image-team

Tom Akkerman July 6, 2022 Average reading time: 5 min

Elliot Waves

In his 1938 book titled “The wave principle”, ‘Ralph Nelson Elliot’ postulated the “Elliot wave theory”. Then, everyone thought that stock market prices were random and chaotic but he discovered that they follow patterns that often repeat. Elliot wave theory is a popular technical analysis principle that is applied in the financial markets; which includes the forex market.

When you look at a forex chart in a small timeframe such as M1 or M5, the pattern is usually zigzag as the prices go up and down. Elliot believed that these upward and downward price movements, which he called waves, are brought about by the psychology of the market participants. He asserts that the price waves follow a repetitive pattern, so, you can study the patterns and correctly predict the next price movement.

He also believed that the financial markets are fractal. When something is fractal, it means that it shows self-similarity; its geometrical structure when viewed at different scales repeats the overall pattern. Fractals are seen all over nature; in some flowers, snowflakes, seashells, tree branches, leaf veins, etc. Elliot waves are also fractal and can be divided into smaller waves while retaining the overall pattern.

Impulse waves

Elliot drew a 5-3 wave pattern which he used to describe a trending market. The first 5-wave pattern depicts a trend in one direction followed by a 3-wave pattern in the opposite direction.

The first 5-waves are called impulse waves while the second 3-waves (labeled a-c) are called the corrective waves. This can be drawn for a bullish market and also for a bearish market.

Let us consider the bullish impulse wave pattern below. For clarity, the numbers 1-5 are written to identify each wave. From the diagram, waves 1, 3, and 5 are called motive waves because they move in the direction of the trend. Waves 2 and 4 are called corrective because they are retracements and not in the direction of the trend.  

ABC Corrective Wave Pattern

Rules for drawing the Elliot wave impulse waves

If you look at the price action of a forex pair and it seems to fit the 5-3 wave pattern, you can check if it obeys the following rules:

  • The end of wave 2 must not go past the start of wave 1.
  • Wave 3 must not be the shortest motive wave.
  • The price area of wave 4 and wave 2 must not overlap.

In some cases, wave 5 may not go past wave 3, this is known as truncation.

The waves are fractal: meaning that the patterns repeat at different scales. For example, if you numbered the waves on a daily chart (D1), moving to a smaller timeframe such as M5 will show that the 5-3 wave pattern occurs within each subdivision of the numbered waves. 

The smaller subdivisions are referred to as waves of a lesser degree. Also, all the waves will not be equal; some are longer than others.

 

Waves of a Lesser Degree

Corrective waves

After the impulse waves, it is followed by the 3-wave pattern reversing or correcting the wave trend. Here, we use letters a, b and c to mark the correction waves. There are many types of corrective wave patterns. They are generally formed by 3 basic formations as follows:

Zigzag formation

The pattern is formed by the steep price movements that go against the established trend.

 

Simple Zig Zag

These are corrective waves that occur in a sideways trend. The second wave b may retrace below the starting price level of a, while wave c may not go much below the end of a.

 

Flat Formation

 

Triangle formation

 These are corrective patterns formed by converging or diverging trend lines as shown in the diagram below:

Triangle Correction

 

They comprise 5 waves moving against the established trend in the sideways direction. The triangle formed may be descending, ascending, symmetrical, etc.

Trading forex with Elliot waves

The primary focus of Elliot wave traders is to identify charts that fit into the pattern, draw lines, and the number counts. Then, this knowledge is used to predict the future price direction.

Make sure that the rules for drawing impulse waves are obeyed. Most traders love to go with the trend and catching it right from the beginning is crucial. This makes trading wave 1 difficult because you might not be able to find where it begins. Most traders concentrate on trading wave 3 since it is mostly the longest wave; this means that if you catch it from the start, you are likely to make good profits. To do this, Fibonacci levels come to the rescue.

 

Trading Elliot waves with Fibonacci

Ralph Elliot connected his waves to Fibonacci levels to help him identify the market potential turning points. To do this on the MT4: locate the Fibonacci retracement tool on the toolbar or go to the menu bar and click: insert>Fibonacci>Retracement. Drag the mouse pointer over the area on the chart. The following default Fibonacci levels are majorly used by traders:

  • 0.0
  • 23.6
  • 38.2
  • 50.0
  • 61.8

 

Waves and Fibonacci Retracement

61.8 is often regarded as the Fibonacci golden ratio. In the diagram above, the second wave bounces on the level and resumes the uptrend. The trader can use this level as his entry point while the 100% level might be your stop loss. This is because our rule says that wave 2 must not go below the starting of wave 1.

Just like other technical analysis tools, it is better to use the Elliot waves principle in combination with other tools and indicators. Constant practice is needed to perfect the strategy. Critics of this theory say that is mostly subjective which is true.

 

Conclusion

Elliot wave theory by Ralph Elliot states that “market prices make 5 swings in the overall trend direction and then reverse and makes 3 swings in the new direction”. He called these market movements "waves" which are fractal in nature. Fractals are continuously repeated patterns found in nature such as plants, snowflakes, etc.

Impulse waves comprise 3 motive waves in the overall trend direction and 2 corrective waves which move in the reverse direction.  

To draw impulse waves in an uptrend: make sure that the end of the second wave is higher than the beginning of wave one in an uptrend. For a downtrend, it is vice versa. In all cases, wave 3 must not be the shortest wave and the corrective waves must not overlap.

To trade Elliot waves; use the Fibonacci levels to identify reversal points and aim to catch the longest wave from the beginning. This is the most popular way of trading it though traders can also trade other waves. It generally depends on your skills and experience.