Trade Stock Indices

The Elliott Wave Theory

This is a form of trading analysis that traders and other investors use to forecast trends in the trading markets by identifying extremes in investor psychology, highs & lows in prices, and other collective activities. This theory model shows that collective human psychology develops in natural patterns over time, through buying and selling decisions reflected in market prices.

This trading theory of analysis was created by Ralph Nelson Elliott that's based on the theory that, in nature, many things happen in a five-wave pattern. These patterns are also applied to trading analysis, to analyze the behavior of price trends using this technical analysis theory.

When this theory is applied to Indices, the assumption is that the trading market will advance in a pattern of five waves - three upward moves, numbered 1, 3 and 5 - which are separated by 2 downward moves, number 2 and 4. When the 3 up moves (1,3,5) are combined with the 2 down moves (2,4), they form the 5 Wave trading pattern.

The theory further explains that every five-pattern up movement will be followed by a down pattern move also consisting of three-pattern down moves - this time, 3 down ones are not numbered but use the letters A, B & C. So as to differentiate these from the 5 ones for the up move.

5 and 3 Wave Pattern

Main trend will comprise of 5 moves while the price retracement will comprise 3 moves.

Five pattern formation (dominant trend) - uses 1, 2, 3, 4, 5

3 setup (corrective trend) - uses A, B, C

Elliot Wave Theory Explained - Five and Three Elliot Count - Elliott Wave Theory

This article is about how to trade online markets using the Elliott Theory as the driving force of instruments. This model relies heavily and mostly on looking at price charts. Technical analysts use this theory to study developing trends to identify the waves & discern what prices might do next.

By analyzing these patterns on a chart and applying the Elliott Wave Theory, stock traders are able to decide where to get in and where to get out by identifying the points at which the trading market is likely to turn.

One of the easiest places to see this theory at work is in the trading market, where the changing investor psychology is recorded in the format of price moves. If a stock index trader can identify the repeating patterns in prices, & figure out where these repeating setup is relative to the Elliot pattern counts then the online trader can predict where the prices are likely to head to.

Rules for Elliott Wave Count

Based on the trading market patterns formations formed by this theory, there are several guide-lines for valid Counts:

  1. Wave 2 shouldn't go below the beginning of Part 1.
  2. Wave three should be the largest among Part 1, 3 & 5.
  3. Wave 4 shouldn't over-lap with Part 1.

Five setup (dominant trend)

Elliott Wave Theory - 5 and 3 Wave Elliot Count Rules in Trend

1: This one is rarely obvious at its inception. When the first wave of a new bull market starts, the fundamental news is almost universally negative. The previous market trend is considered still strongly in force. Fundamental data analysts continue to revise their estimates lower: the beginning of a new trend probably does not look strong. Sentiment surveys are still bearish and the implied volatility in the trading market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

2: This one two corrects 1, but can never extend beyond the starting point of wave 1. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, & "crowd" mentality reminds all that the bear market is still in place. Still, some positive signs appear for those that are looking: volume should be lower during 2 than during 1, prices usually do not retrace more than 61.80% of 1 part one gains. Price will reach a low that is higher than the previous low resulting in to a higher low.

3: This is usually and generally the largest and most powerful move upwards, larger than 1 and 5. News is now positive and fundamental analysts start to raise estimates. Prices rise quickly, corrections are short-lived & shallow. Anyone looking to get in on a pull-back will likely miss the boat. As three starts, the news is probably still somewhat bearish, & most/many traders remain still negative: but by part three midpoint, the crowd will often join in and agree that the new sentiment in the market is bullish. Wave 3 will extends beyond the highest level reached by 1.

4: This is typically & clearly corrective. Prices might move sideways for an extended period, and 4 mostly retraces less than 38.20% of 3. Volume is well below that of wave 3. This is a good place to buy a pull-back if you understand the potential that is ahead for a Part 5. Still this 4 is often frustrating because of their lack of progress in the larger upwards trend.

5: This is the final leg in the direction of the dominant market trend. The news is almost universally positive & everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the price hits the top. Volume is often lower in wave 5 than in wave 3, and many momentum indicators start to show divergences (prices reach a new high but the trading indicators do not reach new highs). At the end of a major bullish trend, bears may very well be ridiculed, for trying to pick a market top.

3 Pattern (Corrective Trend)

Elliott Wave Theory - 5 & 3 Wave Elliot Count Rules in Trend

A: Corrections are often much harder to identify than impulse moves. In A of a bearish market, the fundamental news data is usually still positive. Most analysts see the drop as a market correction in a still active bull market. Some indicators that accompany A include increased volume, rising and implied volatility & possibly a higher open interest in selling/shorting.

B: Prices reverse & move slightly higher, which many see as a resumption of the now long gone bullish trend. Those familiar with classical trading analysis may see the peak as a right shoulder of a head and shoulders reversal trade pattern. The volume during B should be lesser than in A. By this point, fundamentals are probably no longer improving, but they most probably have not yet turned negative.

C: Prices move impulsively lower. Volume picks up, and by the third leg of C, just about almost everyone realizes that a bearish trend is firmly entrenched. C is typically at least as large as A & often exwill tend to 1.618 Fib expansion level beyond A lowest point.

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