The Elliott Wave Theory claims that the price of a stock or any other investment asset moves in waves. These waves move in specific patterns and can be predicted when you know how to do so.
Technical analysis involves tools such as charts, graphs, and indicators. One particular type of technical analysis is the Elliott Wave Theory, a method for determining where a market is within a big picture up or downtrend by looking at clear repeating patterns called Elliott Waves. This way, investors can find out about possible future price movements before they happen.
The theory was developed by Ralph Nelson Elliott, who was studying social mass thinking processes after the 1929 crash. Since then, it has been widely used by traders, although it remains poorly understood by many.
According to the theory, market prices alternate in a five-wave pattern (five waves up and three down) until they reverse direction. An investor who recognizes this pattern in its early stages can use it to predict future price movements and make money off of it. The below graph shows an example of what five waves look like:
Elliott Waves are made up of 5 sub-waves known as waves A, B, C, D and E. Each pattern or wave can be divided into smaller patterns with their names, such as the smallest pattern inside the A-wave is known as an impulse. In contrast, the largest one inside the five primary waves is called a diagonal triangle.
While the theory works well in trending up or down markets, it has its share of critics. One of the most common criticisms against this theory is that it cannot be applied across different time charts due to its subjective nature. It sees each move as part of a more significant trend without considering the possibility of an overall change in direction within that same time frame.
Another essential thing to consider is that while it is true that the theory helps determine where a market is in its trend, it does not tell you for sure whether or not that trend will reverse soon. Also, since this theory fails to consider news and other causes of patterns outside of human behaviour, some traders have written it off entirely.
Fortunately, one can use strategies when trading with Elliott Waves that can help limit their mistakes and maximize their gains. One such strategy calculates the Fibonacci ratios from previous waves so that an investor can know when a correction or reversal is most likely going to happen.
Another popular method entails drawing a parallel line between the start of wave one and the end of wave four. Once this line is drawn, a new line is created from the top of wave five to the bottom of wave one. Lastly, a horizontal count can be used to determine how long an impulse will last if its length matches that of previous waves. This method also helps investors know when a correction or reversal will likely happen.
Elliot Waves are one way for traders to identify whether a market trend has become exhausted and thus ripe for reversion. This unique form of technical analysis helps them pinpoint the beginning and end of each pattern inside a more significant trend and make better decisions when their investments may be losing value.
While it offers no guarantee on returns, understanding which patterns exist within a significant trend and how each one works can help traders keep their portfolios on the right side of the market. Beginner traders should use a reputable online etf broker singapore like Saxo Bank before starting their investment journey.