What Is Elliot Wave Theory? A Comprehensive Overview

Acting as the basis of technical analysis, Elliott Waves have become a real sensation among financial traders. The theory was developed by American accountant Ralph Nelson Elliott in the 1930s when he analyzed over 70 years of stock market data. Although Elliott came up with this theory when evaluating the stock market, it applies without limitation to all financial markets, including Forex.

Here we delve deeper into Elliott Wave Theory, examine its components and illustrate a real-life example.

What is Elliott Wave Theory?

Nelson Elson first shared his Elliott Wave theory in a book called The Wave Principle.

According to him, markets move in "repetitive patterns" due to public psychology and external factors. He explained that the ups and downs in prices known as "waves" regularly follow a certain rhythm and are driven by general public sentiment. Like the recurring movement of ocean waves, the movement of financial values ​​also follows a predictable pattern.

The theory is that if you can identify these market waves, you can make informed predictions about where the price will go next. This technical analysis technique can help you identify specific points where the market is making a low, high or reversal.

Simply put, Elliott concluded that although the stock market (or any other financial market) may appear chaotic and chaotic, they are structured and organized. By studying the market patterns described in this theory, traders can predict future price directions and potential profits.

Elliott Wave - Stimulating and Corrective

Now let's look at the two types of waves that are part of Elliott wave theory.

In theory, a trending market follows a 5-3 wave pattern . This means that the first part of the chart has 5 waves called impulse waves and the last part of the chart has 3 waves called corrective waves . The last partial correction waves are usually called A, B and C.

pulse wave

Impulse waves 1, 3, and 5 are also called "motivational waves" because they follow the same direction as the general trend. On the other hand, waves 2 and 4 rotate in the opposite direction of the normal trend and are called "corrective waves". (These latter parts of Elliott waves are not corrective waves. ABC corrective waves are different and will be discussed in the next section.)

For better understanding, the following is a convenient representation of the 5-wave bullish impulse pattern. The same pattern changes in bear market conditions.

What each of these waves represents.

(We've seen a "bullish" Elliott wave scenario that occurs after a downtrend.)

• Wave 1: Indicates the emergence of a new trend after the end of the previous trend. Wave 1 occurs suddenly when the property is devalued and people start buying. Note that identifying this wave can be challenging because it occurs close to previous trend waves.

• Wave 2: Represents the first reversal of wave 1 towards the previous trend. Those who were part of the previous cycle pulled their money out of the market when signs of a reversal trend appeared. This action causes the asset price to fall, causing wave 2 to return. Note that wave 2 can never cross the starting point of wave 1.

• Wave 3: Wave 3 represents the time when the property attracts public attention and most people rush to buy it. Therefore, this is the strongest wave in the Elliott pattern that easily breaks the top of wave 1. Note that wave 3 can never be a short wave in an Elliott Impulse.

• Wave 4 : This is another corrective wave in the pattern, indicating that the "boom" phase of the price increase is over. Generally, wave 4 shows ambiguity and weakness as there is a tension between still strong and exiting markets. Note that wave 4 may not reach the same price zone as wave 1.

• Wave 5 : This particular wave shows the last buying activity before a new trend is formed. This is the last wave in the direction of the current trend, after which the ABC adjustment phase begins.

Remember that an Elliott wave always "expands". This is usually wave 3, but it can also be wave 1 or wave 5.

Corrective wave

After completing wave 5, the trend reverses through 3 opposite waves called corrective waves. This is what the corrective wave – ABC – looks like at the lower trend and high.

According to Elliott Wave theory, there are 21 possible ABC patterns. However, all ABC patterns have variations in these 3 directions, so you only need to remember their 3 basic shapes.

zigzag

Zigzag ABC pattern is a price action that is consistent with the previous impulse wave trend . Generally, wave B will be shorter than wave A and wave C in this case.

Apartment

As the name suggests, plane rectifier waves produce a side pattern. In this case, all the waves - A, B and C - are generally the same length, although they are not set in stone.

the triangle

The ABC triangle shape can be made as an ascending, descending, symmetrical, or open triangle. This pattern usually consists of 5 side waves, 3 of them (A, B, C) are part of the correction phase.

This is a complete picture of Elliott Waves based on the theory proposed by Nelson Elliott.

Also note that Elliott Waves are "fractal" where each wave is divided into 5 or 3 other wave patterns. Simply put, Elliott waves can be decomposed into many smaller Elliott waves.

A real example of applying the Elliott Wave theory - XAUUSD

Below is an example of a recent successful Elliott Wave analysis on the XAUUSD 4-H chart. As you can see, the bullish pressure waves have run their full course and given many trading opportunities to market participants. Note that traders typically use Fibonacci retracement levels to determine possible retracement points for waves 2 and 4.

A zigzag corrective wave is then formed in the opposite direction of the previous uptrend. What followed was the start of a new downtrend and a new Elliott wave.

In general, Elliott Wave Theory allows traders to approach the market in a systematic way and use recurring price waves. Although Elliott Waves look a little tricky on recent price charts, you can improve your ability to spot them with careful analysis and regular practice .

Learn more:

https://thetradingbay.com/fibonacci-retracement-levels-using-how-to-trade/