22. Elliott Wave Theory
Trader’s psychology is the main driver which drives the Forex market. Elliott wave theory, discovered by Ralph Nelson Elliott in the late 1920s measures this psychology. As if you are sitting in a history class. Don’t worry you don’t have to memorize this. We mentioned it so as to give you an idea of how this theory got its name. We know that market prices keep swinging and is the result of trader’s psychology. Elliot discovered that market behaves in repetitive cycles. Through his years of experience he was able to prove that the upward and downward movements always happened in a repetitive pattern. These patterns could be further divided into “waves”. So prices move in waves. Interesting.
Time for a new term here. This time it is “Fractal”. Forex market is fractal in nature. Fractals are structures which can be subdivided into parts and each part is a copy of the original structure. That means, when subdivided it repeats itself in each of its parts. Since the market is fractal in nature, Elliott was able to break down the market patterns and study it in more detail. So, the theory is based on the basic principal that trader’s behaviour in the market tends to follow repetitive cycles.
Getting into the principles of Elliott Wave theory now. It is based on a 5-3 wave principal. This means, five waves move in the direction of the original trend and followed by 3 waves against the direction of the trend.
The waves in the direction of trend are impulses (the first 5-wave pattern including the waves 2 & 4 which act as small retracements or interruptions). The waves against the trend are corrective waves (marked by letters A, B & C). The waves 1, 3, 5 are known as motive as they move along the trend.
Thus, a complete cycle of wave is made up of 8 waves (5 impulse waves and 3 corrective waves). Now each wave by itself can be subdivided further into an 8 wave pattern and so on. The main idea is that waves of any degree subdivide and re-subdivide into waves of lower degree while being the components of the higher degree wave.
It is simple. Elliott waves are fractals. That is, each wave is composed of sub waves.
Elliott Wave Theory named the series of waves based on the order of their degree as:
- Grand Supercycle
What does this mean? This means a Grand Supercycle is made of Supercycle waves which is made of Cycle waves which in turn is composed of Primary waves and so on. Elliot has named the waves till the 9th degree.
A bit more on the corrective wave pattern now. According to Elliot Wave Theory, corrective waves do not always include three waves, a corrective wave can also be identified with five or more movements. Elliott has come up with various corrective wave patterns. We mean the patterns for ABCDE… waves (waves represented by letters). Here are the three basic formations for the ABC corrective patterns:
- Zig-Zag Formation
Zig-Zag is made of three long waves, two corrective and one impulsive wave in the middle. And as you see wave B is the shortest in length when compared to waves A and C.
- Flat Formation
The waves in flat formation are normally equal length corrective waves.
- Triangle Formation
When the corrective waves are bound by a converging and diverging trend line it is known as the triangle formation.
3 Cardinal Rules
So, to correctly make use of the Elliot Wave theory, you should be able to identify the waves in your chart and then mark them. When you are trying to label the waves there are 3 cardinal rules of the Elliot Wave Theory which should be followed:
Rule 1: Wave 3 can never be the shortest impulse wave.
Rule 2: Wave 2 can never go beyond the start of Wave 1.
Rule 3: Wave 4 can never cross in the same price area as Wave 1.
Here are some guidelines which need not be true always but you should know them so as to use this theory efficiently:
Guideline 1: When wave 3 is the longest impulse wave, wave 5 will be approximately equal to wave 1 in length.
Guideline 2: Wave 2 and Wave 4 will alternate in forms. Which means, if wave 2 was a steep or sharp correction, wave 4 will be a flat correction and vice versa.
Guideline 3: After a 5-wave impulse, corrections (ABC) usually end in the area of prior Wave 4 low.
That is all we wanted to discuss about Elliot Wave Theory. Our intention here was to give you an overview of the Elliot Wave Theory which we feel we have successfully done. A good understanding of the basics of the theory, the rules and the guidelines can greatly help technical analysts to identify the waves and project future movements.