Elliott Wave Theory

Back in the old school days of the 1920-30s, there was this mad genius and professional accountant named Ralph Nelson Elliott.By analyzing closely 75 years worth of stock data, Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually didn’t.When he hit 66 years old, he finally gathered enough evidence (and confidence) to share his discovery with the world.

He published his theory in the book entitled The Wave Principle.
According to him, the market traded in repetitive cycles, which he pointed out were the emotions of investors caused by outside influences (ahem, CNBC, Bloomberg, ESPN) or the predominant psychology of the masses at the time.
Elliott explained that the upward and downward swings in price caused by the collective psychology always showed up in the same repetitive patterns.
He called these upward and downward swings “waves”.
He believes that, if you can correctly identify the repeating patterns in prices, you can predict where price will go (or not go) next.
This is what makes Elliott waves so appealing to traders. It gives them a way to identify precise points where price is most likely to reverse. In other words, Elliott came up with a system that enables traders to catch tops and bottoms.
So, amidst all the chaos in prices, Elliott found order. Awesome, huh?
Of course, like all mad geniuses, he needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.
But before we delve into the Elliott waves, you need to first understand what fractals are.

Fractals

Basically, fractals are structures that can be split into parts, each of which is a very similar copy of the whole. Mathematicians like to call this property “self-similarity”.
You don’t need to go far to find examples of fractals. They can found all over nature!

A sea shell is a fractal. A snow flake is a fractal. A cloud is a fractal. Heck, a lightning bolt is a fractal.
So why are fractals important?
One important quality of Elliott waves is that they are fractals. Much like sea shells and snow flakes, Elliott waves could be further subdivided into smaller Elliot waves.

• Elliott Waves are fractals. Each wave can be split into parts, each of which is a very similar copy of the whole. Mathematicians like to call this property “self-similarity”.
• A trending market moves in a 5-3 wave pattern.
• The first 5-wave pattern is called impulse wave.
• One of the three impulse waves (1, 3, or 5) will always be extended. Wave 3 is usually the extended one.
• The second 3-wave pattern is called corrective wave. Letters A, B, and C are used instead of numbers to track the correction.
• Waves 1, 3 and 5, are made up of a smaller 5-wave impulse pattern while Waves 2 and 4 are made up of smaller 3-wave corrective pattern.
• There are 21 types of corrective patterns but they are just made up of three very simple, easy-to-understand formations.
• The three fundamental corrective wave patterns are zig-zags, flats, and triangles.

There are three cardinal rules in Elliott Wave Theory when labeling waves:

• Rule Number 1: Wave 3 can NEVER be the shortest impulse wave
• Rule Number 2: Wave 2 can NEVER go beyond the start of Wave 1
• Rule Number 3: Wave 4 can NEVER cross in the same price area as Wave 1

If you look hard enough at a chart, you’ll see that the market really does move in waves.