The stock market is filled with investing theories, each of which typically falls into one of two types – technical and fundamental. The Elliott Wave Theory is a form of technical analysis invented by Ralph Nelson Elliott in the late 1920s. Elliott believe the market was not chaotic but instead trades in cycles. The makeup of these cycles (or waves) and how they operate forms the basis for Elliott’s theory.
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Cycles and Waves
Cycles in the stock market, Elliott said, result from investor reaction to outside influences and follow a specific pattern, which he identified. The Elliott Wave Principle suggests that investor psychology moves between positive and negative in a natural sequence. Cycles are divided into waves and based somewhat on the Dow theory that stock prices move in waves.
Elliott saw the nature of markets as fractal in nature and that made it possible for him to analyze the market and its psychology in detail. Fractals infinitely repeat themselves and, according to Elliott, so do stock-trading patterns. The obvious end goal is to use fractals to predict future market moves.
According to Elliott, it all starts with an impulsive wave that goes with the main trend. This impulsive wave contains 5 waves. These 5 waves move in the direction of the main trend followed by 3 corrective waves or sideways movements. This pattern continues ad infinitum.
In the stock market, action creates reaction. Price movement up is followed by contrary movement. All movement is divided into trends and corrections. To Elliott these were impulsive and corrective waves.
The 5-3 Pattern
This 5-3 action consisting of 5 waves that move in the direction of the main trend, followed by 3 corrective trends is essential to wave theory. A 5-3 move, the theory suggests, completes a cycle and becomes two subdivisions of the next higher 5-3 wave. The underlying 5-3 pattern is constant although the time span of each may vary.
The underlying or main trend can be up (bull) or down (bear). The corrective wave, which has 3 price movements, follows a pattern in which 2 move in the direction of the correction and 1 moves against it. An impulse-wave followed by a corrective wave form an Elliott wave degree consisting of trends and countertrends.
Elliott Wave Theory assigns categories to waves from largest to smallest. In order they are: Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette and Sub-Minuette.
In everyday trading the investor determines the Supercycle, goes long and then sells or shorts the position as the pattern runs out of gas and faces imminent reversal.
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Applied To The U.S. Dollar
Elliott Wave Theory has been applied to the weakness in the USD Index and suggests there may be one more dip coming. After that, Wave Theory suggests, the USD Index may well have its largest rally in more than a year. If, as some analysts believe, the U.S. Dollar Index is in wave 4 (of 5), when that wave finishes there will be a final wave 5, which will carry to dollar to new lows.
After that, theory posits, the U.S. Dollar Index may be staged for a rally. The same analysis suggests that EURUSD has just finished wave 3 with wave 4 currently underway in a mirror opposite version of Elliott Wave for the USD. Wave Theory is considered best applied to more liquid markets like FX, stock indices and common commodities like gold, silver, copper and energy.