Elliott Wave Theory

Elliott Wave Theory

The Elliot Wave Theory represents a development of the well-known Dow theory. It applies to any freely traded assets, liabilities, or goods (shares, obligations, oil, gold, etc.). The Wave Theory was proposed by accountant and business expert Ralph Nelson Elliott in his study titled "The Wave Principle" published in 1938.

After he had retired and a serious illness had been discovered in his organism, Elliott started to observe stock markets and their charts in the hope of understanding the market behavior. After he had performed a large work, he concluded that the market, being a product of predominant psychology of the masses, followed some laws.

The Elliott Wave Theory is based on a certain cyclic laws in human behavior psychology. According to Elliott, the market price behavior can be clearly estimated and shown in the chart as waves (wave is here an explicit price move). The Elliott Wave Theory says that the market can be in two large phases: Bull Market and Bear Market.

Elliott explained that the upward and downward swings in price caused by the collective psychology always showed up in the same repetitive patterns.

He called these upward and downward swings “waves”.

He believes that, if you can correctly identify the repeating patterns in prices, you can predict where price will go (or not go) next.

This is what makes Elliott waves so appealing to traders. It gives them a way to identify precise points where price is most likely to reverse. In other words, Elliott came up with a system that enables traders to catch tops and bottoms. 

So, amidst all the chaos in prices, Elliott found order. Awesome, huh?

Of course, like all mad geniuses, he needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.

3 Cardinal Rules of the Elliott Wave Theory

As you may have guessed, the key in using the Elliott Wave Theory in trading is all about being able to correctly identify waves.

By developing the right eye in recognizing what wave the market is in, you will be able to find out which side of the market to trade on, long or short.

There are three cardinal “cannot-be-broken” rules in labeling waves. So, before you jump right in to applying the Elliott Wave Theory to your trading, you must take note of the rules below.

 

 

 

Failing to label waves correctly can prove disastrous to your account.

3 Cardinal Rules of the Elliott Wave Theory

  • Rule Number 1: Wave 3 can NEVER be the shortest impulse wave
  • Rule Number 2: Wave 2 can NEVER go beyond the start of Wave 1
  • Rule Number 3: Wave 4 can NEVER cross in the same price area as Wave 1

Then, there are the guidelines that help you in correctly labeling waves. Unlike the three cardinal rules, these guidelines can be broken. Here they are:

  • Conversely, sometimes, Wave 5 does not move beyond the end of wave 3. This is called truncation.
  • Wave 5, more often than not, goes beyond or “breaks through” the trend line drawn off Wave 3 parallel to a trend line connecting the start of Waves 3 and 5.
  • Wave 3 tends to be very long, sharp, and extended.
  • Waves 2 and 4 frequently bounce off Fibonacci retracement levels.
 

 How to Trade Forex Using Elliott Waves

This is probably what you all have been waiting for – drumroll please – using the Elliott Wave Theory in forex trading! In this section, we will look at some setups and apply our knowledge of Elliott Wave to determine entry, stop loss, and exit points. Let’s get it on!

Hypothetical, will-most-probably-be-right scenario:

Let’s say you wanted to begin your wave count. You see that price seems to have bottomed out and has began a new move upwards. Using your knowledge of Elliott Wave, you label this move up as Wave 1 and the retracement as Wave 2.

 

 

In order to find a good entry point, you head back to the School of Pipsology to find out which of the three cardinal rules and guidelines you could apply. Here’s what you found out:

  • Rule Number 2: Wave 2 can NEVER go beyond the start of Wave 1
  • Waves 2 and 4 frequently bounce off Fibonacci retracement levels

So, using your superior Elliott Waving trading skillz, you decide to pop the Fibonacci tool to see if price is at a Fib level. Holy mama! Price is just chillin’ like ice cream fillin’ around the 50% level. Hmm, this could be the start of Wave 3, which is a very strong buy signal.

 

 

Since you’re a smart forex trader, you also take your stop into consideration.

Cardinal rule number 2 states that Wave 2 can never go beyond the start of Wave 1 so you set your stop below the former lows.

If price retraces more than 100% of Wave 1, then your wave count is wrong.

Let’s see what happens next…


 

 

Your Elliott Wave analysis paid off and you caught a huge upward move! You go to Vegas (or Macau), blow all your forex profits on roulette, and end right back where you started. Lucky for you we have another hypothetical scenario where you can earn imaginary money again…

Scenario 2:

This time, let’s use your knowledge on corrective waves patterns to grab those pips.


 You begin counting the waves on a downtrend and you notice that the ABC corrective waves are moving sideways. Hmm, is this a flat formation in the works? This means that price may just begin a new impulse wave once Wave C ends.

 

 

Trusting your Elliott Wave skills, you go ahead and sell at market in hopes of catching a new impulse wave.

You place your stop just a couple of pips above the start of Wave 4 just in case your wave count is wrong.

Because we like happy endings, your trade idea works out and nets you a couple thousand pips on this day, which is not always the case.

You have also learned your lesson this time around so you skip Vegas and decide to use your profits to grow your forex trading capital instead.