Elliott Wave Theory

Markets make very complex moves and as a trader predicting such movements is not easy. There are many strategies that exist, but few are simple. One strategy that is easy & simple to execute is elliot wave. Elliott Wave Theory helps us understand market trends by using waves. It was created by Ralph Nelson Elliott. Let's see what this theory is and how it can help traders make better decisions.

Elliott Wave Theory falls under a technical analysis. It says that markets move in patterns called waves. Ralph Nelson Elliott developed this idea in the 1930s. He believed market prices move in repeating patterns. These patterns are not random. They are caused by people's emotions and actions. By understanding these patterns, traders can predict future market movements and make better decisions.

In this chapter, we will learn the basics of Elliott Wave Theory. We will look at how the waves are structured and how traders use this theory to predict market trends. We will also look at some examples.

Let's see the core principles of Elliott Wave Theory

1. Wave Patterns

Elliott said that market prices move in cycles called waves and there are two main types of waves: impulse waves and corrective waves. Impulse waves move in the direction of the main trend. Corrective waves move against the trend. An impulse wave has five smaller waves. A corrective wave has three smaller waves. You can see these patterns in any time frame, from minutes to years.

2. Fractals

Wave patterns are like fractals. This means each wave has smaller waves inside it. These smaller waves also have the same pattern. This helps traders analyze the market on different time frames. For example, in a daily chart of a stock like Infosys, you may see a five-wave pattern. If you zoom in to an hourly chart, you will see each of those waves is made of smaller waves.

3.Wave Degrees

Waves come in different sizes and time frames. The largest waves are called Grand Supercycle waves. These can last for decades. The smallest waves are called Minuette waves. They can last only a few minutes or hours. Knowing these wave degrees helps traders see where they are in the bigger market cycle. For example, in the Indian stock market, a Grand Supercycle wave could be the bull run from 2003 to 2008. A Minuette wave could be the price change in a single trading day.

The Elliott Wave Theory has a basic pattern called the 5-3 wave pattern.

1.Impulse Waves (1, 2, 3, 4, 5)

An impulse wave has five smaller waves that move in the direction of the trend. In an uptrend, waves 1, 3, and 5 are upward movements. Waves 2 and 4 are pullbacks. For example, if Tata Motors is going up, the price will move up in five waves. Waves 1, 3, and 5 go up, while waves 2 and 4 pull back a bit.

2. Corrective Waves (A, B, C)

After the five-wave impulse pattern, there is a corrective phase. This phase has three waves called A, B, and C. These waves move against the main trend and take back part of the move. For example, after a five-wave uptrend in Tata Motors, the stock may go into a correction. Wave A goes down, wave B goes up a bit, and wave C goes down again.

Reference Image of Elliott Wave Theory

Applying Elliott Wave Theory in Trading

Elliott Wave Theory can help traders, but it takes practice. Here are some ways to use it:

1.Identifying Waves

First, find the main trend in the market. Look for the five-wave pattern in the direction of the trend. Once you find the five waves, expect a three-wave correction. For example, if you see a five-wave pattern in HDFC Bank, get ready for a correction. During the correction, look for a chance to buy near the end of wave C.

2.Using Fibonacci Retracements

Traders use Elliott Wave Theory with Fibonacci retracements. These help find levels where waves may reverse. In fact Impulse waves often pull back to Fibonacci levels like 38.2%, 50%, or 61.8% before continuing. For example, if ICICI Bank completes a five-wave uptrend, Fibonacci retracements can help predict where the A-B-C correction might end.

3.Wave Counting

Counting waves correctly is very important. If you count them wrong, your predictions will be wrong. Many traders use other tools like RSI or MACD to help count waves. For example, after counting five waves in Infosys, use RSI to check for divergence. If RSI shows bearish divergence during wave five, it may mean the trend is ending.

Elliott Wave Theory has some challenges:

Subjectivity: Different traders may see different wave counts. Complexity: Waves are fractal, which means multiple patterns can exist at the same time. This makes it hard to find the correct wave. Market Conditions: Elliott Wave works best in trending markets. In choppy markets, wave patterns can be unclear.

In conclusion, the Elliott Wave Theory helps us understand market movements by breaking them down into patterns. It takes practice, but it can give traders good insights. Using other tools like Fibonacci retracements can make this strategy even stronger.

In the next chapter, we will learn about Gann Theory. Gann Theory is another tool that helps traders predict price movements using time, price, and geometry.