Elliott Wave Theory: How Charting is Based on Market Psychology!

Forex world is huge and there is a lot you need to learn in order to be a pro in this game. There are various techniques, theories, rules that can help motivate you to be a forex trader but this learning would never stop because of the introduction of new trends and theories in the field.

While there are various concepts and techniques that traders and analysts use, you cannot forget one of the most observant and time-tested theories which is The Elliot Wave Theory. It explains how markets behave in a manner that is predictable and is purely based on influences, psychology, and prevalent sentiments of the market participants at the time.

 

History

Named after Ralph Nelson Elliot (July 28th, 1871 to January 15th, 1948) who was an American author and accountant, the theory has proved extremely beneficial to the field of forex trading. Elliot found through his keen observations for almost 75 years and data that markets did not actually behave in a chaotic manner and that it rather traded in repetitive cycles.

These cycles were formed as result of sentiments and psychology of the masses that was majorly influenced by outside sources.

He analyzed that there were specific patterns through which wave patterns can be recognized and that the upward and downward movements, referred to as waves, in price caused by collective psychology kept repeating in similar patterns.

Because of its repetition in patterns and predictability, it is one of the famous theories followed by traders who like to call themselves Elliot wave traders.

 

Concept of Fractals

Structures that can be split down into further parts are known as fractals which are very similar to the original. Because of the fractal nature of the markets, Elliot proposed that the waves formed because of his observations and study are fractals and therefore can be subdivided into smaller waves to understand market psychology.

 

Basic 5 Wave Sequence

The Elliot waves and its fractals are broken down into two categories of waves; impulse waves and corrective waves. These waves form a trending market pattern which moves in a 5-3 wave pattern. The first 5 waves are known as the impulse waves and the remaining 3 are called the corrective waves.

Impulse Waves

These wave patterns are further subdivided into numerals and alphabets. The waves named 1, 3, and 5 are motive. This is because they mostly follow the overall trend and current behavior of the market. The remaining 2 wave fractals 2 and 4 are corrective, as they keep adjusting the trend line where and when necessary.

This wave, its fractals, and overall pattern can be better understood by having a look at the graph below and description of each wave, considering any specific asset class which can be from the stock market or the foreign exchange market.

elliott wave charts

Let’s take an example of one stock to understand the movement of waves for the ease of using and understanding it.

Wave 1

The prices of the stock start climbing and takes its initial move upwards because of being noticed by some people who believe that the prices of this stock are low and would grow in the future because of the potential that this stock holds. This causes the price to rise.

Wave 2

This is the first corrective wave where some people who initially took the stock start believing that the stock has become overvalued. Because of this perception, they start taking profits which cause the prices to fall. This stock will, however, not fall as much as its initial price from where it started before it is considered a bargain again.

Wave 3

This is where the stock’s awareness has reached a wide public who now become interested in buying it. This causes the prices to climb back again and cross its previous high to get to a new high. This is usually the strongest and the longest wave.

Wave 4

Once the prices are too high, some traders start to feel that it has become too expensive and overvalued. They start taking profit, but not all traders are of the same view and are still bullish on the stock because of which the nature of this wave is mostly weak.

Wave 5

This wave is when there is absolute madness in the market for the stock and everybody is in on buying it. Here the stock becomes most overpriced. Some traders even start shorting the stock.

Out of these 5 waves, it is always that one of the impulse waves (1, 3, and 5) will always get extended and will be longer than the other two. Mostly it is the 3rd or the 5th wave which gets extended and is considered to be the strongest.

Corrective Waves

As discussed previously, the 5 wave trend is followed, or more properly said is corrected and reversed by 3-wave countertrends hence called the corrective waves. For these waves, instead of numbers, letters are used to track the corrective wave pattern. This makes it a complete 8 wave cycle. This cycle can turn from bullish to bearish or from bearish to a bullish pattern.

To help understand these cycles better, below are two graphs that clearly show how the market corrects and reverses itself.

elliott wave fibonacci

elliott wave forecast

Types of Elliot Wave Corrective Patterns

According to the man himself, there are in total 21 of corrective patterns whose nature ranges from simple to complex. But all these 21 patterns are made from 3 easy-to-understand formations. These three formations apply in the same manner to both uptrend and downtrend and are discussed below in detail for you to understand.

The Zig-Zag Formation

This is formed when there is a very unpredictable movement of prices in the market. The formation of this pattern is steep and goes against the predominant trend. Below is a graph for you to have a look at what it looks like.

elliott wave predictions

Here, the wave a and wave care long as compared to wave b which is the shortest. This formation can take place two or three times during correction and would be linked together. These waves in this pattern, like all other waves, can be broken into a 5 wave pattern.

The Flat Formation

elliott wave correction rules

As the name indicates, these formations are simple sideways waves. Generally, they are equal in length with each wave reversing the previous wave’s move.

The Triangle Formation

This formation is formed mostly either due to converging or diverging trend lines. It is made up of 5 waves that move in a sideways fashion against the trend and are made up of 5 waves. They form a triangular trend that can be ascending, descending, symmetrical, or expanding.

Below is a graphical representation of the triangle formation

elliott wave retracement

 

Fractals in a 5-wave pattern of Elliot Wave Theory

As per the Elliot wave Theory, each wave is a fractal based on the fractal nature of the market. This means they can be further sub-divided which is shown in the graph below.

elliott wave time ratios

The above graph clearly shows how the impulse waves and the corrective waves are further divided into smaller waves known as fractals. This is always the case. It may look easier to label these straight lines forming the Elliot wave pattern but in reality, these waves aren’t shaped perfectly and need to be found out by the trader himself or herself by continuously following the pattern and staring at the charts. One example of the real-life wave is as such.

elliott wave fibonacci retracements

In order to make the labeling of these waves easier, a series of categories have been assigned in order of largest to smallest by the Elliot Wave Theory that is mentioned below along with the labels they are denoted with.

  • Grand Supercycle – used to form a multi-century wave pattern
  • Supercycle – used to form a 40 to 70 years wave pattern
  • Cycle – used to form a one year to several years wave pattern
  • Primary – used to form a few months to a couple of years wave pattern
  • Intermediate – used to form a few weeks to months wave pattern
  • Minor – used to form few weeks wave pattern
  • Minute – used to form a few days wave pattern
  • Minuette – used to form a few hours wave pattern
  • Sub-Minuette – used to form minutes wave pattern

 

Rules of Elliot Wave Theory

In order to be able to trade correctly, it is extremely important that you are able to analyze and correctly interpret the chart patterns and are able to label them accordingly to take advantage of the current market situation and place your trades accordingly.

For this very reason, there are three extremely important rules in labeling waves that cannot be broken at any cost and hence are known as ‘Cardinal’. If you do not follow these rules you are sure to head towards disaster.

Rule # 1: Wave 3, out of the three impulse waves, can never be the shortest wave

Rule # 2: Wave 2 can never go beyond the starting point of Wave 1

Rule # 3: Wave 4 and wave 1 can never overlap (can never cross in the same price area)

 

Trading Guideline of Elliot Wave Theory

Well, you might have started to feel a little uneasy hearing all these rules and where they could lead you. But don’t worry! Just like for every problem there is a solution, for helping you to correctly label these waves and get all the benefits by trading with the help of Elliot wave theory, few guidelines have been provided for this purpose. These guidelines, however, can be broken, unlike the cardinal rules.

  • Wave 5 does not move beyond the end of wave 3 which is called truncation.
  • If wave 3 is the longest and the strongest of the three impulse waves then the remaining two would be approximately equal to each other.
  • Wave 2 and wave 4 forms will alternate. If one of these forms a sharp correction then the will form a flat correction wave.
  • Corrections usually take place in the end area prior to the lowest of wave 4.
  • Waves 2 and 4 frequently bounce off Fibonacci retracement levels.

 

Trading Forex Using Elliot Waves

Just like every other tool in the forex world this tool can be used individually or in combination with other tool or tools to get the maximum benefit you can while trading and making some money. For using Elliot wave theory in trading there are two possible scenarios that can take place and which you need to keep a keen eye on.

Scenario # 1:

So you are sitting in front of the screen and staring at the chart in front of you. You start your wave count and realize that an upward trend is forming in the market because previously the prices seemed to bottom out. Below is a chart that represents this scenario.

elliott wave triangle rules

Here the waves have been marked as 1 and 2 using the Elliot Wave Theory. You look how wave 2 is a corrective wave and predict the next would be an impulse wave 3 moving upwards. One way to be sure about it is using the rules and guidelines that you have already learned and made use of them now.

According to the Wave 2 can never go beyond the starting point of Wave 1 and Waves 2 and 4 frequently bounce off Fibonacci retracement levels. So we see if something can be done here and take a position and place stop loss as per Fibonacci retracement levels.

If your prediction and labeling are correct then what you would possibly get to see next is the chart below.

elliott wave complex correction

Scenario # 2

Scenario 2 is when after a 5-wave trend you start seeing a corrective pattern and that too from one of its types.

visual guide to elliott wave trading

In the graph above you can clearly indicate what is happening. A correction in the form of flat formation is taking place. This indicates that once wave C ends a new impulse wave might start where the price starts to climb upwards. If your analysis is correct then you are in luck to witness this pattern in front of you.

mastering elliott wave

 

Source of Graphs: http://stockcharts.com/school/doku.php?id=chart_school:market_analysis:elliott_wave_theory

https://www.babypips.com/learn/forex/waves-within-a-wave

https://www.babypips.com/learn/forex/riding-elliotts-waves

https://www.babypips.com/learn/forex/corrective-waves