On today’s episode, we will be discussing and introducing Elliott wave theory. Elliott wave theory was developed by Ralph Nelson Eliot in the 1930s. Elliot believed that markets generally did not behave randomly, and in fact, traded in repetitive patterns, let’s now take a look into Elliot wave theory and how it is applied to the forex market.
Elliott theorised that trends in financial prices resulted from market participants psychology. He found that swings in mass psychology always relayed themselves in recurring fractal patterns or waves in financial markets.
Elliott’s theory resembles another theory we will talk about in the future, known as the Dow theory. Both theories recognise that prices move in waves. Elliott however additionally recognized that the market had a fractal nature. Fractals, which we have discussed previously, are mathematical structures. On a small enough scale, they infinitely repeat themselves.
Elliott identified that price patterns were also structured the same way. From this, he then tried to find a way that is repeating patterns could be used as a leading or predictive indicator.
Elliott derived detailed stock market predictions, based upon the reliable characteristics he discovered in the wave patterns.
In this example, we have an impulse wave, it travels in the same direction as the larger trend, and there are always five waves within this pattern.
Next, we have a corrective wave. This travels in the opposite direction of the main trend.
Within the forex market, wether price moves up or down, it is always followed by a correction or an opposite movement. Trends show the main direction of prices, while corrections move against the trend. These examples are two waves that represent both movements.
Lets now take a closer look into the impulse and correction waves. The impulse wave has five waves moving in the direction of the overall trend. This is followed by three waves moving in a correction against the trend. This two waves made up of 5 and 3 moves, they then become the two subdivisions of the next higher wave move.
Look at the following example made up of the eight total waves we have discussed. The impulse wave is labeled 1 to 5, and the correction wave is labeled A to C. The five wave impulse, in turn, goes on to form wave 1 at the next largest degree, and the three-wave correction goes on to form wave 2 at the next-largest degree.
The properties of the corrective wave normally have three distinct price movements. Two of the movements are usually in the direction of the correction, these are counter-trend, and one move travels in the -direction of the trend. Similarly, in Waves 2 and 4 of the impulse wave, these are corrections against the trend.
So to summarise this information so far, waves are formed by market movements, they are defined by their behaviour. The entirety of an impulse wave and correction wave together can form the beginning of a larger degree wave.
How do we know if we are seeing a wave in progress? As always, there are rules to the identification of waves.
Wave 1: Wave one is not always apparent at first. When the first wave of a new Bullish market begins, fundamental and technical outlook is usually entirely negative. The previous trend has not given us enough information to consider that it is about to reverse. Sentiment is usually still bearish at this point and, remember, Elliot wave is rooted in psychology.
Wave 2: Wave two is the correction of wave one, it can never extend beyond the beginning of wave one, or it becomes invalid.
Prices retest the previous low, bearish sentiment can quickly increase as people anticipate the downtrend may continue; however, volume is generally lower than seen in wave 1. If we were to measure this retracement, it’s very common that it doesn’t go beyond the 61.8% level when using Fibonacci.
Wave 3: Wave three is usually the largest movement in the wave in a trend and can generate the largest yield in pips. This can vary in different markets such as commodities where wave 5 is sometimes the largest.
The fundamentals now are more positive, and prices begin to rise quickly, Smaller corrections usually are short-lived and shallow, and an opportunity to now get involved in a pullback is limited. It is often at the midpoint of wave three that market participants begin to change their sentiment and heavily get involved in the buy-side. The bullish trend is now becoming certain. Wave three often extends wave one by a ratio of 1.618:1. Fibonacci shows it’s hand once again.
Wave 4: Wave four is the second corrective move. Prices may stall and move sideways for an extended period. Wave four typically retraces less than 38.2% of wave three. We see volume levels well below that of wave three. This can be a good opportunity to buy in the pullback when expecting the potential rise for wave 5.
Wave 5: Wave five is the last phase in the direction of the now dominant trend. News is almost universally positive, and bullish outlook is almost universal. Volume is often lower in wave five than in wave three, and we begin to see divergence on momentum indicators. Despite market participants still entering buys the move is now complete, and the correction wave is anticipated.
Next the Correction
Wave A: Corrections are generally harder to identify than impulse moves. In wave A of a bear market, the fundamental news is still positive. The behaviour seen is similar to that of the beginning of wave one. We may see increased volume and possibly a turn higher in Open interest, our video explaining open Interest is a very good lesson in regards to this.
Wave B: Is the correction, Prices reverse higher, some participants see this as a resumption of the bull market. Technical analysts may see the peak as the right shoulder of a head and shoulders reversal pattern. Fundamentals are probably getting worse at this point, but not entirely negative, and volume during wave B should be lower than in wave A.
Wave C: Prices move steadily lower. Volume increases, and the bear market is now confirmed. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.
Elliot wave theory is a complex and expansive subject that we will look to continue teaching in the future. This introduction to the theory is just the tip of the iceberg in terms of what there is to know. Please contemplate what you have learned here today and remember contemplation is the key to learning.