Elliott wave theory is one of the most powerful theories that traders all over the world use to analyze the market. Most importantly, it provides a picture of current market psychology. Ralph Nelson Elliott, an American accountant and author, came up with Elliott wave theory in the 1930s.
After his retirement, Ralph did a systematic study of 75 years worth of stock market data. He went through index charts of yearly, monthly, weekly, daily, hourly and 30-minute time frames. Then, he documented the results of his findings in the book ‘The Wave Principle ‘ that he published in August 1938. He had concluded that even though the prices of the market appear chaotic and random, they indeed follow predictable and natural laws the one can measure using Fibonacci numbers. The theory became popular when Ralph made an extraordinary prediction of the stock market bottom in 1935.
Ralph further wrote 12 articles on the request of Financial World magazine in which he described the Elliott wave principle in detail. In 1994, the books, articles and letters on Elliott Wave theory written by Ralph were published under the title ‘R.N. Elliott’s Masterworks’. Elliott Wave International, a financial analysis and market forecasting firm has the world’s largest group of independent market analysts who work on technical analysis based on the Elliott wave theory.
How do Elliott waves work?
Elliott waves are fractals. So, you can subdivide each fractal into smaller fractals. This theory is based on the notion that market forms the same types of patterns on a smaller time frame that it does on a longer timeframe.
According to Ralph, a trending market moves in a 5-3 wave pattern. The first 5-wave pattern is known as impulse waves or larger degree waves. The last 3-wave pattern is known as corrective waves. In this pattern, Waves 1, 3, 5 are motive, i.e. they move along the direction of the overall trend. Waves 2 and 4 are corrective and they move in the opposite direction of the overall trend. The 5 waves of the impulse wave pattern and the 3 waves of corrective wave pattern together form the complete Elliott wave sequence. The whole sequence contains a total of 8 waves.
Let us consider an Elliott wave in an uptrend. Wave 1 starts when a relatively small group of people decide to buy a currency pair. Wave 2 starts when enough people in the original wave decide to take profit. This causes the wave 2 to go downwards. Wave 3 happens when even a larger number of people decide to buy the currency pair, causing a longer and stronger upward movement. During Wave 3, the trend gets enough public attention which leads many traders to place their trades at this point. Wave 4 is a downward movement again, as many traders take profit at this point. The last wave is again an upward movement.
It is very important to note that one of the three motive waves (1,3 and 5) is always an extended one. Usually, it is the 3rd wave.
Corrective wave is a 3-way pattern which moves in the direction opposite. For easier understanding, let us name the waves a, b and c. Inside this corrective wave pattern, wave a and c are impulse waves as they move in the direction of the larger trend (the trend of corrective wave pattern). Wave b is a corrective wave as it moves against the larger trend. According to Ralph Nelson Elliott, there are 21 corrective patterns which are made up of three simple formations.
1) The Zig-Zag formations
In a zigzag formation, wave b is the shortest in length. It is common to see 2-3 zigzag patterns linked together.
2) The Flat Formation
In flat formations, the length of each wave is usually equal in length. Wave b reverses the Wave a’s move and wave c reverses the wave b’s move.
3) The Triangle Formation
A triangle formation is bound by either converging or diverging trend lines, giving the shape of a triangle to the corrective wave pattern. Unlike the other two formations, a triangle formation is made up of five waves.
Trading Forex using Elliott Wave Theory
While trading Elliott waves, you need to remember the four important points of Elliott Wave theory. They are:
#1: Wave 3 of the impulse wave pattern cannot be the shortest impulse wave.
#2: Wave 2 of the impulse wave pattern can never go beyond the start of Wave 1.
#3: Wave 4 of the impulse wave pattern can never cross in the same price area as Wave 1.
#4: Waves 2 and 4 often bounce off Fibonacci retracement levels (50%, 38.2% or 61.8%).
Let us say you see a pattern with wave 1 and 2. After wave 1 and wave 2 had formed, traders can analyze where wave 3 will end. When the price is at Fibonacci level, you can anticipate that it is going to bounce off. Since wave 3 is a strong trend, there is a possibility to make a really good profit.
As you can see, you need to trade in the direction of impulse waves as the price is making the largest move in that direction. You can enter into a trade in a corrective wave so that you can catch the next massive impulse wave. Buy during a corrective wave in an uptrend so that you can take advantage of the price hike that happens next. Similarly, in a downtrend, sell during the corrective wave so that you can get profit at the next impulse wave.