The Elliott Wave principle is a form of technical analysis, which is used to analyze market trends, locate extremes in investors’ psychology and forecast future market trends. Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognizable fractal patterns, called waves. The theory can be validated by using the Fibonacci sequence and the Golden ratio, which derives from it.
Technical analysis is a method of forecasting the direction of price trends by studying past market data. Technical analysts use price chart patterns and several technical indicators, in order to find actionable trading opportunities.
There are numerous techniques, not a single universal one. For example, some technicians use trend lines or support and resistance levels, while others rely on candlesticks, Elliott waves, moving averages or sentiment indicators.
Among the pioneers of technical analysis are Charles Henry Dow, Ralph Nelson Elliott, William Gann and Richard Wyckoff. Half-art and half-science, technical analysis postulates that history tends to repeat itself, so if we study the past carefully, we better prepare for the future.
However, technical analysis works only with expectations and probabilities. Nothing is ever certain in the market.
Markets are not random or chaotic. Price movements progress in certain direction for a while. Those directed movements are called trends. Each trend has a beginning and each trend inevitably ends. When one trend ends, a new trend in the opposite direction starts.
Ralph Nelson Elliott
Ralph Nelson Elliott (1871-1948) was an accountant in one of the biggest railroad companies in the U.S. He also had his own consulting firm and spent his last 20 years studying the stock market.
Stock Market Prices
A stock price is the price of a single share of a number of salable shares of a company. It depends not only on the company’s business results, but also on social mood. Stock prices trend and reverse at a certain point depending on social mood.
If social mood is positive, stock prices tend to go upwards, while negative mood drives prices down, decreasing the value of the company.
Fibonacci and the Golden Ratio
The Fibonacci sequence is 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and so on. It begins with the number 1 and each new number is the sum of the previous two. The limit ratio between the terms is 0,618034…, an irrational number called the “divine proportion”. The progress of waves has the same mathematical base as so many phenomena in life (e.g. DNA).
The Elliott Wave Principle
In 1930, Ralph Nelson Elliott discovered that stock market prices trend and reverse in recognizable pattern. He described how they link together to form larger versions of themselves and how they connect to form the same patterns at the larger scale, producing a structured progression. He called this phenomenon the Wave Principle. In his honor, we are today calling it the Elliott Wave principle.
Extremes in Investors’ Psychology
When a trend begins, only a few know about it. As the trend develops, it becomes easily recognizable and more and more people are joining it. At the end of the trend almost everyone is already participating in it. The majority of investors share the same opinion about the market, namely that the trend has just begun and will last for a long time, even forever.
Ironically, when everyone has already joined the trend, there is no-one left to support it. There is no power left in it anymore, so it reverses. Usually at the time of the reversal over 90% of the people still believe in the trend. That is an extreme in investors’ psychology.
Fractals and the Elliott Wave Principle
A fractal is an irregularly shaped object that is nonrandom in the sense that its discontinuities at all scales are similarly irregular. Johann Wolfgang von Goethe is the first person to advance the idea of self-similarity of the parts to the whole of plants. The Elliott Wave principle best describes the fractal nature and behavior of financial markets.
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