The Elliott Wave Theory, created by Ralph Nelson Elliot in the early 1900s, is a form of technical analysis that uses waves to explain financial market behaviour. This theory has gained recognition amongst many investors and traders alike because it offers an insight into how humans act under certain circumstances, which can be more reliable than other known theories like crowd psychology. Using his knowledge of history, economics, social science and stock market trends, Elliott came up with this system of predicting future price movement in the stock market.

The basis for this wave formation is based on mass psychology of crowd behavior, assuming that people base their decisions not only on logical reasoning but also on their emotions (i.e., greed and fear). They are more likely to buy when they feel greedy (like the sky’s the limit). When they feel fear (like the market is crashing), they are more likely to sell.

The basic structure of this theory consists of five waves that show a change of behavior from bearish to bullish or vice versa. In 5 waves, there will always be three smaller waves and two bigger waves. The first wave will often coincide with the previous trend, while the third wave will go against the trend. These movements from one extreme to another make up a cycle that can be either an impulse or a consolidation phase. 

This sequence is repeated again and again

Wave 1: People tend to feel pessimistic about investments during this state because they believe that prices have already risen too much. If the market is in a downtrend, there will often be three price decreases which will convince the majority of investors that prices will drop even more. At this point, many people sell their assets for fear of losing too much money.

Wave 2: This part of the sequence happens after Wave 1 has peaked and bottomed out, creating the highest volume of trades at this point. Many traders are still sceptical, but they begin to think that things can only get better from here. Prices go back up slightly, making them feel excited about getting into the market.

Wave 3: During this stage, greed starts to kick in, and people hold on to their investments, thinking that it cannot go any lower than this. Because of this, there are usually three price increases at this point. While people believe that prices will continue to ascend, some of them begin to take profits after the initial rise because they want to lock in their gains at this point.

Wave 4: As investors take their last profit from the market, prices tend to go down again at this stage which creates a lot of emotional tension among traders and speculators. Because of this, many people start selling their assets once again, which causes panic in the market, causing everyone else to do the same thing. Prices drop even more than they did before, and it appears that Wave 1 seems like nothing compared to what is happening now.

Wave 5: During this stage, pessimism becomes so widespread that prices can only go up at this point. As many people start buying again, the market seems to be calming down, which is not true because no more assets are being sold. It means that Wave 1 started all over again.

Bottom line

The Elliott Wave Theory is an exciting way of looking at financial markets, which makes it helpful in predicting where they are heading next. When prices go up or down on some time frames, it can be possible to count these waves and determine when the market will trend in another direction using them as clues for your next move. Although this theory has been successful so far, there are no guarantees that you will not find losses while trading with it because nothing can ever beat the unpredictability of the stock market.
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