Elliott Wave Theory (aka Elliott Wave Principal)
The Elliott Wave Theory (also know as the Elliott Wave Principal) is a form of technical analysis that is used to help forecast trends in the financial markets. The Elliot Wave is named after Ralph Nelson Elliott who concluded that markets moved in a repetitive pattern of waves and he attributed this action to the mass psychology of the market. He also concluded that market movement is a direct result of mass psychology due to a human trait of herding, not economic growth or slowdown and the market is a fractal.
Fractals are objects similar in shape at different scales. A good example of a fractal in nature could be the branches of a tree. The base of the branches look the same, but branches smaller in scale. Fractals also form in accordance with Fibonacci Ratios.
Elliott Wave Analysis is one of the most reliable tools traders use to predict market swings. Elliott waves help to identify trends and countertrends, trend continuation or exhaustion and help to evaluate potential price targets of a trend.
Elliott waves also follow a sequence. Three (3) waves up (impulses) and two (2) waves down (corrective retracements). These sequences form the foundation of the 5 Wave Impulse Pattern. And the opposite would hold true in a downtrend.
The following is what an Elliott Wave pattern looks like:
Wave 1 - Short Covering
Wave 2 - Pullback from Short Covering
Wave 3 - Major Rally Phase
Wave 4 - Institution Pause in the Rally
Wave 5 - Retail Buying
Let’s break down each wave so you better understand what they are.
Wave 1 is usually the weakest of the Impulse waves. This is considered a “brief rally” due to the bears covering their shorts. When this completes, the pairs briefly sells off again, creating Wave 2.
Wave 2 ends when the market fails to make new lows. In other words the low of Wave 2 does not go below Wave 1. Dominant reversal patterns often form at the end of Wave 2 and this signals the start of the “rally phase” of Wave 3.
Wave 3 is the longest and strongest of the impulse waves. This wave signals strong currency buying (or selling) in the direction of the trend. Wave 3 starts slowly, starts accelerating and breaks new highs above Wave 1.
Waves 4 is the start of the correction. Like any trend, especially a very strong trend, corrections occur. Forex traders begin to take some profits off the table and the currency pair will begin to retrace. This signals the beginning of Wave 4. And once again, as Wave 4 exhausts itself, the currency pair will begin to rally which is now the beginning of Wave 5.
Wave 5 is supported by retail forex traders (normal folks like you and me), not institutional traders (the herd). Wave 5 tends to lack the momentum generated by the Wave 3 rally. This move will create divergence that can be measured on any technical oscillator, MACD, stochastics etc. Once the highs of Wave 3 are broken by Wave 5, the rally loses steam and starts changing trend. This can either result in a new 5 Wave impulse pattern or a correction.
There are some very important rules you need to follow when analyzing Elliott Waves:
1. Wave 2 can never retrace more than 100% of Wave 1
2. Wave 4 may never end in the price territory of Wave 1
3. Wave 3 can never be the shortest by price distance when compared to Wave 1 and Wave 5
4. Wave 2 is usually a sharp retracement of Wave 1
5. The most likely wave to extend is the 3rd wave of an Impulse.
6. Waves 2 and 4 alternate between sharp and sideways movement
7. When Wave 3 is extended and complete, Wave 1 and 5 are usually about the same length in time and price
8. The corrective Waves 2 and Wave 4 often form an ABC pattern
Elliot Waves are best used with Fibonacci Studies. Fibs help you know when a retracement (correction) may end and another impulse begin. Here are some fib levels to be aware of when analyzing Elliott Waves:
1. More often than not, Wave 2 is a sharp correction and should retrace Wave 1 by approximately 61.8% or 78.6% of the price distance
2. Wave 3 is often a 200.0-261.8% fibonacci projection of Wave 1 by distance
3. Wave 4 often retraces 38.2-61.8% of Wave 3 by price distance. If Wave 2 is a sharp correction, Wave 4 will be a shallow correction, to trend towards possible consolidation
4. Wave 5 is often a 127.2-161.8% fibonacci projection of Wave 3 by distance and this last impulse Wave 5 forms with reducing momentum, thus creating a Divergence
Bullish Elliott Wave Example:
In this example, the first impulse wave is from EW0 to EW1. The move from EW1 to EW2 is the corrective wave which is usually a sharp pullback and forms at 61.8 to 78.6% fibonacci retracement of the EW0-EW1 move in distance. Many times the EW1-EW2 move itself will have a smaller ABC pattern form as it retraces. If you're using a higher timeframe chart like the 1 hour, 4 hour or daily, the ABC pattern could also be broken down into fibs where A=50 to 61.8% of EW0 to EW1, B=50 to 61.8% of EW1-A and C=1.27 to 1.618% projection of A-B. Our chart is too small to show this breakdown, but it is something to look for on the higher timeframes. Next, EW3 forms at 200 to 261.8% fib projection of EW1-EW2. EW3 is the 2nd impulse wave and is the largest of all the three impulse waves. After EW3, EW4 forms which is a shallow corrrection. EW4 is usually 50 to 61.8% of EW2-EW3. As we noted above, EW4 should not go beyond the level of EW1. After EW4, the 3rd impulse wave EW5 forms and has less momentum and usually creates divergence on any of your oscillators. EW5 is typically 1.27 to 1.618% of the EW3-EW4 move. In this example, we have 3 impulse waves and 2 corrective waves before hitting EW5 and starting a reversal.