Elliott Wave theory is another way of predicting the movement and direction of the stock market. Invented by Ralph Nelson Elliott, the theory is based on the belief that the markets have well-defined wave patterns that predict the future of the market direction. Under the Elliott Wave theory, the market moves in predetermined waves, up and down. The theory claims that bull markets move in five waves up and three waves down, with waves 1, 3, and 5 called impulse waves. In a bear market, the waves are reversed with five down and three up.

The Elliott Wave theory goes against the chaos theory. It is the only cyclical theory that does not require a specific time period for market changes. The theory is somewhat based on the Dow theory, in that both theories focus on waves in the market.

Interpretation

Every cycle in the Elliott Wave theory includes the 5-3 wave move. The second set of waves “corrects” the first set of waves, based on the assumption that for every action there is a reaction. There is no predetermined amount of time these waves take.

The Elliott Wave theory assigns the waves into categories in order of largest to smallest. These categories are grand supercycle; supercycle; cycle; primary; intermediate; minor; minute; minuette; and sub-minuette. The main wave is the supercycle. Using the Elliott Wave theory in trading, the investor identifies the supercycle and bases trading on that, predicting when the next wave will begin, when the pattern begins to lose momentum and a reversal is imminent.

Technical Analysis

The Elliott Wave theory uses technical analysis as its model for stock prediction. Technical analysis is a method that analyzes the statistics that are generated by stock market activity. The method is not meant to measure the value of the stock. Instead, it is looking at patterns and other indicators on the stock market’s movement. Predictions are then made based on those patterns. The Elliott Wave theory is aligned with fractal mathematics. Technical analysis has risen in popularity as a stock market predictor because it takes past history into consideration. In recent years, more investors and market analysts are paying more attention to historical patterns of stock movement as a way of predicting future growth.