In this article, I will take a look at the Elliott Wave Theory and how it is used to trading.
The Elliott Wave Theory was developed by Ralph Nelson Elliott to predict price movements by analyzing nearly 75 years worth of stock data in the 1930s.
Ralph Nelson Elliott is an accountant and he believed that stock markets, usually thought to behave in a somewhat chaotic manner, in fact, the markets traded in repetitive cycles.
According to Elliott, market cycles result from the reactions of investors against external influences or the predominant psychology of the masses at that time.
Furthermore, he discovered that the downward and upward swings of the mass psychology always showed up in the same repetitive patterns.
The name of these upward and downward swings that he found is ‘’waves’’.
Elliott thinks that you can guess where price will go next if you are able to accurately identify the repetitive patterns in prices.
This is the reason of why Elliott waves so appealing to the traders. So, this provides them with an opportunity to determine the points where price is most likely to reverse.
Other words, even though not give the exact reverse point, Elliott discovered a system which traders able to predict tops and bottoms.
The markets have ‘’fractal’’ nature. Thanks to that, Mr. Elliott was able to analyze them in greater detail.
So, if you are thinking what is fractal let’s talk about them.
Fractals are mathematical structures that are self-similar across different scales. Elliott discovered that stock trading patterns were structured in the same way.
Elliott waves can be divided into smaller Elliott waves.
Now we can dive in the Elliott Wave Theory!
Elliott gave the following two terms to the trading literature. Impulse Waves and Corrective Waves.
According to Mr. Elliott, a trading market moves in a 5-3 wave pattern. So, what is 5 and what is 3?
The first 5 wave pattern is impulse waves. The last 3 wave pattern is corrective waves.
In Impulse Wave pattern, Waves 1,3, and 5 are motive, these are in the direction of the trend. Waves 2 and 4 are corrective and are against the trend.
Waves 2 and 4 are different from ABC corrective pattern. Do not confuse them. I will tell them below.
We will take a look at the 5 wave impulse pattern firstly. I will give a short description of each wave.
Mr. Elliott used the stocks for his theory and I am going to use stocks but it can be currencies, bonds, gold, silver or oil.
The important thing is that the Elliott Wave Theory can also be adapted to the forex market.
The stock moves upwards first.
If some people think the stock is cheap, they suddenly buy it and this causes the price to rise.
Some people who were in the original wave think the stock overvalued and take profits. This makes the stock to decrease.
Nonetheless, the stock is not as low as before.
This wave is the strongest and the longest wave usually. The stock attracted the attention of the more people.
They want to buy the stock because they think that it will rise again. Yes, they are right. The stock rise and rise again. This wave usually past the high level at the end of wave 1.
As the stock is expensive again, profits are taken. But it does not affect the price too much. Because there are usually more people who are still bullish on the stock. They are waiting to buy on the dips.
In this wave, most people buy the stock and as a result of that, the stock becomes the most overpriced.
Extended Impulse Waves
There is one thing you should also know about the Elliott Wave Theory. It is that one of the three impulse waves (1,3 or5) will always be extended.
So, one wave must be longer than the other two, regardless of degree. According to Mr. Elliot, it is usually Wave 5 which is extended.
As time went on, more and more people began to label the third wave as the extended one.
I told you the last 3 wave pattern is corrective waves. The last 3 wave corrects and reverses the first 5 wave.
Letters are used instead of numbers to track the correction.
You can check the 3 wave pattern in this picture below.
The Elliott Wave Theory works on bear markets also. I have been giving a bull market as an example.
So, the 5-3 wave pattern also can look like this:
Corrective Wave Patterns Types
There are 21 corrective wave patterns from largest to smallest. You don’t have to know all 21 types of corrective ABC patterns. It is enough to know they occur three very simple formations.
The formations are the zig-zag formation, the flat formation and the triangle formation.
The following examples apply to uptrends, but you can reverse them when dealing with a downtrend.
The Zig-Zag Formation
Zig-zag formations are very steep movements in the price that stands against the dominant tendency.
Commonly, Wave B is the shortest one compared to Waves A and Waves C.
These zig-zag patterns can be two or three times in a correction. As with all waves, each of the waves in zig-zag patterns can be divided into 5-wave patterns.
The Flat Formation
The flat formations consist of simple side-by-side corrective waves.
Usually, the lengths of the waves are equal and the wave B reverses the wave A’s move and wave C reverses wave B’s move. Sometimes wave B can pass the beginning of wave A.
The Triangle Formation
In the triangle formation, the waves are bound by two trend lines, thus forming a “triangle” shape. These trend lines can be either converging or diverging trend lines. Triangles are made up of 5-waves that move against the trend in a sideways manner. These triangles can be symmetrical, descending, ascending, or expanding.
Like I mentioned earlier, Elliott waves are fractals. Let’s open it a little.
The wave patterns can be found in any time frame and in smaller and smaller degrees. This means that each larger is made up of smaller sub-waves.
As you can see, each wave can be broken down to sub waves. The Elliott Wave Theory categorizes these waves in order of the largest to the smallest:
- Grand Supercycle
A Grand Supercycle is made up of Supercycle waves which are made up of Cycle waves which are made up Primary waves, which is made up of Intermediate waves which are made up of Minor waves which are made up of Minute waves which are made up of Minuette waves which are made up of Sub-Minuette waves.
Three Basic Rules of the Elliott Wave Theory
Elliot Wave Theory gives us some tips when trying to analyze the market using this model. There are three basic ‘’cannot-be-broken’’ rules in labeling waves.
So, you should take note of the rules before you enter into applying the Elliot Wave Theory to your trading.
- Wave 3 is never the shortest wave of the three impulse waves 1, 3, and 5.
- Wave 4 never enters the price territory of wave 1.
- Wave 2 never retraces beyond the start of wave 1.
A common observation of waves 2 and wave 4 is that they make alternate patterns. For example, if wave 2 makes a sharp move, then wave 4 will make a mild move, and vice versa.
Summary: Elliott Wave Theory
The last words about the Elliott Wave Theory. Elliot waves are fractals. Each wave can be split into parts, each of which is very similar to the whole.
There are 21 corrective patterns types but they are just made up of three very simple formations.
These main formations are zig-zag, flats and triangles. You can use them for your technical analysis.
As I mentioned above there are three basic rules in Elliott Wave Theory. Here is my advise to you try to learn all about the Elliot Wave Theory before using it in your trading. Otherwise, you may lose your money.