Elliot Wave Theory
Most trading strategies and indicators were created with the intention of doing so. The analysts who created such strategies would spend months and sometimes even years in order to perfect the strategy and make sure it actually works in real market conditions. However, the trading strategy and theory we’re going to be taking a look at today were actually created by accident as the creator had no intention of making a strategy that would become so popular.
The Elliot Wave Theory was created by Ralph Nelson Elliot in the 1930s. What’s most surprising is that this theory was created during the later years of his life and that too by accident. Elliot knew he wanted to study market behavior in the later stages of his life but what he didn’t know was that this would lead him to develop one of the most popular trading strategies in the industry. After analyzing the markets, he developed The Wave Principle which would be followed by traders all around the globe.
Breakdown of the Elliot Waves
Like any trading strategy, there are a couple of components that go into the Elliot Wave theory in order for it to actually work and form a pattern that can actually be proved and followed. These components usually seem quite complicated when you first look at them on a chart or hear about them from another trader. In reality, they’re actually not that complicated once you actually understand them in the general language. The Elliot Wave consists of two components. They’re explained below:
Impulsive Waves make up the first component of the Elliot Wave strategy. It consists of five different waves or line directions that are said to follow the historical pattern of that particular trend. The Impulsive Waves could either be following an uptrend or a downtrend. Either way, whatever trend it does follow, the Corrective Waves which come after it will follow the opposite trend, but we’ll get to that in a second. Wave 1 will be a long line and let’s assume that it goes in the upward direction. If so, Wave 2 will be a retracement and will fall about 50%-60% the length of Wave 1. Then will come Wave 3 which will be the longest wave of the five and will take up a considerable height. Wave 4 will follow which will be another retracement and will also fall to about 50%-60% of Wave 3. Finally, we will have Wave 5 which will be another uptrend that will be about the same length as Wave 1.
Following the Impulsive Waves, we get the Corrective Waves. The Corrective Waves are meant to follow the opposite trend of the Impulsive Waves. Since in this scenario the Impulsive Waves followed an uptrend, the Corrective Waves will follow a downtrend. Unlike the Impulsive Waves which followed the numerological order, the Corrective Waves will follow the alphabetical order. Following the uptrend of Wave 5, the market will face a retracement known as Wave A which will fall to about the same level as Wave 4. Then the market will face a slight uptrend again with Wave B but it won’t be as high as Wave 5. Then it’ll face its final downfall which will be Wave C and it’ll fall much further than Wave A. Combining Waves 1-5 and A-C, we would have just witnessed the Elliot Wave Theory.
Best Timeframe for Elliot Waves
Although it is common knowledge that most trading strategies including the Elliot Wave strategy can be performed using any timeframe, we would really advise against it. We really recommend using the shorter time frames for this strategy like the five-minute, hourly, or daily time frames. This is because these timeframes show a more diverse candlestick pattern which would make it so much easier to identify and interpret any Elliot Wave patterns if they would be formed. However, if you’re more comfortable with any other timeframe, we do still recommend using that one instead as the last thing we want to do is take you out of your own comfort zone which is clearly helping you make good profits.
When to Place a Position on the Elliot Wave
Just like any other chart pattern strategy, we are often left quite confused on when we can say for certain that a certain pattern like the Elliot Wave is currently taking place. Do we wait for another wave to form? What if we’re too late and we miss the trend? What if this isn’t really the Elliot Wave? These are just a couple of the questions that go through our minds when we’re deciding on whether or not to open a position on what we think is an Elliot Wave. There is no real rulebook to guide us on when is best to open a trade or when do we know for sure that the pattern we are seeing is an Elliot Wave. The best we could probably do is wait for at least three waves to form which all follow the Elliot Wave pattern in order to have a good chance of being right about the wave theory.
Elliot Wave Trading Strategies
Unlike most trading strategies which are usually performed on their own, the Elliot Wave Strategy usually works best with another trading strategy performed along with it. This is because we’re mostly just guessing when the wave will change direction or if it’ll continue in the same direction. In order to have a better chance of knowing the wave directions, we have to combine this strategy with another. Here are some of the most profitable and popular Elliot Wave trading strategies:
Elliot Wave with Fibonacci Retracement
One of the most popular combinations with the Elliot Wave is the Fibonacci Retracement. This is because the Fibonacci helps us better predict when a wave is going to end and the next one is going to begin. With the Fibonacci, we’re mostly just guessing on the length of each wave which is quite a risky way to trade. Let’s look at some possible extension levels:
- If wave 1 is extended, wave 3 is about 61.8% to 78.6% of the size of wave 1.
- If wave 1 is extended, waves 2 and 4 will usually retrace between 23.6% to 38.2% Fibonacci retracement.
- If wave 3 is extended, wave 1 and wave 5 are equal in length or the 61.8% relationship is next most likely.
- If wave 3 is extended, wave 4 retraces between 23.6% – 38.2% Fibonacci retracement levels.
- If wave 1 and wave 3 are equal, wave 5 is extended.
- If wave 5 is extended, then it finishes at 161.8% Fibonacci extension.
Elliot Wave with SMA
If a negative Elliott Wave signal is seen at the same time as a 50-day simple moving average that suggests downward momentum, this might reinforce the assumption that a price decrease is expected in the near future. On the other hand, if the Elliott Wave signal is positive and there is upward momentum in combination with the 50-day simple moving average, this may encourage a bullish trend on that currency pair.
Elliot Wave with MACD
The MACD line may be used to assist in locating the third wave of a five-wave structure. The third wave is often the longest and strongest wave of the structure. Traders may use this to their advantage in order to recognize a five-wave structure while it is forming rather than after the pattern has been properly developed.
Benefits and Drawbacks of This Strategy
Although the Elliot Wave theory is quite popular, you shouldn’t just follow it because everyone else is following it too. It’s best to properly understand its pros and cons before making any decisions. Here are the benefits and drawbacks of this trading strategy:
The Elliott Wave Theory provides value because it gives a framework for arranging information on price movement into graphical representations that are simple and easy to comprehend. Even inexperienced traders are able to start using this theory to guide their decision-making if they have a solid knowledge of the theory’s underlying laws. On the other hand, the fact that Elliott Wave trading is so common is an asset in and of itself. Its importance to forex trading is increased when a big number of traders are studying these patterns and trading based on the information.
Despite its many benefits, the Elliott Wave Theory does have several shortcomings that can make trade analysis more difficult and result in incorrect assumptions being drawn. In contrast to the precise ratios and thresholds that traders may keep an eye out for when using Fibonacci patterns and other comparable methods, the identification of patterns using Elliott Wave Theory is more up to interpretation. Traders are responsible for independently recognizing these patterns, and the price fluctuations that indicate the beginning and ending of a wave can be interpreted in a variety of different ways depending on the trader. As a result of this, some critics of the theory believe that it is too unpredictable to provide reliable direction in the financial markets.