The Elliott Wave Theory breaks down the price fluctuations of financial markets into cycles, each comprising of eight "waves" with specific characteristics.
To this day, price fluctuations in the financial market still pose somewhat of a conundrum for the scientific community. However, in the early 1900s, theorists were already trying to link the markets’ behaviour with nature, an innovative concept known as “biomimicry” and the basis for the Elliott Wave Theory.
Just like the Dow Theory, the Elliott Wave Theory was also developed in the 1930s by Ralph Nelson Elliott. Inspired by the natural waves of the sea, this theory attempts to break down the fluctuations of the financial markets into a series of repetitive patterns formed by a succession of "waves".
Whether bullish or bearish, the repetitive patterns described by this theory all comprise eight waves: five impulse waves, which travel in the direction of the main trend, and three corrective waves, which travel in the opposite direction of the main trend.
Each wave can also be considered an independent repetitive pattern, which when analysed can be further broken down into a series of eight smaller "sub-waves". The ability to observe the same pattern at different time periods is what makes the theory fractal, and why it can also be said to mimic nature.
In this theory, depending on the time period during which a wave is observed, the wave is referred to as super-cycle (a few decades), cycle (a few years), primary wave (about a year), intermediate wave (a few months), minor wave (a few weeks), or minute wave (a few days).
Elliott found that financial markets primarily respond to swings in mass psychology. Since human psychology is a constant factor over time, the profound nature of price movements should also remain constant over time, and its theory should therefore continue to be proven year after year.
Although appealing on paper, the Elliott Wave Theory is often confronted with the reality of financial markets, and it is not always easy to count the waves without breaking the rules of the theory’s very strict principles. Therefore, some followers of this analysis method opt for a more flexible approach and a freer interpretation of price movements.
When the book "Elliott Wave Principle: Key to Stock Market Profits" by AJ Frost and Robert Prechter was published, the authors had predicted the rise of the market in the 1970s and its crash in 1987. Whether this was down to genuine ability or just pure luck, it’s difficult to say.
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