Importance of the Elliott Wave Theory

In the last part of this series, we provided an overview of the Elliott Wave Theory. In this part of the series, we’ll discuss the psychology behind the Elliott Wave Theory’s two phases—the impulse phase and the corrective phase.

Why is the Elliott Wave Theory important in technical analysis?

The above chart shows the entry and exit signal for Home Depot’s (HD) stock. It used the Elliott Wave Theory.

In the impulsive phase, wave 1 forms at the beginning of an uptrend. In this phase, the stock price rises due to psychological factors—like investors expecting a change in trend or hedge funds buying at market bottoms. The fundamental news is negative during this period. All stock market forecasts are negative. This negative sentiment causes the stock price to fall. This forms wave 2.

Wave 2 doesn’t fall below the beginning of wave 1. Wave 3 forms when stock market news is positive and the trend rises. In wave 4, stock prices fall due to profit booking. Wave 5 is formed when stock news is positive and investor optimism is high.

In the beginning of the corrective phase, it’s difficult to predict that the market trend has stopped. The stock price starts dropping due to correction. This phase is called wave A. In wave B, the stock price increases on the anticipation that the long uptrend is still there. Wave C is formed when stock market news is negative and a downtrend is confirmed.

The Elliott Wave Theory is used to identify the trend direction. It’s also used to identify entry and exit points for investing in stock markets.

Applying technical analysis concepts

The technical analysis concepts can be applied to stocks like Ford Motors (F), General Motors (GM), Tesla Motors (TSLA), and Goodyear Tire (GT). These companies are all major parts of exchange-traded funds (or ETFs) like the Consumer Discretionary Select Sector SPDR Fund (XLY).

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