Elliott Wave Theory Principle: The Definitive Guide (2020)
Forex Blog Articles
In the art of market chart analysis, one of the most popular and interesting approaches is the Elliott Wave Theory principle. This is a method that has been in use since the 1920s.
Interestingly, old as it is, the method has proven to be a tough concept for most traders. This is no surprise, since the method is a pretty tricky trading concept, even for the big boys, at times.
In this article, we are going to look at the Elliott Wave Theory forex trading approach in the simplest details to make it an easy-to-grasp-and-trade concept.
What Is Elliott Wave Theory Trading?
A little history about the method:
All the credit for this trading approach goes to a man named Ralph Nelson Elliott. Back in the day, he sat down and analyzed the data from the stock market dating 75 years back. It was from this analysis that Elliott discovered and was able to conclude that the financial markets do not move randomly. Rather, they follow some repetitive cycles.
Elliott’s conclusion was that the prices move in alternating waves. In short, during an uptrend, there will be large upward movements that will be occasionally opposed by smaller downward movements.
In the same way, during a downtrend, there will be large downward movements by price accompanied by smaller upward movements.
Collectively, these alternating price movements create a trend.
Upon further observation, Elliott concluded that these cycles resulted from two factors:
- Investor emotions.
- Mass psychology.
From these observations, Elliott was able to formulate an outstanding trading method that remains one of the most powerful trading approaches to this day.
Let’s see how this principle works:
Elliott Waves Basics
According to this theory, a trending market moves in a 5-3 wave pattern. The “5” wave usually represents the trending phase, while the “3” phase is a reversal of the trend.
The 5-wave Phase
The first phase of the Elliott wave theory trading principle consists of 5 waves. Waves 1, 3 and 5 move in the direction of the main trend. They are collectively known as the Impulse waves. Waves 2 and 4 move against the main trend and are known as the Corrective waves.
A graphical representation of the basic 5 Elliott wave pattern looks like this:
As we can see, Elliott found out that the markets move in alternating waves. During an uptrend, like the above, waves 1, 3 and 5 (impulse waves) are larger than waves 2 and 4 (corrective waves). Because of this, the prices move upwards.
A downtrend would look like this:
The 3-wave phase
Once the 5-wave phase has completed, there is usually a reversal wave that opposes it. This time, the wave is made up of 3 smaller waves known as “a”, “b”, and “c.”
So, a complete uptrend as per the principle would look like this:
In a nutshell, an Elliott wave Theory is said to be complete once all the 8 waves have been formed. The wave marked “I” is the main trend while wave “II” is the reversal trend.
A complete 8-wave downtrend looks like this:
Similarly, after the first phase (wave I) ends, a reversal uptrend (wave II) forms.
How to Identify an Elliott Wave
Good old Mr. Elliott did not end his discovery there. His invention was so perfect that he came up with 6 cardinal rules to help traders in identifying and validating the Elliott waves.
By adhering to the rules, we can easily identify the perfect waves and use them in making our trading decisions.
Let’s look at each rule in detail.
Rule 1: Wave 2 should never retrace more than 100% into the territory of wave 1
The end of wave 2 should not be equal or larger than the starting point of wave 1.
Rule 2: Wave 3 should be the longest
In most cases, wave 3 will be the longest. In addition, it should never be the shortest. If this happens, then the wave count is wrong.
Rule 3: Wave 3 must extend past the height of wave 1
During an uptrend, wave 3 should end above the high of wave 1. During a downtrend, wave 3 should end below the low of wave 1.
Rule 4: Wave 4 should not retrace more than 100% of the end of wave 1
Wave 4 should not go into the territory of wave 1. As such, in a downtrend, wave 4 should end below wave 1’s end. Again, in an uptrend, wave 4 should end above the high of wave 1.
Rule 5: Wave 5 should extend above the end of wave 3
The final phase of wave I (wave 5) should extend above the end of wave 3. In short, during a downtrend, wave 5 should form and end below the low of wave 3. Similarly, in an uptrend, wave 5 should form and end above the high of wave 3.
Rule 6: Wave II should not retrace more than the size of wave I
If wave II retraces more than 100% of wave I, that whole wave becomes invalid and the counting should start again.
Below is a real-life example of the perfect Elliott wave chart.
Here is another one.
As you can see;
- We have 2 main waves, I and II
- Wave I has 5 waves inside it (3 impulses and 2 correctives)
- Wave II is a reversal of wave I
All the waves adhere to the 6 cardinal rules of the Elliott Wave Forex trading method.
The theory part is easy. Most Elliott Wave traders find the application part hard. This, however, is as a result of improper identification of the cycles.
Worry not; we are going to see the proper way of spotting and trading them today.
You need to have a good understanding of Support and Resistance, trends and, better still, candlestick patterns. These three elements will go a long way in helping us to draw, validate and trade the Elliott wave forex method.
Where to Start the Wave Count
The best place to hunt for the start of an Elliott wave is at MAJOR support and resistance zones. These waves are very rare to form. Therefore, you need to keep a sharp eye at the best places so as to take advantage of when they form.
- Step 1: Identify Support and Resistance zones
We are going to use the daily timeframe to plot our support and resistance zones. To do this, we load any currency pair on our chats then select the D1 timeframes.
Next, we zoom out on the chart so that we can see at least the past 300 candlesticks from the current market price.
After that, we identify the most dominant swing highs and swing lows then connect them using rectangular shapes found in the MT4 platform.
We are now ready to hunt for the Elliott waves.
- Step 2: Wait for the market to react
With our strong support and resistance zones in place, the next step is to wait for the market to reach the marked areas.
Once it does, we need to see how the price will react to the zones. Remember that the price can either break or reverse upon hitting the zones. Here, we watch out for tell-tale signs such as consolidation and long spikes. These are indicators that the price is likely to reverse.
- Step 3: Wait for a new trend to form
This is one of the most important factors to consider when starting your wave count.
You should wait for a new trend to form and become validated before starting your count.
For instance, if the market was going up and met a strong resistance level, we would expect it to either reverse and start falling or break the zone and continue rising.
So, we wait for trend confirmation.
If the market was rising before it hit a resistance zone and started reversing, we need a confirmation that the uptrend is over. This is easy. We should observe the rules of trend formation.
For a trend to qualify as going down, it should break the previous swing high and form a swing low.
Image: Uptrend changes to a downtrend
For a downtrend to end, paving way for an uptrend, the previous swing low should be broken and a higher high formed. Only then do we qualify that as an uptrend.
Image: Downtrend changes to uptrend
- Step 4: Mark Wave 1
Now, with the confirmation that an old trend has ended and a new one is forming, we are ready to mark our wave 1. This is the beginning of wave I.
If we can use the above examples:
In this chart, when the price hit the support zone, it bounced and formed a new higher high (higher low). This is a confirmed trend change. Therefore, we wait for wave 1 to form. Once it forms a higher high (new swing high), we wait for it to pullback. This will be the start of wave 2’s formation.
Next, we wait for wave 2 to pullback. As per our 6 rules, wave 2 should not retrace into the area where wave 1 started. As such, we wait for the wave to slow down and start reversing upwards.
This is where you use confirmatory tools such as candlestick patterns. In the above example, we had a bullish engulfing candlestick pattern which also formed a second higher high. This is our confirmation that wave 2 has completed forming and that wave 3 is starting.
This is where we place our “buy” trade.
Here is another example of locating wave 1:
In this chart, once the previous higher high (swing high) was taken out, we had a perfect wave 1 formed. In short, our newest lower high represents our wave 1.
Wave 2 formed perfectly as well since it did not rise beyond the start of wave 1. At this turning point, we have a bearish spinning top accompanied by a huge bearish candle. This was a “sell” trade entry.
We can see that wave 3 formed perfectly as it extended below the low of wave 2. However, our wave 4 failed us since it retraced into the area where wave 2 ended. As such, our Elliott wave failed here although it went on to form a perfect wave 5 as well as a and b.
How to Use the Elliott Wave Indicator
There are several indicators in the market that promise to help in drawing and identifying these waves. However, none can spot them with as much accuracy as you can. Most of these indicators are based on the zigzag, which we know extends as prices move up and down.
As such, if followed blindly, it can give false signals. If you have to use an indicator, it should only help to confirm the signals that you have already plotted.
How to Draw Elliott Waves in MT4
The MT4 platform has all the tools that you need to mark your wave counts.
You can use the “Text” tool to mark your waves. Just click on “Insert” then “Text.” In the dialog box that pops up, edit the text to what you want to appear in the chart.
You can also mark your Support and Resistance zones using the “Shapes” tool. Just click on “Insert”, then “Shapes” and click on “Rectangle”. From here, click and drag your mouse in the chart area to draw your zones.
Your chart will look like the following example:
How Elliott Waves Method Work
The fact that we need to wait for waves 1 and 2 to form for the confirmation of the formation of an Elliott wave means we cannot trade all the waves. Most traders usually target waves 3 and 5 as they are not only confirmed by waves 1 and 2, but they are also quite large.
This image explains how to trade the typical Elliott wave forex approach:
So, how do we trade the Elliot wave Theory?
The price went up to the resistance level and showed signs of reversal (long wicks on upper sides of candles and small-sized candles).
A lower high was formed below the resistance level. This indicated that the uptrend was ending and that a downtrend was imminent.
After the lower high formed, the price went lower and reached a minor support level where it began going up. We marked our wave 1 here.
After rising for a short distance, the price obeyed our first rule as wave 2 did not retrace into the territory of wave 1.
Next, we waited for the confirmation of the end of wave 2 and the start of wave 3. This would also be our entry signal. Another engulfing candlestick formation formed, confirming our entry.
From here, we can easily place our stop loss at the high (start) of wave 1. Our first take profit level would be on the next support level BELOW the starting point of wave 2. This is because as per the rules, the end of wave 3 should extend further from the end of wave 1.
We can see that the market reached the next support level and began consolidating. This marked the end of wave 3. We can take partial or full profits here.
Next, we wait for wave 4 to form. As per our rule number 4, wave 4 should not go into the territory of wave 1. So we wait for a reversal back into the main trend. This would be the start of wave 5, and also another “Sell” signal.
Another engulfing pattern formed here and we took the trade.
Our stop loss for this trade would be located at the bottom of wave 1. The take profit would go on the next support level BELOW the end of wave 3. This is because as per rule number 5, wave 5 should extend beyond the endpoint of wave 3.
The formation of a new higher low after wave 5 ends signifies the beginning of the reversal phase (wave II). If waves a, b and c form, our Elliott wave cycle is said to be completed. We now start hunting for more trades.
Is the Elliott Wave Theory Accurate and Reliable?
Just like all other forex trading strategies, the accuracy of the Elliott wave approach is determined by the trader.
If the trader is keen enough to spot the setups accurately, then this method will give them high-probability setups. This forex trading method is one of the most profitable and reliable price action approaches when applied properly. This, however, proves to be a skill that requires extensive attention and practice.
In a nutshell, you should strive to capture the best setups as they start to form. If you adhere to the steps outlined in this post, then you will be assured of more profitable trade setups than losses.
Elliott Wave Principle Summary
The majority of the best traders in the world use the Elliott waves concept.
This method has been in use for the longest time and still proves its worthiness to the traders that know how to use it. It is simple if explained correctly. However, it promises the best setups and a profitable earning curve.
In addition to giving exemplary trade signals, it also gives professional stop loss and takes profit zones. As such, we can quantify it as an accurate, reliable and all-round trading system that has made traders rich for decades and will continue doing the same for many more to come.
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