“The Wave Principle” also known as the Elliot Wave Theory, was developed by Ralph Nelson Elliott for the stock market in 1920 and is one of (if not the) earliest rational system of market analysis to recognize that prices move in trends, and that there exists a prevalent crowd behavior or underlying market psychology behind each and every trend and reversal moves in the market. Elliott observed that the directional movement in prices occurs in a five wave pattern which recurs regularly throughout the historical data of any financial asset. He observed further that these patterns are repetitive only in form but not in time or magnitude.
According to Elliot, this five wave pattern in price movement is made up of three impulse waves and two corrective waves. The impulse waves point in the direction of the trend (or the direction which the crowd comprising the majority of the traders trading simultaneously during a particular session wants to take the price). The two corrective waves are deemed as counter trends, meaning they go against the main trend.
Elliott wave analysis is an acquired skill that can be learned in no time at all. There are only about a dozen rules and guidelines you need to follow to use it effectively, so the learning curve is short and rigid. And, as with any acquired skill, you can achieve proficiency only through diligent and constant practice. It is not something you can learn by just reading a book on the subject. However, as you gain proficiency in identifying and counting waves, your trading performance will improve tremendously.
Identifying a Stock's Trade Opportunity
The real value of Elliot’s Wave Principle is in its ability to identify and establish if a particular stock is in a bearish, bullish, or corrective phase, thus revealing short term trading opportunities of which a trader can take advantage. Remember the saying “the trend is your friend”? It still holds water today more than ever - and with the Elliot Wave Analysis charts, you have the perfect tool to establish and identify at what stage of a trending market the present price level of a particular stock currently rests.
Much more than that, the Elliot Wave charts can vividly portray the story behind the ebb and flow of the prevailing market sentiment as it cycles from pessimism to optimism and back. For example, the first impulse wave represents the initial excitement and thrill resulting from some positive developments that attracted buyers to get into the market, thus pushing the price to a new intermediate high. The first corrective wave represents the anxiety that normally seizes the hearts of traders as prices tread uncharted territory, making them take short term profits and trim their positions. The second impulse wave represents the growing optimism of the traders which is now turning into euphoria as buyers beef up their longs. The second corrective wave represents the influx of new shorts as the bears find the price level too attractive to pass on. The third and final wave represents extreme optimism that has engulfed the traders who establish more longs, pushing the price way up where it has never been before in a while.
To make the story short, the Elliot Wave Analysis becomes more meaningful to a trader if used in perspective with the underlying market sentiment.
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