Ralph Nelson Elliott, a great accountant, formulated the Elliot wave theory. He analyzed 75 years worth of stock market data and concluded that there is a definitive pattern in the stock market and there is no haphazard and undefined pattern that determines the market.
A lot of human psychology is involved which results in the pattern. These patterns are repetitive, and investors can predict the market behavior by monitoring these trends. The Elliot wave theory is formed by two different patterns called the impulsive and compulsive.
Impulsive is when the there is a positive trend in the market, and the share value goes up, and compulsive is a when there is a negative trend, and the market value falls. If you can determine where the exact market value is then you can predict the behavior and find exactly when to buy and sell shares.
A 5-3 wave pattern explains the Elliot wave theory. The wave pattern 1-5 represents the five impulsive, and the wave pattern a-c represent the three compulsive. Once you understand the pattern, then it is easy to mint money in the share market.
The 1, 3 and five are called the motive, and the 2 and four are called the corrective. Wave 1 is when the stock is moving upwards, and people take notice of it. Once it has reached a certain amount of money people sell it for profit, this causes the dip in the peak and hence forming wave 2. Some people are waiting for that particular stock to go down so they can buy it. This results in the upward movement and hence the wave 3. This particular wave keeps rising, and some people notice it. Then traders sell the stock and make a huge profit and hence causing the stock to fall again forming wave 4. Now, more investors are waiting for the dip to buy the stock. Once it has reached a limit number of investors, start buying stocks and hence increasing the stock value.
Once the stock has reached its peak, the corrective waves come into play. These corrective waves are denoted as a, b, and c. The corrective way can be of 21 different patterns. These patterns ensure that the stock goes back to the impulsive wave pattern 1. We were discussing the bull pattern which starts with the upward trend, but there can also be a bear pattern where it starts with a downward trend.
All waves have a sub waves which is formed by the same 5-3 wave patterns. When you can determine which wave the market is at then, you can predict the behavior of the share market. There are three rules to be followed when implementing this theory.
Wave 2 cannot fall beyond wave 1
Wave 3 can never be smaller than the other impulsive waves
Wave 4 can never be the same as wave 1
By keeping these basic principles, you can determine the market share position using these wave patterns. Elliot wave theory has been criticized saying that when a number of people know the wave patterns, then the pattern is meant to change. Similarly, since no one can find the beginning or the end of the wave, it is considered a vague theory.