Ralph Elliott was a professional accountant and theorist who lived in the first half of the XX century. He discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves.
What is Elliott Wave Theory?
Elliott proposed that trends in financial prices resulted from investors’ predominant psychology. He found that swings in mass psychology always showed up in the same recurring “waves” in financial markets.
Elliott theory resembles the Dow theory in that both recognize that stock prices move in waves. However, Elliott was able to break down and analyze markets in much greater detail. Elliot began to look at how these repeating patterns could be used as predictive indicators of future market moves.
In the financial markets, we know that “what goes up, must come down,” as a price movement up or down is always followed by a contrary movement. Price is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.
Five waves move in the direction of the main trend, followed by three waves in correction (totaling a 5-3 move). This 5-3 move then becomes two subdivisions of the next higher wave move. Waves 1, 2, 3, 4 and 5 form an impulse, and waves 2, 4 are corrective.
Let’s discuss the Wave Theory using an uptrend as an example:
- The first wave is a beginning. It is abrupt price change triggered by a large infusion into one or another asset. It is difficult to predict because the sharks determine the trend, and lesser traders just support it.
- The second wave is a correction. It is formed as a result of partial closing of buyers’ positions and a desperate attempt by sellers to “add” to the previous position and hedge the loss.
- The third wave is the strongest. Sellers stop selling as more buyers come to the market. A steady upward movement is forming.
- The fourth wave is correction. Large players fix their profits, realizing that the current movement is already losing its relevance.
- The fifth wave is dangerous. It is formed at the expense of late buyers. It is misleading because the trend reverses sharply.
A similar situation occurs with the downward movement. However, the down trend has three waves.
How to trade according the Elliott Wave Theory?
Well, it goes without saying that for successful trading you need to enter a trade at the beginning of the third wave formation. To predict its appearance, you need to determine the wave structure and predict the end of the second wave.
To do it, you will need:
- Two indicators: SMA and moving average.
- Two moving averages 14 and 21 periods.
- Japanese candlesticks.
- Timeframe – 15 to 45 minutes.
More tips how to trade options according to Elliott Wave Theory?
Let’s watch for the impulse movement, which will define the first wave. In this case, after the flat, the 14-period moving average should cross the 21-period moving average. The direction of the intersection indicates a trend.
If the trend is up, build a support line and wait for its breakout (the beginning of the formation of the second wave). With a downtrend, everything is exactly the opposite.
With the second wave, build a resistance line (for an uptrend) or support (for a downtrend).
When there is a breakout, it means there is the third wave. You can buy a contract in the direction of the trend.
Reminder! On the chart, moving averages should not touch or intersect. Otherwise, the signal is false and there is no stable trend in the market.
It is recommended to set the expiration time to three candles.
Elliott Wave practitioners stress that simply because the market is a fractal does not make the market easily predictable. Scientists recognize a tree as a fractal, but that doesn’t mean anyone can predict the path of each of its branches. In terms of practical application, the Elliott Wave Principle has its devotees and its detractors like all other analysis methods.
One of the key weaknesses is that the practitioners can always blame their reading of the charts rather than weaknesses in the theory. Failing that, there is the open-ended interpretation of how long a wave takes to complete. That said, the traders who commit to Elliot Wave Theory passionately defend it.