The origin of the wave analysis theory

In this article we will speak about one of the methods of technical analysis which is now one of the most popular among some traders - wave analysis. Let's consider the basis and the origin of this method in details.

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The wave analysis was founded by the world-known author and analytic Ralph Nelson Elliott 1871-1948. He is also an author of a series of articles and a book which has become a bestseller called “Nature’s Law — The Secret of the Universe” published in 1946. According to Elliott's point of view the chart of price changes of market instruments has a wave structure. And the form of price fluctuations is nothing else but a chart which shows the changes of psychological mood of the crowd (market participants). A person is often driven by emotions especially if he is a trader. And quite strong emotions are revealed in the branches of human activity which are connected with finances where there is a possibility of both loosing your funds and making profit. Trading on the commodity and stock markets can be also attributed to such branches. Later, from the end of 70s of the last century the Forex market has been also included to them. Human emotions gradually change from optimism to pessimism, from euphoria and belief in the future through uncertainty to disappointment, fair and panics while trading. Sometimes even such negative emotions as fair and greed control the market participants that's why absolutely unexpected changes of the price of the trading instruments may take place on the market. These changes look like waves on the chart of price fluctuations. Elliott argued that there is a limited amount of wave models (patterns). He payed special attention to the sequence of Fibonacci numbers.

The main elements of Elliott's wave theory are geometry and arithmetic of Fibonacci numbers. According to him, there is a specific clear logic in rotation of waves, which gives an opportunity to predict future changes in the mood of the crowd and to forecast price changes in particular. The major role in the structure of price movement play five motive and three corrective waves.

Another feature of waves and wave models is their ability to form great price movement and create larger wave models using the set of simple waves similar to them, this fact shows the fractional nature of the waves. Thus Elliott has almost predicted the foundation of modern science about nature processes based on the fractional principal in half a century. Using this science it is possible to identify and describe clearly the components of graphical models, waves which repeat in the market conditions. Elliott himself and his followers named and illustrated the models, described the relationship between them. This phenomenon was dubbed “Wave principal” by him. Nowadays wave principle is not a science yet but it seeks to this level. And it is quite possible that Elliott's wave theory will become a full-fledged science in the near future.

However there is a mistaken belief that the Elliott's Wave Principle can be used only for analysis of the market and the price fluctuations of the trading instruments. This belief radically reduces the value and prospect of the theory. Elliott meant human activity and market activity is only one of its segments. In addition to that some problems with application of Elliott's theory were caused by the great amount of interchangeable terms which appeared because Elliott's books and the ones of his followers were translated by different people at different times. That's why a lot of criticism has been aimed at this theory. Let's hope that all these problems will be solved and the Elliott's theory will get even more distribution among traders.