Welcome to your first lesson on the Elliott Wave Theory! The Elliott Wave Theory is a broad and complex principle that can take time to master, so we’ll start with the basics — including what this theory is and how to apply it to your daily trading strategies — to get you pointed in the right direction.
Read on to learn more about stock wave analysis, including how to identify all Elliott Wave patterns, so you can improve your stock trading today. We’re confident you’ll quickly get up to speed on implementing the Elliott Wave Theory with help from our trading experts here at Raging Bull.
What Is the Elliott Wave Theory?
The Elliott Wave Theory is a principle used to analyze specific and measurable patterns that occur repeatedly in the stock market. These price movement patterns are also known as waves. A series of waves creates a cycle that rises and falls continually as stock prices peak and plummet. Elliott Wave Patterns are driven by changing investor psychology that is surprisingly predictable. Ralph Nelson Elliott developed this theory in the late 1920s after studying 75 years of stock market behavior. It’s also known as the Elliott Wave Principle.
People used to think the stock market behaved chaotically and that there wasn’t a clear way to predict price movements. Elliott proved this common belief to be false after observing that the same patterns occur repeatedly in the stock market. He tested his theory by making stock market predictions based upon its principles and found success. Nowadays, thousands of traders apply the Elliott Wave Theory to their daily trading decisions.
Elliott was the first to make the connection that repetitive waves happen daily, weekly, monthly, and yearly due to collective human behavior. It turns out that mass psychology moves from pessimism to optimism and back again in a natural sequence. This mental cycle is what creates specific and measurable patterns in the market that traders can use to successfully buy and sell stocks. If you learn to identify repeating Elliott Wave Patterns, then you can figure out where you are in those waves today and predict which way the stocks are heading.
What Is an Elliott Wave Pattern?
An Elliott Wave Pattern is a basic five-three wave structure that shows stock price movement over a period of time. This pattern includes a five-wave impulse phase and a three-wave corrective phase. The Elliott Wave Theory contains specific rules about how to identify, predict, and capitalize on these wave patterns. Knowing which waves happened recently and which are likely to be underway helps you forecast what the stock prices are likely to do next.
What Is an Impulse Wave Phase?
An impulse wave is a large price movement that’s shown as an upward trend at the beginning of the Elliott Wave Cycle. Impulse waves move in the direction of the main trend, reaching higher prices each time. To be considered an impulse wave, the stock price’s upward movement must be larger than the down movement between the up waves.
The impulse phase of the cycle includes three large upward movements and two smaller corrective waves. The five-wave pattern is as follows: impulse, correction, impulse, correction, and impulse. Elliott set three rules that can’t be broken when it comes to identifying this initial wave sequence:
- Wave two can’t retrace more than 100% of wave one.
- Wave three can never be the shortest of the three impulse waves.
- Wave four can never overlap wave one.
This pattern is also known as the motive phase.
What Is a Corrective Wave Phase?
A corrective wave phase is a downward trend, or countertrend, that follows the uptrend. After the impulse phase reaches a price peak, the corrective phase comes next due to human emotions and actions. This phase includes three waves of distinctive price movements:
- A wave down.
- A correction up.
- Another downward wave.
The small upward correction found between the two downward waves is evidence of traders earning a profit during a downtrend.
Which Phase Is Better for Trading?
During the impulse phase, the stock price is making the largest movements, so this is when a trader has a better chance of making a larger profit. Buy during a corrective wave on the uptrend, and wait to sell until the next impulse wave has taken the stock price higher. This trading method is what some investors refer to as “riding the wave.” Traders can make a profit in the corrective phase as mentioned before. It requires short-selling during corrective waves in a downtrend so you can profit from the next impulse wave that’s heading down.
What Is the Elliott Wave Cycle?
The Elliott Wave Cycle is a complete eight-wave cycle that consists of a five-wave advance and a three-wave retracement. This pattern remains constant no matter what span of time you analyze. You can also identify smaller wave structures within larger waves because Elliott waves are fractals. When a fractal is split, the split parts will be similar copies of the original structure. Elliott waves can be subdivided into smaller Elliott waves again and again, making it difficult to identify whether you’re looking at a small cycle or the larger cycle as a whole.
Luckily, Elliott has provided a set of wave theory guidelines to help. In addition to the impulse wave rules, the wave pattern you’re studying must show the following characteristics:
- When wave three on the uptrend is the longer impulse wave, wave five will be about equal to wave one.
- Wave two and four will alternate between a sharp and flat correction. They can be the same type of correction.
- After a five-wave impulse advance, the corrections phase ends near the wave four low.
How Does Elliott Wave Analysis Work?
Investor psychology, not the news or extraneous events, is the true driving force behind stock markets. Elliott Wave Patterns occur in the same way time and again, no matter what, because people don’t change significantly from year to year. The thoughts and feelings of people in the investment crowd move from an extreme point of optimism to an extreme point of pessimism and back again. You can observe and measure this repetitive path through wave patterns in the stock market.
Elliott also discovered that wave patterns’ structural design reflects a harmony found in nature. The Fibonacci sequence can help determine the number of impulse and corrective waves in a cycle. These numbers are derived from a pattern where each number equals the sum of the previous two numbers in the sequence. Price and time relationships between waves often exhibit Fibonacci ratios such as 38%, 50%, and 62%. Traders use these ratios to predict when one wave might end and when another wave might begin.
How Do Traders Apply the Elliott Wave Theory?
Traders apply the Elliott Wave Theory to the stock market by looking at charts of market action and counting waves. They use these charts to identify any completed five-three wave structures. From this point, they can interpret where the market is and predict where it’s likely to move. This type of technical analysis requires patience and diligence, but it’s simple to employ. Guidelines for wave pattern interpretations and Fibonacci relationships work together to help traders define less risky investment strategies and improve their trade timing.
For example, a trader who identifies an upward impulse wave might buy with the expectation of selling at a higher price in the future for profit. Traders might also sell or short the position as the pattern completes its five waves because they know a reversal comes next in the cycle. They repurchase the stock at a lower price and realize a profit in this way, too.
Day traders use the Elliott Wave Theory to identify the highest probable moves with the least risk. Applying this theory to daily trades allows you to make better buying and selling decisions, which can then lead to more trading success.
How Do I Learn More About Day Trading?
It’s important to note that although the Elliott Wave Theory has led to much success, it doesn’t provide absolute certainty that the market will move as predicted. Two or more wave interpretations can exist at any time. So be careful when using this type of sophisticated technical analysis, and ask an experienced Raging Bull mentor for help as needed. Whether you’re a new trader or simply looking to improve your trading, we’re always here to advise and guide you on your journey to success.
Our team of millionaire traders are experts at what they do. Let them help you take your trading skills to the next level so you can be a better stock trader. Schedule a free training session at Raging Bull to learn more about trading at a time that’s convenient for you. You’ll soon be on the road to success as you implement the top-notch insights, tips, and strategies they’ve gathered through years of experience. Avoid costly mistakes, achieve stock market success, and move toward financial freedom with Raging Bull today.
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