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Elliot Wave Theory was a discovery of an American accountant, Ralph Nelson Elliott. He believed that it was a common misconception that stock markets, behave randomly and in a chaotic manner. The markets according to him, showed repetitive and recognizable patterns.
In this article, we will attempt to understand the Elliott Wave theory given by R.N. Elliott. We will also cover the relation between Elliott Wave and Fibonacci Retracement and Fibonacci Extension levels. And finally, we are going to explain how you can identify these patterns in order to improve your security analysis.
So, in the early 1930s, he began his in depth analysis of 75 years of stock market data. This data including charts with increments ranging anywhere from yearly to half-hourly.
In August 1938, he published the results of his studies in his book ‘The Wave Principle’. Elliott established that, while stock prices may look unpredictable, they actually have certain recurring patterns, and follow natural laws. He further explained the process to calculate and identify these patterns. R.N. Elliott suggested that stock prices can be measured and predicted using Fibonacci retracement levels.
He isolated 13 patterns of waves (movements) that recur in the market. He then went on naming, defining and illustrating those patterns. Elliott, further explained how these patterns link together with each other to form larger versions of those same patterns. To summarize, the Elliott Wave theory suggests a catalog of price patterns and an explanation of where the waves are likely to occur, in the market.
SImpulsive Waves: Waves 1, 3 & 5 are impulsive waves. ‘Impulse Wave’ is a term used to describe waves that overall move in the direction of the ongoing trend.
Corrective Waves: Waves 2 & 4 are corrective waves. ‘Corrective Waves’ is a term used to describe waves that overall move against the direction of the ongoing trend.
Probably, the most fascinating part of the Elliot Wave Theory is its relation with Fibonacci Retracement Levels. According to the Elliott Wave theory, markets unfold in sequences of five and three waves, the number of waves that exist in the stock market's patterns reflects the Fibonacci sequence of numbers (1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89...).
What you, as a trader or an investor need to follow is Fibonacci retracement levels. Use Fibonacci numbers at all retracements you see i.e. 23.6%, 38.2%, 50%, 61.8% and 78.6%.
What the Elliott Wave Principle says, then, is that the progress of the market doesn’t occur in a straight line, or randomly or cyclically. We all as traders know that when the stock price goes up, it is going come down sooner or later. In fact, progress takes place in a ‘three steps forward, two steps backward’ pattern. The Elliott Wave theory shows that the periods of setback, in fact, are essential for overall progress.
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