Elliott Wave Theory was created to reveal the secrets of the development of financial markets. It is one of the strategies that allow you to successfully trade in such markets, in particular, Forex. This article gives the principles of the Elliot theory, according to which you can continue to study such a complex but interesting strategy.
What are Elliot Waves?
Elliott Wave Theory is a theory based on mathematics that allows you to determine the behavior of society or financial markets using established patterns. Elliot believed that the development and change in the behavior of society or traders can be predicted using the theory of waves.
Elliott Waves can be used to trade the financial markets as they apply to any commodity or asset. To do this, it is necessary to recognize wave patterns in the price chart that are constantly repeating.
History
The theory of waves was developed by Ralph Nelson Elliot in the 30s of the 20th century. Studying price changes in the stock markets, he came to the conclusion that they all occur according to the same scenarios (models). All identified models, and he counted them13, have the same shape, but may be different in amplitude and time.
Elliot in 1938, together with the financier Charles Collins, published the book "The Wave Principle". After 12 years, Elliot wrote his main book, The Law of Nature. The Secret of the Universe”, which became the starting point for the study of the wave theory not only of financial markets, but of all mankind as a whole.
What is the wave theory? Core Principles
In order to analyze Elliott waves, you need to know the principles and postulates of this theory, as well as the symbols:
- Every model has the same construction. First, there is a price movement (shown in green on the chart), and then a correction of these prices (shown in red on the chart).
- All waves are divided only into impulsive (movement waves) and corrective (price correction waves). They follow each other. For example, after impulse wave 1 comes corrective wave 2.
- Price movement or trend movement is represented by five waves. Three of which are impulse, i.e. cause price movement, and two corrective, directed in the opposite direction from the impulse side. These Elliot waves are numbered 1, 2, 3, 4, 5. Below are the Elliot waves on the chart.
- After the completion of the trend movement, a period of correction of such a movement necessarily follows. Which consists of two impulse waves and one corrective wave, they are designated as A, B, C.
- Each wave consists of smaller waves that have the same structure aslike big waves. Now the wave chart looks like this. Based on this model, it is easy to predict what will happen next with the price and make an Elliot wave forecast.
- All waves are interconnected, none of them exists separately from the others. Each wave has a certain structure and occupies a certain place in the model.
- All wave patterns are connected to each other, thus they create models of large sizes, and those, in turn, other models.
Fibonacci mathematics and its connection with wave theory
Leonardo Fibonacci was a great Italian mathematician. Among his many works in the key of the article, only one sequence of numbers identified by him, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc., will be of interest. There are many interesting things in this number sequence:
- When adding the previous two numbers, the following number is obtained: 1+1=2, 1+2=3, 2+3=5, 13+21=34, etc.
- Dividing the number by the previous one, we get approximately 1, 618.
- When dividing the previous number by the next one always comes out approximately 0.618 or 61.8%, this is the so-called "golden ratio".
"Golden section" - this is a division of the segment, in which most of the segment will be related to the entire segment as well as a small segment to a large one. Objects having such a shape have always been considered ideal, although not proportional, and the "golden section" itself is a kind of standard. The world's golden ratiofound everywhere, and allows you to determine the development of both animals and plants, and financial markets. To understand the relationship between Elliot Waves and the Golden Ratio, consider an example.
The figure shows 4 large waves 1st and 3rd (impulsive), and 2nd and 4th (corrective). If you look deeper, then the impulse wave contains 5 small waves, and the corrective wave contains 3 waves, add them up, and you get 8. The sequence will continue if you count even smaller waves, their number is 34 and so on. Here you can clearly see the Fibonacci number sequence.
So, the theory of Elliot waves and Fibonacci are related. Using Fibonacci openings, you can determine the continuation of the trend or the end of the correction, which is very important.
Rules for the formation of waves in a trend impulse
There can be no common truths in the theory of waves, since there are no axioms in the financial markets themselves. But there are rules that apply to most situations and allow you to conduct Elliot Wave analytics. And a violation of at least one should make you wonder if the model is correctly superimposed on the pricing schedule. These rules include:
- Wave 2 cannot go down to the level of the beginning of wave 1. The characteristic size for wave 2 is approximately 38% - 61% of the length of wave 1. Wave 2 develops due to market uncertainty. This is one of the most important and invariable rules, a corrective wave cannot reach and be larger than the impulse wave that precedes it.
- Wave 3 should not be the smallest among waves 5, 3, 1 i.e. impulsive. Its end level must be higher than the end level of wave 1. In exceptional cases, wave 3 may be shorter than other waves, but it must be remembered that this is more of an exception, and the pattern is incorrectly overlaid.
- Wave 4 is quite difficult to identify, as it is often only 38% of wave 3 in size. Wave 4 does not approach the price range of wave 1 (2).
- Wave 5 in most cases reaches a level higher than wave 3. It is 38% larger than wave 4.
- Waves 4 and 2 must differ from each other in one or more criteria: different nominal move size, different internal structure, formation time, retracement level.
Signal lines
One of the main assistants in determining the beginning and end of an impulse, as well as the beginning and end of waves, are signal lines that pass through certain points of the model.
- The first signal line can be seen by drawing a line through the starting point of wave 1 and the top of wave 2. Rule of this signal wave: waves 1, 2 and 3 should not cross this signal line. Purpose: the line allows you to determine the starting point of waves 3 and 1, the end of wave 2.
- The second signal line is formed by drawing it through the tops of waves 4 and 2. Rule: waves 5, 4, 3 cannot cross this signal line. Exception: wave 5 can cross the signal line atThermal Impulse.
A, B, C – correction
There are a lot of correction models, divided into simple and complex, but the main ones are:
- Zigzags. It is characterized by price jumps in the opposite direction from the momentum period. Wave B is shorter than waves A, C. Correction may consist of several zigzags.
- Range. Characterized by lateral movement.
- Triangles. They have movement against the impulse or sideways, often consist of 5 waves. There are ascending, descending, expanding, symmetrical triangles.
Elliot Wave Indicators
Since the theory itself is complex and involves a large amount of subjectivity, it is impossible to come up with a universal indicator. Despite this, for a simplified analysis of Elliot waves, various indicators are created and improved. In any case, using them, a person must conduct personal control over the situation on the market and be familiar with the theories of Elliott and Fibonacci waves. The indicators are easy to install and all come with instructions for use. The most famous are: Elliott Wave Prophet (EWP), Watl, Elliott Wave Oscillator (EWO), Elliott_Waves.
- EWO determines the strength of the momentum, but is not able to accurately determine the beginning of the wave.
- Watl draws charts clearly and completely, but to use it, you need to study the instructions for the indicator.
- EWP draws waves well and even tries to predict further price development, but often forecasts failis correct.
Each Elliott wave indicator has both advantages and disadvantages. They should be considered as assistants in determining the waves, but by no means accurate forecasts.
Disadvantages of Elliot Wave Theory
There are enough criticisms of Elliot's theory, but it all boils down to a few points:
- The analysis of Elliott waves is diverse and often depends on the subjective opinion of a particular trader. Each trader sees the situation in his own way, which means that the wavelengths are seen differently. Which leads to a difference in strategies.
- Complexity and intricacy of the method. In the tutorials, everything seems much simpler, but in practice, the waves are not so beautiful and clear. It is difficult to determine what wave the financial market is on.
- There are a lot of books and studies on Elliot Wave Theory, so it can be difficult for a beginner to figure it out. In addition, many researchers offer their own interpretation and conclusions on Elliot's theory.
It is impossible to predict the behavior of the financial market only on the basis of wave theory, it is also necessary to take into account the economic, political and social aspects.
