A Brief Overview
An American accountant by the name of Ralph Nelson Elliott developed the famous Elliott Wave Theory, which he published in his book The Wave Principle in 1938.
Elliott analyzed the stock markets covering 75 years of data and noticed a close correlation between investor psychology and price movements. He realized that when crowds of investors reacted to external factors they ended up investing in a certain way. This resulted in repetitive patterns which created market movements that looked like waves.
Therefore, the premise of Elliott’s theory revolved around this collective human psychology, where the predominant sentiment of the masses caused a trending market to move in what he called a five and three – wave pattern in any time frame. The first five-wave phase constituted the main trend, while the second three-wave phase was a counter-trend.
Advantage – Disadvantage
The aim of Elliott’s model is to allow an investor to find the point of an impending reversal. By knowing when a market forms a top or bottom, you would be able to place your buy or sell orders and profit. Therefore, by correctly identifying the repeating patterns in prices, it would be possible to predict where the price will go next.
The disadvantage of the Elliott Wave Theory is that it is very subjective and it is quite difficult sometimes to pinpoint the beginning or end of a wave in the five-wave cycle. With a lot of practice one can get better at recognizing these patterns. Now we will look at the key principles of the Elliott Wave Theory.
The Waves
According to the Elliott Wave Theory, the market moves in repetitive sequences of upswings and downswings. A trending market is made up of a motive phase (made up of 5 waves) and a corrective phase (made up of 3 waves). If the market was in an uptrend, the Elliott Wave would look like this:
In a downtrend, it would look like this:
These patterns can be found in any time frame and in smaller and smaller degrees. This means that each larger wave is made up of smaller sub-waves. For example, wave 1 of a 5-wave sequence can itself be broken down into 5 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
- Supercycle
- Cycle
- Primary
- Intermediate
- Minor
- Minute
- Minuette
- Sub-Minuette
The Motive Phase
This phase constitutes five waves. Waves 1, 3 and 5 move in the direction of the trend and are called impulse waves (or motive waves). Waves 2 and 4 are corrective waves. These two corrective waves in the motive phase must not be confused with the corrective phase (second phase after motive phase) in which the waves are denoted with the letters A, B, and C. Remember that for the first phase (motive phase) the waves are always numbered and in the second phase they are lettered.
In the motive phase, often the corrective waves 2 and 4 will retrace to bounce off Fibonacci levels. If we apply the Fibonacci tool on the chart we can usually check to see when wave 2 or wave 4 will end. We will see later in this section how this is useful when trading.
Let us look at an example to describe an uptrend:
- Prices begin to rise due to some buyers entering the market, creating wave 1.
- Profit-taking results in the price dropping slightly, to create wave 2.
- More buyers enter the market and prices rise again to create wave 3. In the Elliott Wave Theory this wave 3 is usually the longest and exceeds the high created at the end of wave 1.
- Profit taking causes prices to drop again but only slightly as the trend is still bullish. This creates wave 4.
- Even more investors enter the market at this stage creating an abundance of buyers to create wave 5. Eventually there are no more buyers left in the market as the instrument becomes overpriced. Sellers enter the market. This begins the reversal of the trend to start the ABC pattern, which is known as the corrective phase.
Rules and Guidelines
Certain observations can be made in the Elliot Wave Theory which give us some tips when trying to analyze the market using this model.
In the motive phase, three basic rules must be observed:
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.
Corrective Phase
In the corrective phase there are three types of wave patterns:
Zig Zags
Flats
Triangles
Note that the corrective phase is always made up of three waves A, B, C.
Zig Zags
In this example the zig zag pattern applies to an uptrend (in a downtrend you can just invert this pattern).
The zig zag pattern constitutes a sharp move in price that goes against the predominant trend. Wave B is usually the shortest in length when compared to wave A and wave C.As with all waves, each of the waves in zig zag patterns have sub-waves that break up into 5-wave patterns. For example, Wave A can have 5 sub-waves and then wave B has 3 waves for the correction. Then wave C has 5 waves. Look at the diagram which explains this pattern.
The Flat Formation
When we have a flat formation, the corrective waves move sideways. In this formation, the lengths of the waves are generally all the same length. Basically wave B reverses wave A’s move. Then wave C retraces wave B’s move.
The Triangle Formation
In the triangle formation, the waves are bound by two trend lines, hence 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.
How to Use the Elliot Wave Theory for Trading
Elliot Wave principles can be used in trading to determine entry and exit points.
Example 1
Let us look at an example of an emerging uptrend. We wait for wave 1 to be completed. Then we check where wave 2 will end we can apply Fibonacci. Remember one of the Rules of the Elliot Wave Theory is that Wave 2 can NEVER retrace beyond the start of Wave 1. If it does, then you made a mistake in your labeling of wave 2. It is always good to place a stop loss just in case.
Looking at the chart below, we can see wave 2 approach a Fibonacci level. This is a possible entry point to buy.
After prices bounce off the Fibonacci level to complete wave 2, then wave 3 begins to form. Remember from the Rules that wave 3 is the longest wave out of the five-wave sequence. It can be a good time to exit and take profits at the end of wave 3 (or at least part of your profits).
Example 2
Now let us look at an example using corrective wave patterns to help you determine the start of a new motive phase (and for the trend to resume). This will be a good entry point when a new wave 1 emerges.
In the chart below, we can see that after the downtrend has ended, a corrective phase forms (A-B-C). In this case we have the flat formation. This means prices correct in a sideways fashion. This gives you a signal that prices may just begin a new impulse wave once wave C ends.
This could be a good opportunity to place a sell order in anticipation of a new wave forming. Just to be safe in case your wave count was wrong, you can place your stop just a few pips above the start of Wave 4.
You can see that after the corrective phase and wave C ended, the downtrend resumed and we have a new wave 1. This would be a good opportunity to take some profits!
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