The Elliot Wave theory is used to how a stock will behave in future by correlating crowd psychology with the stock price trends.
The theory was discovered by Ralph Nelson Elliot (1871-1948) accountant in the 1930s. It was published in the book The Wave Principle in 1938.
In Elliott's model, market prices alternate between two phases - motive and corrective phase. Impulses are always divided into a set of 5 lower-degree waves. They alternate between motive and corrective character. If there are waves 1, 3, and 5 which are impulse waves, there are 2 and 4 which are corrective.
RELATIONSHIP WITH PSYCHOLOGY
The Wave 1 is the first wave of a new bull market when there is still believed the bear market is not over. The fundamental news is still bad and the analyst communities are pessimistic about the atmosphere. The economy still continues to look weak and the conviction is there that the bear market is dominant.
The Wave 2 is a correction of the wave 1 and here the correction does not retest new lows. On this bears get excited and keep shorting the market on belief that the bear market is very much intact. However, generally this correction does not correct more than 61.8% (Fibonacci number) of Wave 1.
The Wave 3 is the largest and the most powerful rally in the trend. Here the good news starts coming in and the analyst community turns a bit positive. Generally it is only when the wave reaches its midpoint does the bulls starts participating in volumes. There is short covering seen which gives powerful rally. This wave is generally an extension of wave 1 by 1.618:1 ratio.
The Wave 4 is a correction of the wave 3. This is a buying opportunity and the correction is generally 38.2% of Wave 3.
The Wave 5 is the final leg of the trend. Here there is positive news everywhere the sentiment keeps getting more bullish every moment. Volume is very high and there is lack of sellers and there are almost no short positions. There is buying seen almost everywhere. However, soon the peak is seen and the investors get trapped.
The Wave A is the first wave of the counter trend. Though this is the onset of a bear market, investors generally take this as a correction of the ongoing Bull Run. The news is very much positive and investors see this as a buying opportunity.
The Wave B is a correction of the wave A and it is upward pattern. However, this wave does not break the high of the Wave A and head and shoulders pattern may be seen.
The Wave C is a strong downward wave which confirms that bull market is over and bears get aggressive. Bulls suddenly realize they have been caught on the wrong side and soon they too start selling to cut their losses. The wave is an extension of Wave A by 1.618 times.
Elliott believed that the number of waves that exist in the stock market's pattern is reflected in the Fibonacci sequence of numbers. As per Fibonacci series, any number is approximately 1.618 times the preceding number and approximately 0.618 the following number. The relationship between the lengths of waves of an Elliot wave model to a huge extent seems to carry the Fibonacci number relationships.
CRITICISM OF ELLIOT WAVE
The Elliott Wave is considered by many as hypothetical theory and it contradicts the concepts of price and volume actions. It depends on crowd psychology and this may not be a valid reason to go with all the time. It sounds much of a subjective way of analysis and as such this is cannot be a valid way of analysis all the time.