Elliott Wave Theory

Elliott Wave Theory
Elliott Wave

How Many Waves are There in Elliott Wave Theory?

The Elliott Wave is the brainchild of Ralph Nelson Elliott. The theory behind the Elliott Wave is predicated on the belief that stock markets do not behave in a random fashion; there are repetitive patterns at play determining how markets move.

Psychology governs the way market trends move, and based on analysis by Elliott, there are recurring fractal patterns at play. These are otherwise known as waves. These wave patterns begin with an impulse wave which moves in tandem with the broader trend.

The Motive Wave is represented by the first 5 Waves and is known as the impulse. The corrective wave is represented by 3 Waves which zigzag.

Corrective waves move in the opposite direction to the broader trend and can be interpreted as a downswing or an upswing in activity. With the Elliott Wave Theory, there are 5 Waves which move in sync with the main trend overall. This is followed by 3 Waves which act in a corrective capacity, giving rise to a 5-3 wave pattern.

This is a constant feature of the Elliott Wave. In total, there are 8 Waves at play.

The first 5 Waves are known as the impulse, and the final 3 Waves are known as the correction. The initial 5-Wave impulse gives rise to Wave 1 at the next biggest degree, and the 3-Wave correction forms Wave 2 at the next biggest degree.

In summary, the trend direction is represented by the motive wave and the corrections follow-on with 3 waves known as the corrective wave. Now that the ‘waves’ are in motion.

You can open an account at AvaTrade and put this theory to the test

How Does Elliott Wave Theory Work?

The Elliott Wave Theory can be complex for the layman trader to understand, but it can be simplified into its rudimentary components. Each movement in a stock market trend is made up of 5 smaller waves that are known as impulse waves.

These are represented by numbers 1, 2, 3, 4, and 5 on any Elliott Wave chart. If we are visualising an uptrend, the path would be comprised of different waves moving in different directions, with a general trend that is positive.

Each wave is made up of 5 micro-waves known as impulse waves.

Since pricing doesn't move in a linear direction, there are 3 small waves which move contrary to the direction of the trend. These are known as corrective waves, and they move in the opposite direction to the first 5 waves.

On each wave, there are multiple micro-waves as alluded to earlier. There are 5 impulse waves in Wave #1 which move prices in the direction of the trend, followed by 3 impulse waves in Wave #2 which move prices in the opposite direction.

From a trading perspective, several rules need to be understood so that you can trade stocks on the ASX (Australian Securities Exchange). Let's briefly explore these rules:

  • Wave #2 does not retrace Wave #1
  • Wave #3 is always the biggest wave until that point in the Elliott Wave
  • Wave #4 is not allowed to overlap Wave #1

Having said that, the theory needs to be painstakingly studied and analysed in order to identify trends and patterns in the market. Nonetheless, you can apply the Elliott Wave theory when trading online.

If you watch the AUD/USD currency pair for example, it's possible to break the waves down into components known as fractals and evaluate potential trends using this technique. Be advised that there are always 5 impulse waves at play and 3 corrective waves in action with Elliott Wave Theory.

Downtrends and uptrends can be plotted, and always watch for Wave #3 – it largest of all the impulse waves.

What is an Elliott Wave Indicator?

Traders make use of technical and fundamental analysis all the time. The Elliott Wave Indicator is one such tool that is readily available as a technical analysis resource. It helps traders to predict the cyclical price movements of the forex market, the stock market, the indices market, and the cryptocurrencies market.

The crux of Elliott Wave Theory is rooted in the notion that markets do not behave randomly – there is a repetitive pattern at play. Elliott Wave indicators are postulated on trader psychology and speculative sentiment to drive market behaviour.

This sentiment is represented by 5 impulse waves and 3 corrective waves. These indicators must meet the pattern to satisfy Elliott Wave status, notably:

  • Wave 1 > Wave 2
  • Wave 2 < Wave 3
  • Wave 3 > Wave 4
  • Wave 4 < Wave 5

The Elliott wave indicator serves as one of 3 Elliott waves that currency traders typically use vis-a-vis the Elliott Wave Theory. The others include the Elliott Wave Number (EWN), and the Elliott Wave Oscillator (EWO). Whenever a trader is using Elliott Wave indicators, it is imperative that an accurate wave count is undertaken. If the wave count is inaccurate, the count needs to begin anew.

How Do You Trade with an Elliott Wave?

Given the complexity of understanding the Elliott Wave, it's advisable to practice implementing Elliott Wave methodologies on demo trading platforms before applying it in a real-life scenario.

An in-depth understanding of each stage in the Elliott Wave is necessary before you trade Australian stocks, bonds, currencies, indices, cryptocurrencies, or other options.

Given that every financial asset has a fluid price (markets are dynamic), it's imperative that you figure out where that price fits in on the Elliott Wave chart.

With that in mind, it is much easier to anticipate price movements, particularly the magnitude of those price movements (up or down) and what to expect moving forward in the next wave cycle.

Another useful resource for trading the Elliott Wave is known as the Elliott Wave Oscillator. This is predicated on MACD (Moving Average Convergence Divergence) methodology.

Many traders tend to use a 5-period MA (Moving Average) across 35 periods. By plotting the residual difference between the 5-period MA and the 35-period MA, you can pinpoint precisely where you are on the Elliott Wave cycle given the 5-3 wave pattern.

That’s all you need to know to get started. Open an Account at AvaTrade today and catch the next wave!