An Intern Learns – Elliot Wave Theory part 2
Thanks for coming back to learn more about the Elliot Wave Theory. In part 1 I discussed the basic aspects of this theory and how to identify this in your charts. If you recall, this is not simply a random wave pattern, but rather one that has very specific conditions with each part of the wave having its own unique characteristics. As I mentioned in the fist part, I’m using the Elliot Wave in my own trade on my demo account, a GBP/JPY trade. I entered the market at what I felt was the apex of the ‘b’ wave, hoping to make some pips on the descent of the ‘c’ wave. I have a screen grab of the trade as of this morning below (at time of writing). As you can see I also inserted two SMA’s with their periods set at 10 and 20 respectively. This is just an additional analysis tool to help me make a trading decision. The market has unfortunately gone against me and is also in a ranging period. I’m hoping that after this range is over the market will go down. My SMA’s seem to be moving together and along with my prediction with the using the Elliot Wave, hopefully I’ve made a correct trade in going short. As I’m set on a 4-hour chart there’s nothing to do but wait and see what happens! In the mean time, let's learn more about The Elliot Wave theory!
The Elliot Wave theory has a number of rules that it has to adhere to. If these are not met then you may not be dealing with a proper Elliot Wave.
These are the three cardinal rules of Elliot Waves. Rule one: Wave 3 can never be the shortest impulse wave. Rule two: Wave 2 can never go beyond the start of Wave 1. Rule three: wave 4 can never cross the same price area as Wave 1. The best way to learn these rules is by trying to apply them to your charts. Use the line drawing tool on the MahiFX platform, change it’s setting to being a multi-line tool. Start at a point that you suspect might be the beginning of an Elliot Wave and use the line tool to map out the wave. At this point you need to remember the rules above and make sure the lines don’t breach these. If they clearly do then maybe there isn’t an Elliot Wave in this trade. You may want to consider changing the time frame, I found Elliot Waves easier to see in larger time frames. As you may recall from the previous blog, the image of an Elliot Wave shows how they can happen in multiples of themselves. Scientists call this ‘self-similarity’. What this means is that there can be waves within a wave. The 1,2,3,4,5 – a,b,c pattern can repeat itself within a larger ‘1’ wave. By changing the time frame you are able to see a bigger picture. Just bear in mind that changing the time frame must be consistent with your trading style. I’ve gone for a swing trade here, but it would be no good to use a 4-hour time frame if you want to do scalping!
Elliot Wave is a pattern recognition tool. However it’s normally best to use it in conjunction with another technical analysis tool. As you may recall from my how to make a trading system blog, one part of developing your system is learning which tools work best for you in confirming a trend. Elliot Wave can be used for this, either as I have done with multiple SMA’s or perhaps with pivot points. For example, say you’ve identified a potential Elliot Wave 1 and wave 2 in a bullish market. The 3rd wave is an (normally) extended wave and you could get some great pips going long at the start of this 3rd wave. Use the line drawing tool as I did and remember the three core rules I described earlier – if they adhere to these then you might be on to something! Use a second indicator such as pivot points – Elliot Waves tend to bounce off these resistance levels. If they have done this then you may be in an Elliot Wave. There’s no harm is using a demo account for practicing, they are quite difficult to spot as they’re happening and a little practice will definitely help.
However not everyone is convinced with Elliot Wave theory. Some have argued that the benefit of hindsight allows the purveyors of Elliot Wave Theory to fit it into any scenario. In a way I can see their point – it is often easy to find patterns in past price movements rather that as they are happening. Critics have suggested that the rules are too vague and unrestrictive to be truly effective and that it cannot consistently identify when a wave begins or ends. A technical analyst David Aronson, discussing how easily its supporters are able to insert the Elliot Wave into charts, says this is attributed to:
- “The method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong.”
However I believe there definitely is merit in the Elliot Wave theory – but for me it’s a rule to taken with a little pinch of salt, and from learning about this I’ve taken away broader lessons rather than specific trading techniques.
The price charts are subject to all the trader’s sentiment, and this has been proven to follow patterns over time. Bullish trends do succumb to bearish ones, and in time sentiment will reverse yet again. The Elliot Wave theory can help us identify this and may prove particularly helpful for those of you that are more interested in swing and position trading. An idea of Elliot Wave users that I agree with is that it’s these waves pattern of ‘naturally-occurring fractals’ – the self-similarity I mentioned earlier – that reflects the collective psychology of the trader’s buying and selling behaviour over time. This psychology is a natural sentiment of humans and is also found in nature, such as snowflakes, seashells or even mathematics. It’s this inherent natural-ness of the Elliot Wave that makes the concept so appealing and it’s use so widespread and applauded.