In 1934, Ralph Nelson Elliott discovered that the price action shown on the charts, instead of behaving in a somewhat chaotic way, actually had an intrinsic narrative. Elliott saw the same patterns formed in repeating cycles. These cycles reflected the prevailing emotions of investors and traders on up and downswings. These movements were divided into what he called “waves.” Elliott adopts the 3 impulses and 2 corrections of the Dow Theory but achieves greater precision.
In fact, Elliott was in fact describing the fractal nature of financial markets 50 years before the term was used to describe it.
The main objective for the trader, and the objective of this page dedicated to Elliott Waves, is to identify the presence of the most destructive and therefore profitable wave formations, be it a third or a C wave. Forex market, some authors argue that many times wave 5 is the longest.
Note that many analysts combine these principles with Fibonacci ratios and other levels of support and resistance to measure the potential of each price movement including its probable duration.
The point in using the rules and guidelines of the Elliott Wave Theory is to know where in the global structure the market is right now, and what portion of that movement they are most likely to capture. Wave traders are renowned for having their preferred wave pattern, their sweet spot so to speak, which frees them from having to keep a full count of the waves in all time frames.
Although the variability of shapes represents a real challenge for any Elliott apprentice, it is important to distinguish between an impulsive wave and a corrective wave. And here’s another great lesson from Elliott: recognizing that the market spends much more time in corrective mode than in impulse mode and that correction periods can be very complex in terms of price action.
In the midst of a corrective pattern, it is common for patience to run out while waiting for confirmation of a trend reversal. Therefore, we must give corrective patterns the necessary time to develop before entering the market. This requires discipline and a solid understanding of the variety of ways that corrective patterns can be deployed.
Introduction to Elliott Wave
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The publication of The Elliott Wave Principles in 1938 marked the beginning of the Elliott Wave movement, which has attracted a large following in the technical analysis community.
The internet boom of the last ten years or so has uncovered a new generation of Elliott Wave professionals and some, for whatever reason, have taken a more hybrid route in their application, deviating from the essence and principles of what that RN Elliott himself discovered it.
Let’s face it, interpreting the waves of the markets can be difficult, so why not add something new to the mix to help with that process? It is a common theme to use technical indicators in conjunction with the Elliott Wave, the most widespread use being the divergence of settings on the RSI to identify waves 3-4-5.
Others have completely modified Elliott’s work, even giving their new discoveries their own names. Some have so far strayed from the “law of nature” concept of “action / reaction”, where the numbers are “trends” and the “letters” are counter-trends that even wave labeling is almost unrecognizable from its origins .
The Five Elliott Wave Structures
The price in the financial markets makes trend, bullish or bearish and lateral movements. When the price is in a trend and pauses it is possible to detect the next move of continuation or change of trend using wave counting. The main objective is to identify one of the five Elliott Wave structures on the chart. Then we wait for the corrective to find the end and of course the entry to the market.
First Structure, The Momentum
It is known as impulse wave or “motive” in English is a sequence of five waves, three in one direction and two against the trend. Achieving three movements in one direction and two in the opposite direction, in this way you can have a tendency, by taking three steps in one direction and two in the opposite direction is guaranteed to advance. Each wave is marked at its end, in the case of the impulse the numbers from 1 to five are used. Where waves 1,3,5 are impulses that go in the direction of the trend and waves 2 and 4 against the trend to these waves are called corrective.
Figure 1 shows an example of momentum in the USD / CAD pair, at the end of the five-wave momentum in the four-hour temporality the analyst must wait for the three waves against the trend to look for buy trades.
The momentum can have bullish or bearish direction, it all depends on the highest degree cycle that the price is working out. In the beginning, the trader who learns the Elliott Wave theory should devote himself to finding as many of these structures as possible and refine his analysis.
Second structure, the Diagonal
The diagonal wave is the famous Wedge or wedge that happens on the charts in the initial or final part of a cycle. The difference with the impulse lies in the fourth wave, while in the impulse wave four is kept away from the zone of the first wave, in the diagonal wave the fourth wave enters the territory of the first wave, without passing the end of the second wave. It is known as the leading diagonal when it appears inside the first wave of an impulse or wave A in a ZigZag and as the final diagonal when it happens in the fifth wave of the impulse or inside the C wave of the ZigZag.
The information it provides is powerful to orient itself on the chart, the leading diagonal predicts a strong movement in the same direction of the structure. It also confirms that the previous cycle is over. While the final diagonal serves to take utility and look for operations against the trend. To search for an entry the procedure is identical to the impulse, it is expected to finish the diagonal, then three waves against and there is applied the entire strategic arsenal to enter the market.
Third structure, the ZigZag
We have reached the field of corrective waves, the ZigZag is a corrective structure that goes against the trend. Unlike the impulse this wave has three waves and each of them is marked at its end by the letters “ABC”. The ZigZag is usually the inner structure of a wave 2 or B, and sometimes appears in wave four. It is the only deep corrective structure that can be confused with a trend because it reaches to create a new low when it is bearish and a new high when it is bullish. If a ZigZag appears on the screen, take a position against its direction.
Since it is a tendential structure it will be easy to fall into the trap by investing in the same direction of the ZigZag, that is why this figure is also known as the bear trap or bulls. The trick to avoid being a victim of ZigZag is to identify the previous cycle. For example, if a momentum appears as in Figure 1 it will not be viable to sell during ZigZag development on the contrary the idea is to buy when it ends. Another example appears in Chart 2, after the leading diagonal the price falls performing three bullish waves against the trend, this ZigZag of three waves “ABC ” confirms the diagonal wave information, everything is prepared for a bullish trade configuration.
Fourth structure, the FLAT
Also known as flat structure this corrective wave appears inside wave “4”, “B” or “2”. It is a consolidation of the price, a pause after a strong movement, it is the moment when the institutions are closing their operations to take partial profits. A zone of indecision where the smartest participants take advantage to take positions in the direction of the previous trend. It is known as a continuation flag.
Chart 4 shows a FLAT in the middle of a bearish trend in GBP / USD, note that after a strong bearish movement called Wave Three, the price stops dry and begins a lateral cycle, which lasts for two months. The price action within wave three and four is the FLAT. It is denoted by three waves “a, b,c”, at the end follows the downtrend.
A fatal mistake is to go in the opposite direction of the FLAT, the Elliott Wave theory leaves valuable advice in the face of this situation, always invest in the direction of the pre-FLAT trend. It takes practice to master this structure and find its end.
Fifth structure, the Triangle
It is the drawing on the graph most attractive to the analyst’s view, it is a work of art surrounded by science and some mystique. According to Elliott Wave Theory The Triangle is a continuation figure of the trend, therefore, when the price is rising and appears this figure indicates that the price will continue bullish, the opposite is true in a downtrend. The main question is when will it end? Thanks to wave theory we can know how many cycles the Triangle must have before continuing the trend.
Five internal cycles, are labeled by the letters ABCDE. With this simple trick it is possible to anticipate the continuation of the trend by counting the five movements. Before completing these five internal cycles one should avoid entering the market. The Triangle is a gift that the price action prepares for the trader. A gift that should be made the most of. It serves to anticipate the next price movement, avoid going in the opposite direction.
In Chart 4 we see a triangle of great proportion in the EUR/USD pair, are five internal movements denoted by means of the waves “A, B, C,D, E”, at the moment that the wave ” E ” is under construction the analyst must concentrate all his efforts to validate the end of the wave and start the short trading plan. According to Elliott Wave Theory whenever a triangle appears it means that the price will continue with the previous trend after plotting the five cycles.
Using the five Elliott Wave structures it is possible to analyze the price action from a new angle and to master the technique it is essential to practice, look for all possible examples. Study the past Price to understand where the price is in the present. Elliott Wave Theory is not a trading system by itself, it needs to be combined with other techniques to find the trade.
Decision-making process based on Elliott Wave Theory
Find the long-term wave count (monthly and weekly chart).
Confirm information in smaller time periods (daily chart and four hours).
Choose the active Elliott Wave to search for its ending.
Do not use counting alone to enter the trade.
Combine the information with a trend-shifting technique.
Use reverse price action systems, moving average crosses, etc.
When the trend change system confirms the end of Elliott’s wave enters the trade.
With this methodology of analysis and trading it is mandatory to keep the risk under control. The maximum risk per operation is 2%. The less you risk, the more you win, the easier it is to succeed. With good wave analysis, plus an effective trend change strategy to validate the end of the wave and managing risk, the trader will surely achieve incredible results. The Elliott Wave Theory has been on the charts for 81 years by thousands of analysts and will stay for many more years thanks to its versatility and efficiency.