An Intern Learns – Elliot Wave Theory Part 1
Just like all aspects in our world, what goes up must come down. Newton’s Law of Gravitation extends beyond objects falling out the sky, off tables and out of windows, but all the way into our world of foreign exchange. Although numbers, in their truest sense, are infinite and could technically keep going up forever, we all know that the price does eventually come down at some point. Even if it’s a case of two steps forward and one step back, there will always be (at least) one step back. Our job as traders is to try our best to predict these movements as best we can so that we can take advantage of them. Mr. Ralph Nelson Elliot devised some time ago (circa 1930) that these patterns of up and down are not random, but rather adhere to some sort of pattern. In this blog today, I’m going to explore some of the concepts around the Elliot Wave Theory and how we can apply this to our trading decisions. The best way to start is by having a look at this image below.
This image shows a typical bullish Elliot Wave. As you can see, the wave goes up in 5 movements and then 3 down. The upward movements are called the impulsive waves and then 3 down are the corrective wave. You can see that the 3 corrective movements on the wave are labeled as a, b, c. This of course can be applied to a bearish trend too, but for simplicity of explanation I’m just going to talk in terms of a bullish trend. For a bearish trend the opposite in all instances is normally the case. The basic premise of the Elliot Wave Theory is that traders are collectively influenced by market information is specific ways.The action that they take causes the market to move up and down and with each wave having their own characteristics.
Each wave is characterized in the following ways:
This first wave is the markets first move upwards and is usually caused by a small group of early investors who feel it’s the right time to buy. This wave is normally hard to spot at its start. The sentiments that influenced the previous movements are still around and so this initial bullish trend is normally a small move.
Wave 2 will be a corrective wave and the price will make a small move downward. This is caused by traders who perhaps thought that the stock was overvalued; however this is a short a short lived movement as it is normally not long before traders see the pair as valuable again. Wave two will never extend beyond the starting point of wave one.
This is usually the strongest wave and sees a bulk of traders getting in on the trade as the movement has now caught mass appeal. This wave will normally exceed the high created at the end of wave 1. If there are any mini-corrective movements they are normally short lived and shallow. Wave one will normally extend wave one by a ratio of 1.618:1.
Wave 4 will have a strong corrective movement. This is usually caused by traders who consider the trade expensive again and therefore start to take the profits. This wave tends to be weak in nature as the sentiment is generally still bullish.
This wave is the final impulsive movement and is the point where most novice traders join in. The market will rise at this point because everyone now has finally picked up on the bullish trend and is going long on the trade. However there will be those that believe this is the pinnacle and things are going to go down soon, and its these traders that start the corrective a, b, c movements.
The corrective movements tend to follow the opposite described above, with bearish sentiments driving the downtrend. The corrective movements are described in three moves, a, b and c. These can take a number of patterns. If you recall in past blogs I have looked at chart patterns and how to recognize these. Have a look at this past blog to refresh your knowledge on charting patterns. The corrective movements sometimes take on certain patterns such as a ‘flat formation’ – a pattern typified by a sideways moving oscillation of equal highs and lows. Another type of pattern is a triangle, not too dissimilar from other triangle patterns in forex, this is the same as the ‘flat’ pattern above except the up and down movements of the price are not equal in measure and so will diverge or converge to form a triangular pattern.
The image above shows an example from my own trading on my demo account where I’ve tried to find an Elliot wave, it’s a trade I was doing on the GBP/JPY. I have the 5 impulsive movements and then the ‘a’ and ‘b’ of the corrective movement. I have gone short on this trade, hoping to make some pips on the final corrective movement ‘c’. There’s still really quite a lot to discuss in terms on the Elliot wave theory and so in the next blog I will finish by discussing the rules that the wave must meet, how to make practical use of this method yourself, as well as some criticism of the method – just for a different perspective! So in the mean time, why not try identify some waves yourself: use a larger time frame and the trend line tool like I have to try find waves in your trading.