The Elliot Wave theory is a popular indicator for technical analysis traders because it has been proven to be valid in various markets and timeframes. The Elliott Wave theory attempts to explain the mass psychology driving price movements of financial markets.
This indicator was developed by analyst/author Ralph Nelson Elliott who discovered that market prices unfold in specific patterns, which are repetitive. These patterns influence human behaviour, causing people to act predictably at certain times.
The wave structures explain how collective behaviour develops over time, known as social momentum. These structures are created when large numbers of market participants exhibit similar behaviour or crowd mentality during market conditions, often without being aware of what is occurring around them. You can use this theory when trading stocks with Saxo Bank.
There are five parts to the theory
The Elliott Wave theory is based around the concept that collective investor psychology moves from pessimism to optimism and back in a natural sequence, creating specific structures in market prices. This occurs during significant changes in investor attitudes towards risk assets such as stocks. The price patterns created by this behaviour create five waves of different degrees, forming the basis for Elliot Wave Principle. The three motive waves are strong. They usually occur over time with increasing momentum supported by accelerating social moods towards risk-taking among investors. These waves are generally referred to as impulses or trend waves since they create directional movement when they move through a wave structure.
The corrective or countertrend waves are weaker and make up the other two complete waves. These waves create sideways movement and are used to unwind or correct the price action of the previous impulse wave at a later stage in the cycle. They usually occur with declining social mood towards risk assets, collectively reversing direction and creating an opposite trend to that of the motive wave.
The theory is based on human behaviour and its influence on market movement. The theory states that you can identify five stages of crowd psychology within the price structure of financial markets. According to this concept, market prices alternate between an impulsive phase (the trend or motive wave) and a corrective phase (a countertrend wave). Impulses move in the main trend direction while corrections move against it. The typical movement in price action for one complete cycle is as follows:
Impulse wave = 5 Waves Motive Wave: A wave that moves with the trend and forms new highs or lows according to its point count sequence. Corrective Waves: Three waves moving in opposition to the trend forming a corrective structure.
Corrective wave = 3 Waves Countertrend Wave: A wave that retraces or moves against the trend occupies the place of one of the impulse waves. Corrective Waves: Three waves moving in opposition to the trend form a corrective structure
Trend Channel Lines
The Elliott Wave theory uses lines to outline the levels at which the price will find support and resistance as it moves through its cycles (impulse or motive) then reverses direction (corrective). These trend channel lines form boundaries between an advancing impulse wave and its corresponding countertrend correction. They provide visual reference points for where future price action may settle depending on how market participants react to each wave structure.
With the Elliott Wave theory, market participants who recognize specific patterns within these structures can predict future price action and identify where momentum may come to a halt or change direction. By recognizing necessary support and resistance levels, it is possible to anticipate future trends and either take advantage of them or protect capital invested. It provides traders with valuable insight into future opportunities for trading the financial markets that exist within the current trend. These expected changes are called continuations or reversals depending on whether they occur at essential inflexion points, which mark the end of one impulse wave and the beginning of another corrective wave, also known as pivots.
Within this framework, projecting where price will end up after a certain number of waves have occurred provides the basis for price targeting. Because of this, market participants can determine how much capital to allocate for future expected profits based on where they expect the next impulse wave to end. This technique is often referred to as “price envelope”