The Elliott Wave Theory is a theory investors use in technical analysis. According to the Elliott Wave Theory, any movement in the market has a specific cause, and developments create significant data that can influence future developments. In other words, each event affects the next.
Ralph Nelson Elliott came up with the Elliott Wave Theory in the 1930s. Elliott claimed that market movements, which are often thought to behave in a random vague manner, are actually traded in repetitive patterns. Elliott, who examined data covering 75 years of various annual, monthly, and daily indices, said the fluctuations were a result of investors acting according to a collective psychology. He argues that due to collective psychology, fluctuations in financial markets always occur in the same repetitive fractal patterns.
The Elliott Waves have fractal structures. Fractal structures are defined as shapes made up of pieces that resemble or have similar properties to each other. Although many elements in nature appear formless, and the parts or components that make them up may seem to be randomly combined, when examined on a smaller scale, we understand that they have a pattern similar to the object itself. A snowflake is an example of a fractal.
Elliott explained how to identify, predict, and use these wave patterns within a set of rules. These rules are contained in R.N. Elliott's Masterworks, published in 1994. WWe must remember that these patterns do not provide any certainty in future price movements, but instead help us predict possible market events. This information can be used in conjunction with technical indicators in technical analysis to predict opportunities. Each investor can interpret the Elliott Waves structure differently in any market at any time.
How do the Elliott Waves Work?
When historical data analysis is conducted, the price movements give us an overview of the first 5 waves of the cycle, the waves of movement. Investors who want to benefit from the Elliott Wave Theory look for these waves, which follow the rules in historical data.
Waves 1, 3, and 5 follow the direction of the trend. Waves 2 and 4 are countertrend interruptions. Waves 2 and 4 stand for pullbacks within an uptrend. Motive and countertrend waves together create a pattern known as the 5-Wave Structure. Motive waves include 5-wave structures. Corrective waves, on the other hand, include 3-wave structures or variations related to them. If there is no rise following the 5-wave structure in any possible market data, it means that this trend will make a time correction. It can be predicted that the trend will result in a 3-wave correction after a 5-wave rise. As a result, the previous 5-wave structure has reached a total of 8 waves with 3 corrective waves included.
Some of the features of the waves are as follows:
- Waves can occur in two directions. These waves are Motive waves and Corrective waves. Motive waves consist of 5-wave structures and Corrective waves consist of 3-wave structures.
- Motive waves follow the direction of the main trend.
- The 2nd and 4th waves move in the opposite direction of the trend, and they are known as Corrective waves because they correct 1st and 3rd waves.
- Once the 5-wave structure is completed, the 3-wave structure (corrective waves) start. These corrective waves are denoted by the letters A, B and C.
- The 3rd wave cannot be the shortest motive wave. According to Elliott, the longest wave is the 5th wave. But today most investors disagree. They argue that the longest wave is the 5th wave. However, we should not forget that no matter how many different ideas arise, according to the fundamental rule, the 3rd wave can never be the shortest motive wave.
- The 2nd wave cannot go beyond the beginning of the 1st wave. In other words, the 2nd wave cannot retract more than 100% of the 1st wave.
- The 4th wave cannot go beyond the beginning of the 3rd wave.
The debate on the Elliott Wave Theory continues. Some think that the success of the theory depends largely on the investor. Each investor's opinion influences the division of market movements into trends and corrections. We must bear in mind that the conclusions obtained using the theory, as in other methods of analysis, are only predictions or probabilities.
What makes the Elliott Wave Theory stand out is that it considers not only the supply and demand, but also the psychology of the masses and the situations that are being or likely to be experienced. It can be effective in explaining the relationship of public psychology with economics.
