The Elliott Wave Theory: How the Market Moves
New traders may look at a Forex chart and see chaotic movements zig-zagging all over the place as if the market were playing a financial version of pin the tail on the donkey. Fortunately, all this changes with added “seat time”. Charts that once looked completely random soon begin to print shapes and waves that look like recognizable old friends. Familiarizing yourself with the Elliott Wave Theory can go a long way towards understanding how energy is accumulated and expressed in the market.
Where did the Elliott Wave Theory come from?
In the late 1920s, Ralph Nelson Elliott developed his theory concerning the mass psychology of the stock market. Using the Dow Theory (stock prices move in waves) as a jumping off point, Elliott drilled down into this wave-like movement of the markets and used fractals to analyze these waves on a more detailed level.
What are fractals and how do they pertain to Elliott waves?
A fractal is a pattern nested within a pattern repeatedly. Imagine you are looking at a picture of a big yellow smiley face. Once you zoom in closer to see each pixel, you discover that each of those pixels are actually smiley faces all arranged to make the bigger picture. Suppose you zoom in on one of those pixels with a microscope and realize that each pixel is actually made up of micro-smileys. This is a simplified explanation of fractals. We see fractals all around us: Larger wave patterns at the beach are made up of smaller waves. Shells, leaves, snowflakes and even some broccoli exhibit fractal patterns. The fractal patterns that concern us are the ones that are expressed in the wave motion of financial markets.
How are these waves are formed?
Simply put, when we look at waves that are formed in price action, we are looking at the psychology of thousands and thousands of traders all over the world. The confidence or fear that they have about current price movement is expressed in how motivated they are to buy or sell that particular currency. The herd of investors push price up as a buying frenzy gains energy. As some investors get nervous about just how long this upward drive can last, they begin to sell. This has the effect of slowing down and momentarily reversing price movement. The upward burst of energy that goes along with the larger trend is called an impulse. That short pause and small backwards movement in the opposite direction is called a correction. Keep in mind, this can work in a bullish (up) trend or a bearish (down) trend. An impulse can shoot up or down depending on the current larger trend.
Look at a single impulse wave and it’s correction
Before we dive into waves nested within waves, let’s get a good picture of how one impulse wave with it’s correction may look. This is pretty simple.
- Impulse wave: Price makes a move upwards.
- Correction wave: Price then retreats back down a nice 50%. Perhaps it may correct as deep as 62%.
As simple as it may seem, this is the basic building block of Elliott wave patterns.
How to count waves?
The most basic understanding of Elliott wave analysis says that each larger impulse wave and it’s following correction wave are made up of sets of three smaller impulse and mini-corrections with a wave like motion also expressed in the larger correction. To help in understanding this concept, let’s step through one of these larger single impulse and correction cycles with it’s smaller fractals listed.
- Wave 1: An impulse wave drives price movement up.
- Wave 2: Price movement slows and moves back down a bit.
- Wave 3: Price then continues up past where wave 1 momentarily reversed into wave 2.
- Wave 4: The crowd loses a little bit of steam as price again reverses momentarily, going backwards to lose a portion of the ground it covered in wave 3.
- Wave 5: Price makes another thrust upwards, reaching a higher level than the end of wave 3.
Note that the zig-zag upward motion of waves 1 through 5 all combine to make the larger single impulse wave in this example (think fractals). Let’s look at the correction that is about to print after this large impulse wave.
- Wave A: Price drops down below the new high printed at the end of wave 5.
- Wave B: Price rises back up but does not go past the high of wave 5.
- Wave C: To conclude the roller coaster ride, price reverses and prints a low that is below the lowest point in wave A.
All the above listed bullet point actions are smaller waves taking place in one larger impulse and correction.
Here are some basic rules for counting waves
Unfortunately, the market doesn’t always print picture perfect Elliott waves for us to count. Here are a few rules to determine if the waves you may see on a currency chart are actually a nicely forming set of Elliott waves.
- Wave 2 must never retrace further than the beginning of wave 1.
- Of the three impulse waves (1, 3 and 5), 3 must not be the shortest.
- Wave 4 must not invade the price range of wave 1.
How do you put this together to make money in the market?
At this point, we have only worked to get an understanding of how Elliott wave counting works. Let’s take this concept and plug it into some strategies that will put money in your pocket.
Keep probability on your side
None of us traders can predict the future. But we do learn to put probability on our side by recognizing a setup that indicates the likelihood of what the next market move will be. We also learn to recognize when something does not look quite right. The bad trades we stay out of are nearly as important as the good trades we enter. This is because when we lose money on a bad trade, we then have to make that money again just to get back to where we started. As depressing as this sounds, you have to know when to pass on a trade. Let’s apply Elliott waves to this concept with a few examples:
– Because you are a smart trader, you use a combination of concepts to make up your complete strategy.
- Assume that you believe price movement is building energy for a nice bullish move.
- As you look over the chart on a higher time frame, you note that a perfect set of Elliott waves has formed. Price is currently well into wave 5.
- Taking into consideration what you know of Elliott waves, ask yourself what is the market likely to do next? Your predicted upward movement may indeed happen, but only after price goes through the typical A, B and C waves of a correction.
- You wait for the probable pull-back of wave A.
- The upward wave B does not fool you into jumping in because you know that another pullback (wave C) is likely.
- After wave C prints, you enter a long trade.
- If you had entered your trade without recognizing the likelihood of a correction, your trade would have first endured backwards movement before regaining lost ground and soaring into profit. This would increase your risk and cut into profits.
– Let’s make Elliott wave counting a bit more central to this next scenario
- You just noted a frame-able set of 5 waves and their correction.
- As you watch price move into another likely wave 1 impulse and correction (wave 2), you notice that the volume indicator shows less volume for this new wave 2 than for the accompanying wave 1. This gives you an indication of who has the power. The move with greater volume generally has greater power. This reinforces the notion that a nice wave 3 may be on the way.
- Enter your long trade as wave 2 pulls back to 62% of the ground covered by wave 1 and enjoy the ride up wave 3.
- If wave 2 continues moving downward beyond the start of wave 1, you know the pattern has failed and it is time to get out.
- By using the expected pullbacks to get in, losses are limited if a pattern fails beyond the typical pullback.
– Imagine you spot a nice setup in a particular time frame
- With a firm grasp of fractals and how this concept plays into Elliott waves, first check a larger time frame for waves that are printing recognizable shapes. The pull of higher time frames are always more powerful than smaller time frames.
- After you are satisfied with the setting of the higher time frame, check one time frame lower than the one you found your setup in. This is like getting out a magnifying glass and checking the fingerprints of the market.
- Ask yourself if these smaller waves that are nested in the larger time frame you are working in are making recognizable movements. Do they seem smooth or choppy? Chaotic looking patterns may indicate indecisiveness. When sentiment is indecisive, the patterns you see may not be as trustworthy.
Because Elliott wave counting has quite a following in the world of currency trading, you will find enough additional rules and exceptions to the concept to last 5 lifetimes. At first, keep it simple and absorb more Elliott wave particulars at an easy pace. As always, combine Elliott wave counting with other forms of analysis that you find reliable. Remember to listen to the market and never insist on telling it what to do. Here’s to profitable trading!