The Elliot Wave Theory was discovered by Ralph Nelson Elliott back in the 1920s. The theory is based on identifiable and reptitive market movement in the stock market (“waves”) similar to the ranges identified by Fibonacci Retracements.The pattern consists of 5 waves up and 3 waves down – known as the “5-3 wave patterns”
In this example, the first 5 waves take stocks in a bullish direction; however, this pattern also works in a bear market just in reverse. The first Wave (#1) is then followed by a pullback (#2). The next (and longest stage) is a sustained rally up (#3). The correction comes as markets pull back (#4), finally followed by another big rally (#5).
This is the mentality of the investor during each wave cycle:
1. Investors believe that the stock market has been oversold and are begining to enter the market.
2. The initial investors take profit in a sell-off.
3. With these price reductions, the general public and large firms begin to take notice and this buying pushes the market upward – this is the largest cycle.
4. Pull-back in #4 is another round of profit taking.
5. The late bloomers (or laggards) decide that they don’t want to miss out on the action and jump in.
Following wave 5 comes a series of bear market moves. The “5-3 wave pattern” now beings parts A, B and C which indicates a correction in price due to the run up of the market during the previous cycle.
The A, B, C above demonstrates the last 3 waves of the Elliot Wave Theory (again this will be positive in a bear market).
These trends are based on larger models of the behaviour of groups (humans) which seem to run a predictable pattern. Elliot identified waves spanning from the Grand Supercycle to the Subminuette (see below)
Grand supercycle: multi-century
Supercycle: multi-decade (about 40-70 years)
Cycle: one year to several years or even several decades
Primary: a few months to a couple of years
Intermediate: weeks to months
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