Elliott Wave theory is widely used in technical analysis to explain historical price movements in the Forex markets and to predict future trading opportunities. The theory claims that prices move in waves, with each wave representing a particular moment with in a rhythmic, regular and repetitive pattern that reflects group psychology and market sentiment. The infinite repetition of the Elliott Wave pattern means that traders are able to reliably predict the next pattern.
"Very extensive research in connection with practically all human activities indicates that social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring serials of waves or impulses of definite number and pattern. It is likewise indicated that in their intensity, these waves or impulses bear a consistent relation to one another and to the passage of time." - R.N. Elliott 1938
It is this research that refers to the underlying concept that crowd theory is a key explanatory factor in how price points are determined. The price moves in a set of waves, and once the current location of a price point has been determined within the relevant wave pattern, future prices can be gauged.
This educational guide provides an overview of Elliott wave Theory.
In This Article:
- Origins Of Elliott Wave Theory
- Importance Of Elliott Wave
- Types Of Elliott Waves
- Counting Impulse Waves
- Counting Corrective Waves
- Summary
Origins Of Elliott Wave Theory
The Elliott Wave Theory is named after Ralph Nelson Elliott, an American accountant who in the 1930's, conducted extensive research into the financial markets. He concluded that price action is not random or chaotic, but is instead a series of pattern repetitions. When analysed from a broader perspective, they look like ocean waves in long patterns.
Trades that are to count wave patterns and understand that the waves are repetitive, are able to take early positions in anticipation of the next wave pattern commencing. It is the ability to reliably predict the next pattern that makes Elliott Wave theory perhaps the most widely used indicator for traders, including the big financial institutions known as "market movers".
Importance Of Elliott Wave Theory
The Elliott Wave theory claims that price patterns are repetitive. Understanding how the patterns are formed and the psychology behind each wave, traders are able to gain an insight into where price action currently sits within a pattern and what to expect next. Having this knowledge allows for early trading positions very early into an emerging trend.
Elliott classified the waves patterns as either "impulse waves" or "corrective waves". Impulse waves always move in the direction of the longer term trend and consist of a five-wave pattern, corrective waves move against the longer term trend and are formed by a three wave pattern as seen below:
It is important to remember that impulse waves move in the direction of the trend, many traders mistake impulse as meaning bullish. The above sketch demonstrates how an impulse wave can move in either an upward or downward position, but will always be followed by a three-stage corrective wave in the opposite direction.
For the purposes of clarity we will discuss the impulse wave in a bull market shown on the left. The initial five-stage impulse wave is followed by the three-stage corrective wave, counted by the ABC references. This is where Elliott Wave traders have the advantage. Knowing that patterns are destined to repeat themselves and the that corrective wave has completed with Wave C, a long position can be taken knowing that a second impulse wave is due to commence.
Alternatively, the position may have been closed when the initial impulse wave completed with Wave 5 and the trader may decide not to trade the correction. Being able to count the corrective wave accurately means that the trader can sit patiently and wait for the next impulse wave. Many traders choose not to trade corrective waves as they can be quite difficult count, for ,more information, see our guide to corrective waves.
Types Of Waves
The Elliott Wave Theory proposes that all market action can be broken into two types of wave patterns, an impulse wave and a corrective wave.
Counting Impulse Waves
Always made up of five ways and in the pattern shown below, the impulse wave pattern can be found in any time frame. The fractal nature of Elliott waves means that each element of the wave will contain the same pattern within a smaller time frame, for instance Wave 1 shown below will be formed of the same five-stage wave pattern.
An impulse wave should be quite easy to identify, there will be high trading trading volume seen in the three impulse waves 1, 3 & 5, coupled with strong momentum, particularly with Wave 3. The smaller corrective waves 2 & 4 will see both volume and momentum weaken. The pattern is easier to identify on longer time frames due to less market noise, so if you are having difficulty identifying the pattern on a 30 minute chart, zoom out to 1hr and see if that helps you identify where current price is.
Successfully counting the stages of impulse waves is the key to being able to predict future price movements, however, many new Elliott Wave traders will get this wrong and concede defeat before getting to grips with the strategy. To learn how to count impulse waves successfully we have written a guide to the rules of counting impulse waves and the sentiment behind each element.
Counting Corrective Waves
A corrective wave when discussing Elliott Wave Theory is defined as movement against a larger trend. It can be a common mistake by new traders to assume that "corrective" means bearish or downward momentum. Forgetting that both corrective and impulse waves can move in either direction makes it more difficult to count waves.
Corrective waves are formed during periods of consolidation and uncertainty that can last long periods of time. During these period prices will stagnate and trading volume decrease. Due to the lack of momentum, wave patterns are more difficult to track and they can form in a a few different ways and for this reason many traders do not trade corrective waves, but instead track them to see when the next impulse wave is due to begin. For more information on counting, see our guide to corrective wave patterns.
Summary
Elliott Wave theory is perhaps the most widely used technical tool used by Forex traders to predict future price movements. It's claim that price action moves in rhythmic and repetitive patterns means that if the waves are correctly counted, traders are able to anticipate group behaviour and take early positions.
