The theory was proposed by Ralph Nelson Elliott in the 30s of the 20th century. Elliott extended the Dow theory, which describes the behavior of stock prices over time.
The theory is based on a cyclical pattern in the psychology of human behavior. It suggests that market prices move in a wave cycle, have a certain structure and pattern of following waves, based on Fibonacci numbers. The principle of nested waves: in the big time period consists of wave cycles shorter time periods and, in general, the movement of prices on the market can be put into one big super cycle.
The theory applies to any time periods for any freely traded assets.
Elliott suggested that any movement of prices on the market fits into the five-wave pattern.
Impulse (1, 3, 5, A, C) waves forms direction of movement. Correction (2, 4, B) waves forms a counter-movement.
There are the following fixed characteristics for waves:
- wave 2 never falls below the starting point of wave 1
- wave 3 can not be the shortest
- wave 4 never decreases to the price range of wave 1
- one wave cycle consists of eight waves and two phases: a driving phase (1, 2, 3, 4, 5) - consists of five waves; correction phase (A, B, C) - consists of three, it correct the entire driving phase.
According Elliot between waves must be certain ratios defined Fibonacci numbers:
- 2nd wave length: 0.382, 0.5, 0.618 relative of the 1st wave
- 3d wave length:0.618, 1.618, 2.618 relative of the 1st wave
- 4th wave length: 0.382, 0.5 relative of the 1st wave
- 5th wave length: 0.382, 0.5, 0.618 relative of the 1st wave
- wave A length: 0.5, 0.618, 1 relative of the 5th wave
- wave B length: 0.382, 0.5 relative of the wave A
- wave C length: 0.5, 0.618, 1.618 relative of the wave A
Elliott Wave Theory in practice requires a lot of experience to correctly identify the waves. Critics of the theory say that great importance for determining the structure of the waves is the subjective opinion of the expert, and as a result, predictions based on the theory are ambiguous.
However, in practice it possible to use the theory partially - some of its elements, for example, the ratio of wavelengths.