The Elliott Wave Theory was discovered in the late 1920s by Ralph Nelson Elliott. He found that the stock market does not behave chaotically, but rather in repetitive cycles, reflecting human actions and emotions, largely driven by mass psychology, which he considered the main culprit.
His work was partly based on the Dow Theory, which also uses waves to study the stock market. However, Elliott discovered the fractal nature of the market —the same patterns repeating on larger and smaller scales— and, after years of in-depth study, he identified patterns suitable for making predictions.
From the 1970s onward, the theory gained popularity thanks to the successful predictions of booms and crashes made by Frost and Prechter (“Elliott Wave Principle: Key to Stock Market Profits,” 1978).
The basic pattern: three zigzags, with the third one being the shortest, representing the main trends (Waves 1, 2, 3, 4, 5), as shown in the following diagrams:
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Two zigzags for corrections (Waves A, B, C), of the following type:
Obviously, corrections will always be smaller in magnitude than the main trends (whether upward or downward).
Let’s look at an example of upward trends and downward corrections (though the same applies to downward trends with upward corrections):
Next, let’s look at more basic trends, which are slight variations of the ones we just saw:
And more basic corrections:
Furthermore, according to some authors, Elliott’s theory has three main rules that must be followed to guide us in understanding stock market movements and that can be very useful for recognizing patterns:
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The second wave cannot fall below the first wave.
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The third wave cannot be the shortest of the impulse waves.
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The fourth wave must not overlap with the first wave.
Additionally, retracements within waves usually correspond to Fibonacci retracement levels, primarily 38.2% and 61.8%.
Channeling
An important tool for projecting targets in the next wave. It involves drawing parallel or angled lines that define the channel of the trend or correction. Let’s look at some examples:
[Via: http://www.relatividad.org/ondas_elliott/]
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