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What is Elliott Wave Theory?

Elliott Wave Theory measures investor psychology, which is a key component in the movement of prices from one point to another. Ralph Nelson Elliott (1871-1948) was an American Accountant and author, whose study of the stock market led him to develop the Wave Principle. In the early 1930's Elliott began his systematic study of 75 years of stock market data, including charts that varied in time frame from yearly to half hourly.  In August 1938 he detailed the results of his studies by publishing The Wave Principle (written in collaboration with Charles. J. Collins). Elliott said that the stock market may appear random and unpredictable, but that it actually followed a clearly defined pattern that was linked to the Fibonacci number sequence.

Elliott stated that what the Wave Theory measured was the shift in human emotions, from optimism to pessimism, back to optimism, etc. He postulated that stock market averages were basically a measure of mass psychology. In the early 1940's Elliott expanded his theory to apply to all collective human behaviours.

In the years after Elliott's death, other practitioners continued to use the wave principle and provide forecasts to investors, including Charles Collins, Hamilton Bolton, Richard Russell, and A. J. Frost. Frost co-authored Elliott Wave Principle with Robert Prechter in 1978. Prechter came across Elliott's works while working as a market technician at Merrill Lynch. He is today the highest profile Elliottician and largely responsible for popularizing the theory in the modern era.

The diagram below is a basic illustration of the "textbook or idealized"  movement of prices according to the Elliott Wave Theory. Briefly, it says that prices move in five waves in the direction of the trend (labelled 1 to 5) and that corrections trace out three waves (labelled A to C). An important aspect of the Wave Theory is the concept of waves within waves. That is, if we look at a long term chart we may see the waves that govern a move spanning a decade or more, but if we then look within each wave (at the market in more detail) we find that each larger wave is comprised of a series of smaller Elliott Waves.

 The market does not always conform to Elliott Wave type structures and Fibonacci relationships. However, it does so often enough, in all markets that are freely traded, that it is an invaluable part of our methodology here are Wave 3 Technical Trading.

One of the complexities of the Wave Theory is that one of the waves in the direction of the main trend (either waves 1, 3, or 5) is often extended (much larger than the other two and usually related to one or both of the other two by a Fibonacci ratio). The wave that most often extends and is therefore much larger and more powerful than the others is wave 3. Hence the title of this service.

Recommended reading:

Prechter R.,  The Major Works of R.N. Elliott.

Precher,R., and Frost, A.J.,  The Elliott Wave Principle: Key to Stock Market Profits