.