This article in The Trader’s Indicator Series discusses Market Cycles and Elliott Wave Analysis, which is my expertise, having used it for the last 30+ trading years. The previous article discussed Average True Range, a subset of Support and Resistance, and how it factors into price behavior during trends and sideways consolidations. Since market cycles are also an integral component of the trader’s toolbox and crucial for manual trading, it will be useful to gain an understanding of how price action fits into these cycles.
Market Cycles and Elliott Wave Analysis
Ralph Nelson Elliott developed the Elliott Wave Theory in the 1930’s by studying various market indices spanning over a 75-year period. He discovered that stock markets, thought to behave in a somewhat chaotic manner, in fact, did not. They traded in repetitive, predictable cycles. Elliott discovered the correlation between the markets and the emotions of investors, and theorized that the markets reflected the predominant psychology of the masses at the time.
Elliott stated that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he termed “waves.” Subsequently, many other Elliott Wave theorists have applied his principles to markets other than stocks, such as Forex and commodities, with great success. This is to say that the theory is transferable to virtually all traded markets.
Elliott’s work was published in 1938 in a monograph titled The Wave Principle, which is now known as the Elliott Wave Principle (A.J. Frost and Robert Prechter, Jr., 2005). The theory of Elliott ties these patterns of collective human behavior to the Fibonacci sequence, or golden ratio, well known by mathematicians and scientists.
Elliott Wave Theory describes how waves will subdivide until a complete market cycle is established. As the market unfolds in repetitive waves, they have predictive value. Waves are patterns of directional movement and once we learn the patterns, we are more apt to recognize trends and corrections as they occur.
One complete cycle consists of eight waves. To start, a movement will unfold in its primary direction in a series of 5 waves, labeled 1 through 5. This 5-wave impulsive sequence is also called a “motive wave.” The 5-wave pattern is followed by a 3-wave sequence, labeled as A-B-C, which corrects the 1-2-3-4-5 sequence by moving against its trend direction. In other words, at any time a price in the market moves in the direction of the larger trend, it will form a 5-wave sequence followed by a 3-wave sequence which moves in the opposite direction.
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