Elliot Wave Theory: The ultimate guide how can you get profit on this theory
All traders wish for success and safe trading in all situations. However, some circumstances work against trading, causing loss, especially in the case of an incorrect prediction. Elliot Wave Theory predicts the downs and ups of trading, usually in the form of signals called waves.
Elliot Wave Theory is also a theory of fractals: fractal nature of market action. Fractals, by definition, are an exact representation of the original size/shape, irrespective of the new modification: reduce or increase in size/shape. Elliot Wave Theory, in the form of fractals, communicates with traders aiding easy prediction: to proceed with/exist trading. The theory is well accepted globally, claiming to be the reason for many breakthroughs in the trading world. How does Elliot Wave Theory work, and how can you utilize it? Understanding the basic principles of Elliot Wave Theory would be best before you learn the advantages and applications in trading. Here’s how:
Understanding the Elliot Wave Theory
Ralph Nelson Elliot was an accountant and author. He spent most of his life studying books on trading and market value because he was diagnosed with a disability preventing him from performing his daily duties. He discovered a better understanding of trading called the Elliot Wave Theory. The waves connect repetitive patterns of waves and stock market movements. Any trader who understands these factors: “waves pattern” and “market movements,” has an effective evaluation/prediction of the next market action – this is all about Elliot Wave Theory.
By definition, Elliot Wave Theory is an essential representation of fractal waves. The fractal nature of market action is the identical representation of repeated action in which you predict the next waves/market action via proper interpretation.
The Basic Principles of Elliot Wave Theory of 1930
Understanding Elliot Wave Theory requires simple knowledge of ascending (unfolding) and descending wave patterns. From the figure above, the ascending waves are called motive waves, and the descending waves are called correction waves. The motive waves are usually in the form of impulses: a representation of a strong wave moving in the underlying trend’s direction. Underlying trends determine the price of financial assets; thus, a movement coinciding with this trend affects the financial assets and could move upwards or downwards. Contrarily, the correction wave moves against the underlying trends.
For example, “1” represents the upward movements of motive waves, while “2” represents the downward movements of motive waves. So, the waves at this point coincide with the underlying trends. Also, “A” represents the opposite movement of “1”, while “B” represents the opposite movement of “2.” Both motive and corrective waves move “upwards and downwards.” However, the movement against or towards the underlying trends is the determinant factor for classifying the waves in Elliot Wave Theory.
The motive waves are unfolding waves moving in the direction of the underlying trend, labeled as 1, 2, 3, 4, and 5 above. Corrective waves move against the underlying trend, labeled as A, B, and C above. Both waves could be long or short terms. Elliot Wave Theory is unique because it shows a smaller version of the big waves. The term “smaller” and “bigger” wave values indicate the significance of the fractal nature of market action in theory.
Again, study the figure below. (i), (ii), (iii), (iv), and (v) are more minor impulses of the bigger motive waves: 1, 3, and 5. Note that the dominant trend in this market is upwards, so the motive wave. Thus, five waves face up and three waves down.
Contrarily, corrective waves (A, B, and C) move downward. Wave A is against the underlying trend: a five-wave counter-trend impulse; wave B is three retrace waves, and wave C is another five-wave counter-trend impulse. Wave 2 is the smaller degree of bigger corrective waves A, B, and C.
Study the figure below:
Motive and corrective waves are the basics of this theory. The ability to identify, classify, and interpret the waves signifies a better understanding of this theory and how well you can utilize the process. As much as the theory predicts the future of successful treading, do note that “predictions” are not always correct. Likewise, interpretation of wave values varies per trader.
Elliot Wave Theory via Fibonacci
A mathematician, Leonardo Fibonacci da Pisa, developed the Fibonacci ratio from his six years of studying different financial cases. He discovered the relationship between numbers among values of the same degree. For example, the Fibonacci ratio shows that individual waves in Elliot Wave Theory differ among their pairs. Thus, each wave’s significance is unique irrespective of its appearance or values. The Fibonacci ratio shows a slight difference in values because its working principle is in decimals.
Almost all markets, including financial markets, use the Fibonacci ratio: the Fibonacci (numerator) divides the Fibonacci (denominator). The Fibonacci ratio shows slight changes – resistance and support within the value system.
Fibonacci measures the target of a wave’s move in Elliot Wave Theory: as much as there are few apparent changes in Elliot waves by merely looking at them, the Fibonacci ratio shows this relationship between Elliot Waves Structures. In short, the effective application of Elliot Wave Theory requires a better understanding of the Fibonacci ratio. Here are some instances:
- Wave 2 cannot take up to 100% of wave 1; it is about 50%, 61.8%, 76.4%, or 85.4% of wave 1.
- Wave 3 takes about 161.8% of wave 1
- Wave 4 takes about 14.6%, 23.6%, or 38.2% of wave 3
- Wave 5 is 1.236 – 1.618% of wave 4, equal to wave 1
The Fibonacci information above gives traders a better understanding of the point of entry and profit target whenever they want to enter a trade. The first step in achieving successful trade is a good point of entry. All traders know the importance of a “point of entry,” which is why several techniques are employed to secure a good point of entry, indicators, trendlines, moving averages – and obviously, Fibonacci.
Profit target, just like the name sounds, is the point at which traders take profits: once the profit reaches this target, the trade closes. A profit target is important when initiating a trade, especially because you have to set the profit target at the beginning of your trade. With Fibonacci of the Elliot Waves Structure, you know when and how to set a profit target via prediction.
Again, all traders are responsible for their decision and prediction because the theories show only the basis of prediction and not a perfect way of earning profits. However, through the concept analyzed here, entering a market via a good point of entry and profit target gives you a better chance of existing with gain.
Elliot Wave Theory Interpretation
Motive waves are traditionally defined as any waves that move toward a bigger trend and are generally believed to be 5 waves. The 5 motive waves are classified into three subcategories: Impulse wave, Impulse with extension, and diagonal.
The statement, “5 waves move in the direction of the underlying trend,” is the old term and belief. In today’s market, motive waves unfold into 3 waves (not necessarily 5 waves). Thus, a motive sequence is an applicable term instead of motive waves.
A motive sequence is defined as incomplete waves, usually called swings. Although the sequence can be corrective, it is typically important in predicting impulse extension and finished move: you may not necessarily waste much time after observing swings since it predicts the next motive moves.
Study the figure above.
Impulse Wave Guidelines
- Impulse waves exist as 5 waves. In Figure 4, the impulse waves are 1, 2, 3, 4, and 5.
- Waves 1, 3, and 5 are impulse waves. Each subdivision includes (i), (ii), (iii), (iv), and (v) as smaller waves.
- Wave 2 retraces only the beginning of wave 1 (and not more).
- Wave 3 never assumes the minimal form wave of 1, 3, and 5 (the three impulse waves)
- Wave 4 cannot cross wave 1’s price
- Wave 5 closes as momentum division
Fibonacci Ratio Relationship with Motive Waves
- Wave 2 cannot take up to 100% of wave 1; it is about 50%, 61.8%, 76.4%, or 85.4% of wave 1
- Wave 3 takes about 161.8% of wave 1
- Wave 3 takes about 200%, 261.8%, or 323.6% of wave 2
- Wave 4 takes no more than 50% of wave 3: only about 14.6%, 23.6%, or 38.2%
- Wave 5 takes 3 versions of measurements: first, wave 5 is 1.236 – 1.618% of wave 4 (inverse), the same value as wave 1; and 61.8% of wave 1+3
- Impulse waves with extension
Impulse wave with extension guidelines
- One of the motive waves (1, 3, or 5) usually displays impulses with an extension
- Elongated impulses and exaggerated subdivisions are characteristics of an extensions
- The stock and forex markets show extensions frequently in the third wave, while the fifth wave is for the Commodity market.
Elliot waves personality
Wave 1 does not show significant changes in the wave properties; thus, difficult to interpret or locate among the whole waves. The market is in a delicate situation at this point. The beginning of the new bull market shows negative fundamental news. The previous trend still strongly impacts the trade; traders keep a good eye on their earnings because the economy does not look strong. In wave 1, the options market’s volatility is high, active vogue put options, and bearish sentiment surveys. Alerting many technical analysts may not be necessary since the volume rarely increases with an increased price.
Wave 2 corrects wave 1 but still follows the guidelines as stated above: wave 2 retraces only the initials of wave 1 (and not more).Wave 2 cannot take up to 100% of wave 1: it is about 85.4%, 76.4%, 61.8%, or 50% of wave 1. The bear market is in a safe zone, although the news is bad. Also, the price retest the prior low, and bearish sentiment builds.
Wave 3 is the most powerful and largest wave in a trend. However, wave 5 shows to be the largest trend in commodity markets. The fundamental analysts raise earnings estimates, and positive news comes in place. In wave 3, the news is likely bearish, with negative market players. The extension between wave 3 and wave 1 is by the ratio of 1:618:1.
Wave 4 is corrective. Buying begins, and prices rally at the end of wave 4, although the prices may shift to a side way for a long period. Wave 4 follows the same wave guidelines: it takes no more than 50% of wave 3: only about 14.6%, 23.6%, or 38.2%. You may buy a pull back, assuming you know the potential ahead of wave 5.
Wave 5 indicates the final direction of the underlying (dominant) trend. In wave 5, many momentum indicators show divergences (high prices without peak indicators) and lower volume than in wave 3. Advances in wave 5 come as contributions from a small set of traders; it lacks the strength in wave 3 rally, although the prices reach a new high beyond the top of wave 3.
Wave A is usually hard to find in a bear market; however, the fundamental news remains positive. Correction waves are generally hard to identify: most analysts interpret drops as a correction in a still-active bull market. Wave A’s technical indicators are increased volume and open interest in markets. Likewise, increase wave A indicates the options market’s volatility.
Wave B volumes are lower than wave A. At this moment, fundamentals are probably not improving, although they may remain positive.
Everyone realizes the entrenched bear market and that the volume has picked up.