Very Basic Elliott Wave Theory

As you will have seen on previous pages, Elliott Wave Theory was first discovered by Ralph Elliott towards the end of the 1920s.

Elliott found that stock markets, which were thought to behave in a somewhat random manner, did not. He spotted that they traded in repetitive cycles. The emotions of investors as a cause of outside influences, created these cycles. He said that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns. These patterns were then divided into what he termed to be 'waves'.

This link to waves means that his theory is somewhat based upon the Dow Theory. (Please accept my apologies in advance if the following description isn't as lucid as you might hope. I don't claim to be an Elliott Wave Theory expert, but I do find the work of EWI to be very useful.)

People involved with Elliott Wave do not claim that it is a forecasting tool, it does appear to be one of the best, if not the best forecasting tool available. Instead, the tool is a detailed description of how markets behave. From understanding how a market behaves, it is then possible to predict how it will behave in the future.

Of course any stock index is made up of component companies, however the actual trading is done by real people. Elliott Wave therefore also offers observations about the habits and patterns of humans. While this may be less useful to many than stock predictions, it too has many uses.

It could therefore be said the the social nature of man governs Wave Theory.

Alterations in price are divided into trends and corrections or sideways movements. Trends show the main direction of prices. While corrections move against the trend. Elliot called these 'impulsive waves' and 'corrective waves'.

My understanding of The Elliot Wave Theory is:

Every action is followed by a reaction.

There are five waves in the direction of the main upward trend followed by three corrective waves

This is known as a 5-3 move. A 5-3 move is a full cycle

This 5-3 move then becomes a subdivision of the next higher 5-3 wave

Whilst all this may sound a little complex, it does become much clearer when explained properly and in more depth (you have to buy the book for that!) and the regular reports written by Prechter often make for a surprisingly good read.