Developed by Ralph Nelson Elliot in the 1930s, the Elliott wave theory is considered one of the most popular forms of financial market analysis. After studying 75 years of hourly, daily, weekly, monthly, and yearly indexes charts, Elliot noticed that price moved in repetitive patterns in the form of waves. Elliot’s articles and publications were compiled in a single book, “R.N. Elliott’s Masterworks,” and Elliott Wave International is a financial analysis institution based on Elliot’s model.
What is the Elliott Wave theory?
Elliot suggested that price moves in a certain pattern, often in forms of waves. These waves are known as the motive waves and reflect market sentiment and trader’s psychology. The motive waves are further categorized as impulse and corrective waves.
The theory described impulse and corrective waves as a core principle. Hence, they are the types of Elliot waves.
Impulse waves
Impulse waves consist of five additional waves; three are motive ways, and two are corrective. It is drawn as 5-3-5-3-5. These five waves represent the continuation of a trend.
Corrective waves
Corrective waves, also known as diagonal waves, compromises of five waves and illustrates a trend reversal.
Elliot observed that the impulse and corrective waves use Fibonacci ratios for their calculations. For example, a corrective wave retraces 32% of an impulse wave.
Elliot’s theory and Dow theory’s basic concept are somewhat similar, as both theories suggest price waves. However, Elliot presented a more in-depth analysis of waves by including fractals. Fractals are mathematical figures that have the same statistical characters and often repeat themselves.
How to use the Elliott Wave theory?
To implement the Elliot principle, traders first need to count waves and then ride the trend or go against it.
For going with the trend (using impulse wave), there are certain rules which a trader needs to remember before applying the theory:
- First, wave 2 can’t retrace wave 1 by more than 100 percent.
- Wave 2 and 4 bounces off Fibonacci retracement levels.
- Wave 3 can’t be the shortest of waves 1, 3, and 5.
- Wave 1 and 2 are easy to spot. After calculating the price’s Fib level, traders can enter long at wave 3 with stop-losses placed at the recent low and exit the trade on a high.
When using corrective waves for going against the trend, traders locate three waves a, b, and c, right after impulse waves. C is the point where the price finds a reversal, so traders take their sell positions at c with stop-losses near the recent high.
The impulse waves and corrective waves can appear in an uptrend or downtrend.
When conducting his experiments, Elliot noted that the waves don’t forecast any future movements; rather, they act as a guide for the upcoming price actions. So, it can be wise to use the principle with other forms of technical analysis.
Elliott wave theory trading strategy
Simply put, movement in the direction of the trend is unfolding in 5 waves (called motive wave) while any correction against the trend is in three waves (called corrective wave). The movement in the direction of the trend is labelled as 1, 2, 3, 4, and 5. The three wave correction is labelled as a, b, and c. These patterns can be seen in long term as well as short term charts.
Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. This information (about smaller patterns fitting into bigger patterns), coupled with the Fibonacci relationships between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid reward/risk ratios.
Elliot wave works on every timeframe as the author considered every timeframe for conducting his experiment. So, every type of trader can take advantage of the Elliot wave theory, both for day trading and swing trading.
The advantage offered by the Elliott Wave theory is not limited to identifying the direction and maturity of a trend, but it also includes recognising the ranges of movement within which the trend will develop, thus allowing controlled management of gains and losses.
Where to start an Elliott wave count will depend on your trading objectives and where you stand with analysis. According to the Elliott Wave principle, motive waves are followed by corrective waves and vice-versa. You may get the best results by starting the count at the beginning of a market turning point, rather than in the middle of a rally or decline. In other words, if you want to count the sub-waves of a correction, you could start your count from the end of the previous wave.
Elliott wave theory buy strategy
- Locate the impulse wave in an uptrend.
- Wait for the price bar to go bullish before entering.
- Enter the trade at wave 3 or 5.
- Place a stop-loss near the recent low form the entry point.
- Exit the trade on a high.
Elliott wave theory sell strategy
- Look for the corrective waves in a downtrend.
- Wait for the price bar to go bearish before entering.
- Enter the trade at the wave c.
- Place a stop-loss near the recent high.
- Exit the trade on low.
Elliot Wace Theory conclusion
The Elliott Wave theory is a theory in technical analysis used to describe price movements in the financial market. The theory was developed by Ralph Nelson Elliott after he observed and identified recurring, fractal wave patterns.
No training principle in the financial markets guarantees 100% accuracy. The Elliott wave theory is one of the most commonly used trading principles in financial markets. Traders need to follow a few set of rules before applying it as a forex trading strategy.
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