What is the Elliott Wave Principle?
Have you ever watched a market, either in the form of just watching price action or having a chart and watching how the prices move, and noticed that a move up is almost always followed by a slight correction? Or a move down is almost always followed by a slight recovery? Or have you seen that prices never ever move in a straight direction forever, in whichever timeframe you look at it? This are the Elliott waves in action. Unlike the other technical strategies and theories that are based on hypothetical historic mumbo jumbo, the biggest advantage of the Elliott wave theory is the fact that you can see it in action right before your eyes on a daily basis, without fail. That’s the beauty of this theory though it is turned a bit ugly by the fact that it is quite difficult to understand and master it for any average trader.
Elliot Wave Theory Video Tutorial
The Elliott wave theory states that each move in the direction of the trend is composed of 5 smaller waves that are called as impulse waves. Now, assume that the price is in an uptrend, then a move in that direction would not be a straight path or a straight line but would actually consist of 5 smaller waves. Each of these 5 smaller waves would in turn be composed of 5 even smaller impulse waves and so on. But as we said before, the price does not move in a single direction always and so these 5 impulse waves would be interspersed with 3 smaller waves in the opposite direction that are called as corrective waves. So, the entire cycle of a wave actually consists of 8 waves, 5 larger impulse waves in the direction of the trend and 3 smaller corrective waves in the opposite direction.
This is represented in the above picture where it is assumed that the price is in an uptrend. In such a case, we find price moving with 5 waves in the direction of the trend, hence they are impulse waves, and then this would be followed 3 corrective waves in the opposite direction, which leads to a correction of the larger wave. Now, to break it down further, we had said that each of these waves can be further broken down into smaller waves. So, actually, wave 1 can be broken down into 5 smaller impulse waves which push the prices in the direction of the trend while wave 2 would be broken down into 3 smaller corrective waves which push the prices in the direction opposite to the trend.
This is better represented in the picture below:
Where you can see that each wave consists of a set of smaller waves. So, in wave 5, you see the 5 smaller impulse waves while in wave 2, you see the 3 corrective waves. This is the same for all waves, as you can see. This, in essence, is the Elliott wave principle. If you have not understood it fully yet, we suggest that you go back to the beginning of this tutorial and read it again and again till you understand this. The important points to understand are:
1) There are 5 waves in the direction of the trend, called impulse waves
2) There are 3 waves after that which are in the direction opposite to the trend, called corrective waves
3) The waves are fractal in nature, which means that each wave consists of other smaller waves.
The Most Important Elliott Wave Rules
Now that you have understood what Elliott wave theory is, you need to understand how to apply this into trading. For this, you need to understand some simple rules of the wave patterns:
- Wave 2 cannot retrace the entire wave 1. If it does, then that count is invalidated.
- Wave 3 must be the biggest of the 3 waves formed till that point.
- Wave 4 must not overlap wave 1. If it does, then that count is incorrect. You are looking at the wrong wave structure and it is important that you go back to the beginning again and start counting from a different starting point.
There are several other guidelines attached to these rules but we believe that the guidelines need to be developed through the experience of counting the waves and it could vary between different instruments and charts and therefore, as far as guidelines are concerned, it is better to stick to forming our own, based on experience, rather than walking into a trade count with set notions.
How to Trade Using the Elliott Wave Pattern?
Now that we have covered all the theory that is there in this, we have to see how we can apply this to trading and Elliott wave predictions. Before we do that, it is very important to understand that unlike other indicators, the Elliott wave analysis is very difficult to master. You have to be ready to spend the time and the effort in order to look at hundreds and hundreds of charts and plot the waves hundreds and thousands of times for you to fully comprehend. It is not like an indicator that you just throw into your chart and voila, you get your next trade. It does not work that way but just as it is difficult, one reason why you should try to master it is due to the fact that a large number of very good and successful traders and fund managers use it as a tool for their trading. They understand the power of the Elliott wave principle and hence they spend the time that is needed to understand and grasp this powerful technique. So, be ready to put in the hard work so that you can enjoy the fruits of the hard work once you have mastered this theory.
For our practical understanding, let us start with a simple chart and a simple count. Though we have used a smaller timeframe chart, it is good and easy for beginners to use charts from higher timeframes.
Now, focus on the above USD/CAD chart. You can see a sample count there. It is just a sample count as unless we master it and see if our wave counts actually happening in real time, we would not be sure whether we have the right count. So, lets start with this by explaining why we have this count. The last part of the chart clearly shows that the pair is in an uptrend. That is the first thing that we have to make clear, whether it is an uptrend or a downtrend that we are plotting.
Now we start the wave count from the bottom, if it is an uptrend (if it is a downtrend, then the count starts from the top). So, the first move up is labelled as wave 1, then there is a retrace which is labelled as wave 2, then the next move up is labelled as wave 3 and it clears one of our rules which says that wave 3 needs to be the biggest of the 3 waves. Then there is a correction again, which is labelled as wave 4 and if you are confident about your count and are trading this count with a target for wave 5, then it is better to have a stop loss that is below our wave 4 or a stop loss that is within wave 1, as our rules state that wave 4 cannot enter into wave 1. If it does, then it means that we have the wrong count and we have to start the count all over again. This is the basic structure of how we count waves and how we try and trade them.
Below is another EUR/GBP chart which is at the other end, as far as complications go. Here, we have broken down the waves into fractals to show how each wave consists of even smaller waves.
Here we have shown you how wave 3 consists of smaller waves. We have chosen wave 3 as it is the biggest one and hence easy to understand. This is how a complicated count looks like.
Now, below is a chart that shows another simple count.
We have shown a chart with a downtrend and as you can see, we have wave 3 as the biggest one and wave 4 does not enter into wave 1. These 2 are the 2 most basic rules of any wave count. We suggest that you focus on larger timeframes and larger waves for the time being before you move to the fractals i.e. the smaller waves within the larger wave.
As for fixing targets for trades for your Elliott wave trading strategies, we have found that a combination of Fibonacci levels with the Elliott waves are the best Elliott waves strategies that can be used and they help us to come up with targets and also to determine the levels at which a specific wave is expected to end. Moreover, integration of other technical indicators such as MACD, RSI, Bollinger Bands and more can work out well for you if you find the correct formula. So, we can safely say that wave 2 is likely to end at the 61.8 Fibo of the wave 1 while wave 3, being the biggest one, is likely to extend to at least 1.618 Fibo of the wave 1. These are general guidelines and as we have mentioned before, these vary from one instrument to another and these are gained and become better with time, as we count more and more waves within the same instrument.
To make things simpler for beginners, there are also some good Elliott wave forex indicators for MT4 that are available for free on the internet. These tend to look at the patterns of the chart and then plot the wave counts automatically. For a start, the traders’ could possibly use them to understand how the counting is done and then try to overlap with the count that they have done themselves. It may also be good to take a clean chart and plot the counts and then compare it with the counts provided by the Elliott wave indicators.
Market Predictions Based on Wave Patterns
The above is a GBP/USD chart on a daily timeframe where we have labelled a large wave count spanning several years. An important point to note here is that we have done this count manually and we have combined this with Fibonacci. We have applied the fibo on wave 3 so that we can look at targets for wave 4. As you can see, the price now is at the 38.2 of wave 3 and there could be a reversal here which will then mark the end of wave 4. If it breaks through, then the likely targets of this wave are the 50 and the 61.8 of the Fibo.
Of course, this could take several months to form but this gives us an idea of how the Elliott waves work. We can shift the same thing to any timeframe, smaller or bigger to help us make forecasts of the price for our trading. And the waves also give us excellent places where we can place stop losses, something that not many trade strategies can boast of. This example has been given to show how Elliott wave predictions can happen and be used effectively.
So, from the above, you can understand a bit about the power of Elliott wave principle and how, by properly mastering the same, you would be able to make some good predictions of the markets and this would in turn lead to some strong and good trades. A major advantage of the Elliott wave principle is the fact that it works on any kind of a market. Of course, it does take some effort to understand the rules and to start counting and plotting the waves correctly but once the trader gets a grasp of it, it becomes easy and this can then be applied to any kind of a chart to predict that specific market. This is a very powerful technique and a combination of this with other simpler techniques like Fibonacci or MACD would help the traders to build some very good Elliott wave trading strategies.
Tips From the Expert
- There are always 5 impulse waves and 3 corrective waves.
- Each wave is a fractal consisting of similar such set of waves.
- The Elliott waves occur in both uptrend and downtrend. Practice plotting both of them.
- The waves are not easy to master. It takes a lot of plotting, numbering and experience to get it right. Use an indicator and try to plot it yourself without one and then compare it with the ones plotted by the indicator.
- Wave 3 is the largest of the 3 impulse waves. Wave 4 cannot enter into wave 1. These are the 2 most important rules and guidelines that you need to plot the Elliott waves.
- It is easy to start at the top or the bottom of a trend when you start plotting waves.
- Use it in association with Fibonacci and MACD to understand where the waves are likely to end
- Use the previous waves to find areas where you can take profit and areas where you can place your stop loss.
- Take your time, draw and re-draw to find the right number. If the count is not correct, start again afresh.