Elliott Waves: Surf the Market
The Elliott Waves' approach is one of the most popular among traders and investors all over the world. However, it’s not easy. Mr. Elliott invented plenty of wave patterns that should be drawn correctly. In this tutorial, we will help you create a simple system that you will use while trading.
Elliott Wave Theory: A Piece of History
Although the Elliott Wave principle was created in the 1930s, it still has been gaining popularity. Ralph Nelson Elliott, an economist, developed this theory while retired. His approach became famous when Mr. Elliott managed to foresee a plunge in the stock market.
Ralph Elliott based his approach on the behavior of traders. He believed that traders and investors repeat the same actions. Thus, market tops and bottoms can be easily predicted.
Elliott Wave Theory is based on the behavior of traders. Mr. Elliott believed traders and investors repeat the same actions.
Lots of Elliott Wave traders and analysts have been using this theory since Mr. Elliott passed away. Plenty of books and articles were published to describe principles of the Elliott Waves strategy. There is even a “school” of traders who are called “Ellioticians.”
We will sum up and provide you with the most relevant information that will help you “ride a wave.”
What Is Elliott Wave?
Elliott wave theory is an instrument of technical analysis which reflects traders’ psychology. This method differs from standard technical indicators, such as the RSI, MACD, etc. It’s a theory that doesn’t include calculations. As we mentioned above, Elliott Wave analysis assumes that market movements repeat. And waves just help a trader predict the future price direction based on the historical trends.
When you determine the waves on the chart based on the previous price, you will be able to define the further price direction.
There are plenty of types of Elliott waves. Still, the idea is the same: when you determine the waves on the chart based on the previous price, you will be able to define the further price direction.
Look at an example below.
Motive Waves
There are two essential terms: motive and corrective waves. Both include unique Elliott Wave patterns. A motive wave reflects the price movement in the direction of the significant trend. Each motive wave consists of five small waves built according to different rules. Look at the motive patterns below.
Basic terms of the Elliott Wave strategy are corrective and motive waves.
Impulse
Like any other pattern, it consists of five waves. Three of them are motive, so they move in the direction of the prevailing trend; two others are corrective, they move in the opposite direction of the primary trend.
Each of the patterns has specific rules. Look at the rules of the impulse:
- An impulse wave consists of five waves.
- Wave 2 never outperforms the point where wave 1 starts.
- Wave 3 always crosses the high of wave 1.
- Wave 4 never exceeds the endpoint of wave 1.
- Wave 3 is never the shortest, among others.
- Wave 3 is an impulse wave.
- Wave 1 can be either an impulse or a leading diagonal pattern.
- Wave 5 can be an impulse or an ending diagonal pattern.
- Wave 2 shouldn’t be a triangle or a triple three structure.
An impulse wave signals a correction or even a trend reversal. We can find many impulse waves within one trend. Look at the example below. Green waves 1-2-3-4-5 is an impulse pattern. Also, blue waves 1-2-3-4-5 an impulse pattern.
Leading Diagonal
This pattern is considered a beginning (wave 1) of an impulse or a zigzag.
Check the rules below:
- Leading diagonal has five waves inside.
- Wave 2 never exceeds the beginning of wave 1.
- Wave 3 always crosses the end of wave 1.
- Wave 4 usually outperforms the endpoint of the wave 1.
- Wave 5 usually passes the ending point of the wave 3.
- Wave 3 shouldn’t be the shortest one.
- Wave 2 shouldn’t be a triangle or a triple three structure.
- Waves 1, 3, and 5 can be impulses or zigzags.
Ending Diagonal
As the leading diagonal is the beginning of an impulse or a zigzag, the ending diagonal pattern is an end of them. The pattern includes different correction formations, such as zigzag.
- This pattern includes five waves.
- Wave 2 never outperforms the starting point of wave 1.
- Wave 3 always crosses the end of wave 1.
- Wave 4 usually exceeds the endpoint of wave 1.
- Wave 5 usually breaks the end of wave 3.
- Wave 3 shouldn’t be the shortest.
- Wave 2 shouldn’t be a triangle or a triple three structure.
- Waves 1, 3, and 5 look like zigzags.
Corrective Waves
Corrective waves follow motive ones. They are more complicated. A corrective wave is a step backward in a trend. Corrective waves also have several patterns.
ZigZag
Along with the flat pattern, ZigZag is a simple corrective formation.
The common rules:
- Zigzag has three waves.
- Wave A should be an impulse or a leading diagonal pattern.
- Wave B can be any correction pattern.
- The wave should be an impulse or an ending diagonal pattern.
- Wave B is supposed to be shorter than wave A.
- Wave C should be longer than wave B.
- Waves A and C are expected to be motive, but wave B should be corrective.
Flat
There are three different types of the flat pattern.
Follow the rules:
- The same as ZigZag, it consists of three waves.
- Wave A can be a correction pattern besides triangles.
- Wave B can be any correction pattern, but a zigzag is the most common one.
- Wave C is supposed to be an impulse or an ending diagonal.
- Wave B should be 90% longer than wave A.
- Wave C should be equal to or longer than wave B.
- Waves A and C are considered motives, while wave B should be corrective.
Triangle
Triangle is also a correction pattern, but it includes five, not three waves. There are many types of triangles. However, there are some rules for each triangle:
- Impulse Wave 2 isn’t a triangle.
- A, B, and C waves should be zigzag, double zigzag, triple zigzag (not too often), or double/triple three.
- D and E waves can be a triangle.
Double/Triple Three
We have mentioned the double/triple three patterns. Let’s clarify what it is. The pattern itself includes flat, zigzag, triangle, double/triple zigzags. Three correction patterns form a double three pattern.
The general rules for Double Threes trading:
- The pattern has three waves, which are named W-X-Y.
- Wave W can be any correction pattern, but not a triangle.
- Waves X and Y can be any correction pattern.
- Double three pattern is located horizontally or lower than the primary trend.
- Double three is not considered a deep correction.
Triple Three
As you see from the name of the pattern, it’s supposed to be longer than double three one. So, it has five waves (usually marked as W-X-Y-X-Z) that move horizontally against the prevailing trend.
Some rules of the triple three:
- Waves W, X, and Y are any correction pattern, but not a triangle.
- Wave 2 - X and Z – can be any correction pattern.
- Triple three is placed horizontally or lower than the major trend.
- The same as double three, triple three is a deep correction.
- This pattern rarely occurs. It’s not the best pattern to look at the chart.
Double ZigZag
As you can see from the name of the pattern, it includes two zigzags. This pattern appears if only the first zigzag is too small to signal a proper correction.
Look at the rules:
- Double ZigZags has three waves (W, X, and Y).
- W and Y waves are supposed to be zigzags.
- Wave X can be a correction pattern.
- Wave W should be bigger than wave X.
- Wave X is smaller than wave Y.
- Double ZigZag is considered a deep correction.
We considered the most frequent patterns that may occur on the price chart.
Elliott Wave Degree
You may have noticed, when we talked about patterns, we mentioned that they consist of a different number of waves. But patterns are a part of bigger waves. So, each primary wave has several small waves inside.
There are nine degrees. They are counted from the smallest timeframe, which is hourly to the largest available. They all have unique names: Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, and Subminuette.
Look at the example below. We have two waves. These are i and ii. However, wave ii consists of smaller waves. We can mark them as W-X-Y. Still, each of the W-X-Y waves consists of smaller waves, for example, a-b-c.
So, the rule means that we can find smaller waves in any wave until we get the smallest ones.
How to Name Waves?
We are sure you have noticed that waves have different names. We can call them i, ii, w, x, y, a, b, c, etc. How can you understand what name suits our wave?
Wave notation is used to simplify the understanding of wave count between traders.
Wave notation is used to simplify the understanding of wave count. Motive waves are named with three Roman and Arabic numbers that go one by one. Corrective waves are called with capital and lower case letters. In the case of one wave degree, Roman numerals and lower case letters, or Arabic numbers and capital letters are used.
Cycles
The cycle is the central term in the Elliott Wave Theory. Mr. Elliott assumed that the market consists of cycles that always repeat. The primary cycle has three waves forward and two waves backward. This means that the market takes three steps in the direction of the primary trend, and then a correction happens.
The cycle is the central term in the Elliott Wave Theory. Any cycle has both impulse and corrective waves.
You should remember that any cycle has both impulse and corrective waves. Impulse waves are always bigger than corrective ones. Impulse waves are always followed by corrective waves. A cycle can be divided into 5- and 3-wave patterns.
The basic cycle is a set of eight waves, where five are impulse, and three are corrective. In general, there can be an infinitive number of cycles in one wave.
The complete cycle is a set of 34 waves. Such a cycle can include a basic cycle. It’s worth remembering that a basic cycle forms in the direction of the prevailing trend.
The number of waves in one cycle is based on Fibonacci numbers. These numbers help a trader determine the waves' strength and even the duration of them. Usually, a complete cycle includes 2, 8, or 34 waves.
Degrees and cycles are interconnected and have the same names.
Waves Themselves
We mentioned waves 1-5 and A-C but haven’t said what they stand for. Let’s clarify a little bit.
- Wave 1 is the beginning of any cycle. It’s hardly determined on the price chart. But it moves in the direction of the prevailing trend.
- Wave 2 corrects the first wave. It moves in the opposite direction. However, it never breaks the starting point of wave 1.
- Wave 3 moves in the direction of wave 1. Still, it’s supposed to break the endpoint of the first wave. Some analysts consider the wave 3 the most powerful wave in the cycle.
- Wave 4 is a correction of wave 3. It’s an uncertain wave as traders can hardly determine its potential.
- Wave 5 is the end of the primary trend. This wave signals a small potential for traders and means the market will reverse soon.
- Wave A is the first corrective wave. It’s always more complicated to define corrective waves than impulse ones as they are much smaller.
- Wave B may create a false impression of a trend's recovery. Still, its volume should be lower than the volume of the wave A.
- Wave C confirms that the opposite trend takes place. Wave C should either be equal to wave A or outperform it by not less than 1.618 times.
Elliott Waves: Use or Not
Any chart pattern or indicator has advantages and disadvantages. If a pattern has limitations, it doesn’t mean you shouldn’t use it anymore. It just means you should know about them and use them in your favor.
Benefits | Limitations |
Any timeframe. Elliott waves occur during any timeframe. So, they fit any trading strategy. | Complicated. Elliott waves theory is not an easy one. It will take time before you learn how to define waves on the price chart. |
Any security. It doesn’t matter what asset you want to trade. Elliott waves can be found on currency, CFD, stock charts. | Not always clear. As mentioned above, some waves are frustrating and may confuse a trader about the further direction of the price chart. |
Strong signals. Of course, the most crucial advantage of the Elliott wave system is the accuracy of the signals. If a trader determines the waves correctly, it will be a strong sign of the upcoming trend. |
How to Use Elliott Waves in Trading
Elliott waves can be drawn on any trading platform. You can do it by yourself or by using a technical indicator. However, the indicator is not set by default in trading platforms, for example, MetaTrader4. So, you will have to download it from the internet and implement it in MetaTrader.
Here are the general rules on how to draw waves.
- Step 1. Determine the dominant trend.
- Step 2. Try to determine the impulsive waves. Check the rules above. The length of the waves should correlate with the major rules.
- Step 3. Mark waves correctly.
- Step 4. Determine the upcoming waves.
- Step 5. Enter the market regarding the waves.
Elliott Waves Signals
We talked a lot about waves and how to draw them. But why do we need these waves except to define the trend direction?
- Signal 1. A formation of five impulse waves means there will be a market reversal soon. Thus, if you are already in the market, you can simply close your trade.
- Signal 2. If you haven’t opened a position, you can open it on the market reversal. However, wait for confirmation. It’s dangerous to open the trade on wave 5 or wave A. Sometimes, corrective waves are flat. Thus, it’s early to open a trade in the direction opposite to the previous trend.
- Signal 3. You can also open positions within a pattern. We mentioned above that there are 3- and 5-waves patterns. Thus, you can open a trade regarding the current wave.
Elliott Waves: Combination
It’s essential to confirm the signals the Elliott Waves provide. For that, you can use different technical indicators. As waves determine the trend reversal, you should use the tools that serve the same aim. Thus, you can apply the trend indicators such as Parabolic SAR, Ichimoku Kinko Hyo, MACD, along with such oscillators as RSI, Stochastic Oscillator, Awesome Oscillator. Oscillators that determine oversold and overbought zones will be highly useful to confirm the price reversal.
Elliott Waves and Fibonacci Retracements
Elliott Waves' theory and the Fibonacci Retracement indicator are interconnected. Fibonacci levels are used to determine the targets of Elliott Waves. Traders and investors can easily use their interconnection to define entry and exit points.
Fibonacci levels are used to determine the targets of Elliott Waves.
How an impulse wave correlates with the Fibo ratios:
- The impulse wave 2 relates to 50%, 61.8%, 76.4%, or 85.4% of the wave 1.
- Wave 3 can be 161.8% of wave 1.
- 14.6%, 23.6%, or 38.2% of wave 3 relate to wave 4.
- A range of 1.236 – 1.618% of wave 4 is inverse of wave 5. Wave 5 can also be the same as the wave 1, or 61.8% ratio of the sum of 1 and 3 waves.
If we take a flat pattern, we can get the following Fibonacci levels:
- Wave B equals 90% of wave A.
- Wave C is the same as 61.8%, 100%, or 123.6% of wave AB.
Some rules for the Fibo ratios in case of the double three patterns:
- 50%, 61.8%, 76.4%, or 85.4% of wave W equal wave X.
- Wave Y is 61.8%, 100%, or 123.6% of wave W.
- Wave Y shouldn’t cross 161.8% of wave W.
What about triple three?
- 50%, 61.8%, 76.4%, or 85.4% of wave W equal wave X.
- 61.8%, 100%, or 123.6% of wave W are the same as wave Z.
- Wave Y shouldn’t cross 161.8% of wave W. It also can be an impulsive wave (3).
Now, you know how to combine the Elliott Wave theory and Fibonacci Retracements indicator.
How to Use Elliott Waves in Forex
It’s impossible to consider each pattern we mentioned above. However, we can consider at least one example. It’s an hourly chart of the USD/TRY pair. Here, we have a formation of an impulse wave that consists of three motive waves, and two corrective ones.
As you can see, there are smaller waves inside the big wave. After wave 5, we can expect a correction.
Strategy
We would like to share a strategy that may help you start trading with waves before you invent your own trading program.
- Step 1. Any Elliott wave strategy starts with wave counting. We should enter the trade only in waves 1, 3, 5.
- Step 2. Draw a trend line. If you trade in the bullish trend, draw a support line. If you trade in the bearish trend, draw a resistance line.
- Step 3. We are considering the bullish trend. We draw a support level of wave 1.
- Step 4. We need a confirmation of the formation of wave 2. For that, we can look at Awesome Oscillator and Stochastic Oscillator. There should be a bearish divergence between the price chart and the Awesome Oscillator. The Stochastic Oscillator should provide a sell signal.
- Step 5. As soon as the price breaks below the support, we can determine an entry point. It should be located below the level where the previous reversal happened.
- Step 6. The stop loss is placed at the beginning of the second wave.
- Step 7. Take Profit should be placed at the next support level, where the market may turn around.
Tips for Traders: Avoid Mistakes
Investors always make mistakes. We would like to help you prevent them.
Expert advice. It's better to apply the Elliott Wave theory on bigger timeframes. The process of wave drawing is quite complicated. Also, small aims will bring small rewards, which is not the aim of a trader.
Expert advice. You can find instruments to draw waves in the terminal. There are at least Fibonacci Retracements.
Expert advice. There are combinations between the wave theory and indicators to determine entry points. You can also use the approach and graphical analysis to form different patterns in correction waves.
Expert advice. The most effective trades will be in 1,3,5 waves. It’s recommended to enter corrective waves only if there is a confirmation from other indicators. For instance, there is a divergence with the Awesome Oscillator indicator.
Expert advice. Making deals in impulse waves 1,3,5, the risk/reward ratio should be at least 1/3.
Expert advice. Before you start drawing waves, read the rules carefully. It’s vital to understand the process of drawing. Otherwise, you may build the wrong waves that will provide fake signals.
Conclusion
To conclude, Elliott Wave theory provides strong signals that predict a trend reversal. A trader can use the waves to both enter and exit the market at perfect points.
However, it’s not easy to remember all the rules and define waves on the price chart. A trader should practice a lot. It’s better to do it on a demo account. You can use a Libertex free demo account that fully resembles the real account. You can try to draw waves on different timeframes and charts of a wide range of securities.
Why to trade with Libertex?
- access to a demo account free of charge
- technical assistance to the operator 5 days a week, 24 hours a day
- leverage up to 1:500 for professional clients
- operate on a platform for any device : Libertex and Metatrader 4 and 5
- no commissions for extractions in Latin America
FAQ
Let’s answer the most frequently asked questions.
Does Elliott Wave Really Work?
Yes, this theory is widely used by traders all around the world. If you apply it correctly, you will get strong signals of the market direction.
How Many Waves Are There in Elliott Wave Theory?
The basic pattern consists of five impulse waves and three corrective ones.
What Is Elliott Wave Analysis?
It’s an analysis that counts the waves of the price movement and determines the future market direction based on the pattern and basic rules of the wave principle.
What Is Wave 3 of the Elliot Wave Cycle?
It’s one of the impulse waves that move in the direction of the primary trend.
What Is Wave 5 of the Elliot Wave Cycle?
It’s the last impulse wave of the cycle that moves in the direction of the trend. However, it’s supposed to have the smallest volume as not many traders believe in the trend continuation.
Where Do I Start Elliott Wave Count?
As soon as you see the formation of waves on the price chart, you can start counting regarding the picks where the market changes its direction. If you apply major rules, you will understand what wave is on the market now.
How Do You Trade Elliott Waves?
As Elliott Waves define a market reversal, a trader can open positions to trade in the new trend or close the previous position as soon as the wave signals a reversal.