Now it’s time to cover Elliot Wave principle basics. Firstly, if you make your trading decisions based on chart patterns then these decisions should be supported by some form of probability analysis – how potential such a move is and when is it likely to happen.
Elliot Wave theory all by itself is unable to predict specific price movements but it does help us recognize the state of the market and probable price actions. By using Wave theory, it does help us find the most profitable wave formations. Elliot Wave principle is not a replacement for any chart patterns and such, but rather puts the patterns into the bigger picture allowing us make better and more profitable trading decisions.
In order to become a successful trader, you do need to have different skills and lots of knowledge about the markets. However, one very important but often underestimated factor is Timing. In order to take cuts from forex’s 24 hour market, maybe just couple of pips with a trade, but do that dozens of times a day, your timing does need to be very good. Elliot Wave principle tries to help us with that.
At the same time, of course you must know that errors, wrong decisions, flaws are part of life. Elliot wave predictions does have its flaws and we have to accept them as a part of life. The main thing is that Elliot Wave theory, altogether, if used correctly, does help us make better and more profitable trading decisions.
In short, Elliot Wave Principle has only 3 trading rules. Plus around a number of guidelines for its framework that I will discuss in my next post.
What are the 3 Elliot Wave trading rules?
- Wave 2 does not retrace past the starting point of Wave 1. So if the impulse waves are going up, then the end of wave 2 should always be Above the beginning of wave 1. And if the impulse waves are bearish, then it’s exactly vice versa.
- The wave 3 can not be the shortest of the impulse waves, instead usually it is the longest one (but not neccessarily).
- In bullish movement, the bottom of wave 4 can not be as low as the the peak of wave 1. In bearish movement the peak of wave 4 can not be as high as the bottom of wave 1.
These 3 are strict rules that need to be applied. If the chart doesn’t look like that, the sequence is not impulsive and elliot wave pattern can’t be used here - or there's an extension to some wave (more about that in my next post). See the example below to understand it a bit better.
How does a general elliot wave wave chart look like? See this example 1. On this chart there’s a the 5 wave pattern followed by a correction pattern of 3 waves. The waves 1,3 and 5 are called impulse waves (this case upward movements), wave 2 and 4 corrective waves (this case downwards movement). Overally, when looking at the bigger picture we could say that the waves 1-5 is corrected by waves a-b-c. And if we look at a even bigger picture, then we can see that shorter (eg. on 10 minute chart) waves are used to put together similar bigger waves (eg. 10 minute chart). See this example –
Note that the waves do not have to be that nice as you can see on the chart. Sometimes there can be extensions to the impulse waves. It means that some waves might be out of scale compared to other impulse waves. Extentsions occur usually in only one impulse wave, mostly in case of 3rd wave. See the following example where the red (1)-(5) is an extension to the impulse wave 3. There can also be extention waves within the extension wave in the similar manner.
I do agree that sometimes it might be quite confusing to look at such elliot patterns/waves, but I think once you get the theory you are able to notice these things without spending much time.
And just to make things just a bit more difficult, there’s one more variation to impulse waves – diagonal triangle. See how this looks like below –
Note that diagonal triangle’s subwave consists of 3 waves instead of five. However Special Type consists of 5 waves. See below –
If fifth wave fails to exceed the peak of 3rd wave, this is considered an indicator for reversal.
Corrective waves have more variation patterns than impulse waves and we can usually see those patterns only After they have evolved. Some main forms are zigzags, triangles, flats, irregulars; more complex patterns are doubble- and triplle threes. As there’s really lots of different variations here, I won’t go deeper into this issue. Rather – just see the general layout of the waves and I believe we are able to notice these from charts without knowing the exact patterns – maybe when looking for them, just check the variations names brought out above.
Fibonacci numbers & ratios
Elliot Wave uses fibonacci numbers as a part of its theory. What are fibonacci numbers? To get a sequence of fibonacci numbers you would add the previous number to the current number to get the next one. Eg. Fibonacci numbers are 1,1,2,3,5,8,13,21,34,55,89,144 and so on. After the first 4 digits, if you divide the current number to the previous one you will get a ratio of 1.618, eg. 89:55=1.618. Or if you divide the current number to the next number you get the ratio of 0.618, eg 55:89=0.618.
If you divide a fibonacci number by the number that precedes it two places you’ll get 2.618 accordingly. And if you divide a fibonacci number by a number 2 numbers following it, you’ll get the ratio of 0.382. Eg 13:34= 0.382.
What do fibonacci numbers have to do with Elliot Wave theory? Simply put – the fibonacci ratios, according to Elliot Wave theory, are the primary factor of the extent of price and time movements in ANY market. Main relationships can be found between the waves in the similar direction – eg. The length of 3rd wave is influenced by the length of 1st wave.
In Wave theory, deviations and abnormalities are not exceptions in Wave theory, but rather rules.