There are various ways of trading in the financial markets. The more tools you possess in your trading toolkit, the greater opportunities you will have. Indicators such as MACD, RSI, Stochastics, and moving averages evaluate data from previous price levels and highlight present market circumstances. However, Elliott Wave theory is applied differently. It describes future price movements and their trajectory, based on the existing circumstances.
Widely employed in financial markets, this theory holds immense importance. It is a market analysis strategy devised by Ralph Nelson Elliott that is centered around the premise that many things occur in a five-wave pattern.
Elliott discovered that a financial market contains recurring patterns. He designated these motions “waves” because of the troughs and peaks that appear in a cyclical up-and-down pattern.
Elliott Wave trading is a vast and complex subject that takes practitioners a lot of time to master. Despite its complexity, several fundamental features of Elliott wave trading can be used immediately and can help in the improvement of analytical skills and trade timing.
This post will explain some theoretical fundamentals of Elliot Wave Theory and how to use it to discover good trading possibilities.
What is Elliot Wave Theory?
The fundamentals of Elliot Wave Theory are surprisingly simple.
It is a method of technical analysis that was developed by Ralph Nelson Elliott in the 1930s. Ralph Nelson Elliott worked as an accountant in the United States. During the later years of his life, after retiring due to sickness, Elliott committed himself to the study of stock charts.
Elliott expressed his ideas in the book ‘The Wave Principle’ after spending time researching and analyzing the markets.
His theory is now one of the most widely used trading methods. Most traders combine the method with a variety of other tactics, including moving averages, Fibonacci, stochastic, and support and resistance.
The Origins of the Theory
In his analysis, Elliot discovered that stock markets traded in repetitive cycles rather than in a random manner – waves comprising price patterns employed to predict future price movements. His predictions proved that these market cycles have a strong connection to the prevalent psychology of the moment, as well as investors’ responses to such outside variables.
Following this, Elliot found that the increase and collapse of mass psychology always appeared in the same repeated patterns, which he called “waves.”
He also observed that group psychology fluctuates between optimism and pessimism to various degrees.
As a result, when the market experiences a strong uptrend, the mood may shift, and traders can begin to sell. When the market is in a significant downward trend, the traders’ mood can change, and they may exit the trade.
Based somewhat on the Dow Theory, which argues that stock prices move in waves, Elliott was able to analyze and comprehend the market to a much greater extent due to its fractal nature.
What is a Fractal?
A fractal is an endless pattern that repeats itself on different scales. It is a mathematical pattern, which repeats itself infinitely – and because Elliott discovered these patterns (or waves) in the market, he created a method for forecasting the market itself.
Today, we recognize Elliott’s Wave Theory; yet, the scientists of his time refused him acceptance for his wave theory due to the evidence and principles he had founded it on (principles and evidence that they, too, did not recognize as science).
Understanding the Elliot Wave Theory
The Elliot Wave principle states that price increases in a five-wave pattern and retraces in a three-wave pattern, completing one cycle. Whether bearish or bullish, the Elliot Wave Theory suggests that the repetitive patterns described by it comprise eight waves.
Why is this so? A five-wave arrangement is the smallest amount of movement required for advancement because it is practical but also inert in nature. We wouldn’t notice a trend forming if it was less. On the other hand, a three-wave structure is the least movement for the price to make a trend, i.e., two highs and two lows. However, it’s only feasible to obtain a distinct trend by combining both these movements.
Learning how to draw Elliott wave structure is a key component of trading utilizing the theory since it allows traders to identify corrective wave patterns and come to more informed trading decisions. The wave theory is applicable in stock, commodity, Forex trading, and cryptocurrency.
The basic cycle consists of eight waves: the first five waves form an upward “impulse” movement, while the remaining three sub-waves produce a corrective wave. This cycle is infinite: each wave can be made up of one or more shorter-duration cycles. The entire cycle comprises 34 waves, each of which can be segmented according to the basic cycle.
Motive and corrective waves are the foundations of this approach. Motive waves move in the principal direction of the trend, whereas corrective waves move within the counter-trend.
Market fractality is another fundamental pillar of the Elliott wave structures. In other words, waves can be seen in any time frame and categorized in varying degrees. A motive wave, for instance, is a five-wave structure composed of impulse waves 1, 3, and 5, whereas waves 2 and 4 are the corrective type. These degrees are used to categorize the waves in different time frames and describe their place within the market’s overall growth. There are 9 wave degrees, ranging from Grand Super Cycle on weekly and monthly time frames to Subminuette seen on minute time scales.
Understanding Elliott wave cycles is one of the most important parts of this strategy. These cycles assist traders in determining crucial levels of support and resistance as well as when a price is likely to make a big move.
Corrective waves are denoted with the letters A, B, and C, whereas impulse waves are marked with the digits 1, 2, 3, 4, and 5. In the following paragraphs, we will go through them in further detail and explain how to use them to locate trading opportunities.
How the Elliot Waves Work
The application of wave Elliot theory follows proper guidelines and rules. Our major responsibility is to count the waves by these principles and recognize that a set of combinations is available to create acceptable projections.
Impulse Wave
Impulse waves are the principal waves in the trend and can be identified in waves 1, 3, and 5 of the motive wave of the larger degree count.
Three fundamental rules have to be applied in order to identify the impulse wave:
- Wave 2 should not fall below the beginning point of wave 1.
- Wave 3 should not be the shortest wave between waves 1, 3, and 5.
- Wave 4 should not approach the price zone of wave 1.
We employ Fibonacci tools to determine the distance among waves, extension for determining impulse wave targets, and retracement for the corrective waves. Some appropriate Fibonacci levels are commonly employed.
For instance, wave 2 normally retraces to roughly 0.618 of wave one. Wave 3 reaches the 1.618 Fibonacci extension of wave one. Wave 4 is often a sideways Elliott corrective wave that is shallow, merely retracing back to the 0.382 Fibonacci retracement level of wave three.
Note: Waves 1 and 5 are usually the same length if wave 3 is the longest.
Corrective Waves
The three corrective waves, denoted by the letters A, B, and C, come after the first 5 impulse waves and, when viewed together, travel in the opposite direction of the impulse waves. This will be either downward or upward based on whether it’s a bull or bear market.
These three corrective waves can be classified into one of three types of chart formations; however, they are less obvious than the impulse waves. Corrective waves are classified into three distinct categories: zigzag, flat, and triangle.
Corrective waves are far more unanticipated in pattern development because they can be ascending, descending, symmetrical, or expanding.
Applying Elliot Waves in Trading
Trading with Elliot Waves is all about spotting the current trend and the position of price about it. Once you’ve established the movement direction, you may pinpoint the specific kind of corrective formation.
It’s also vital to remember that this strategy isn’t a stand-alone system when employing it in forex, stock, or crypto trading. According to the theory, traders should utilize it in combination with other technical analysis indicators and fundamental analysis.
Live Example
Let us see how to form an Elliot wave strategy by applying the guidelines and rules to a live chart through a charting platform.
There is a chance for a long trade on the H4 EURUSD chart. The first wave to the upside occurred between September 28th and October 5th, 2022. We may wait for it to work out as a corrective move because there was a prior downtrend.
Between the 5th of October and the 3rd of November, an ABC ZigZag correction happened, returning to the normal position of the 0.618 Fibonacci retracement. We might have worked out a long trade of 7.4 risk/reward ratio by extrapolating the price target for a probable third wave at the 1.618 Fibonacci extension.
The 0.618 Fibonacci level at 0.975 can be the entry point, the previous low level, close to the 0.782 Fibonacci retracement at 0.965 will the stop loss level, and the 1.618 Fibonacci extension at 1.049 can be the target.
In this case, we will prefer waiting for corrective wave 2 to complete and confirm the beginning of an uptrend before buying on the most significant move, which is often wave 3.
Furthermore, once the price achieved the target for the third wave, we would remain in the same position, however, raise the stop-loss level near 1.02 as well as the target to grab the finishing wave 5.
It’s also worth noting that Elliott Waves aren’t an entirely flawless method and don’t always give correct signals. Traders must be prepared to alter their trades and accept any necessary losses in these situations.
Conclusion
Investors may gain from Elliott Wave’s basic premise that markets move in predictable, recurring waves or cycles that can be projected and tracked using Fibonacci numbers. These waves are triggered by investor psychology and sentiment.
In terms of practical application, the Elliott Wave Principle, like all other analysis methodologies, has its supporters and detractors. Elliott’s techniques have frequently been compared to those of his contemporaries, including Charles H. Dow and others.
However, Elliott believed that his precise waves might provide more information and predictability than nearly any other technique.
Using the Elliott Wave Theory, traders can predict what the market will possibly do next and what it is unlikely to do.
This theory, however, works best when combined with other types of technical analysis or technical indicators to identify and capitalize on certain opportunities.
