Elliott Wave Theory Explained
Market prices are determined by the interaction of a large number of participants. Ralph Elliott, an American accountant, analyzed their behavior in detail and came to the conclusion that it is quite predictable.
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According to the Elliott Wave Theory, every price movement of an asset is cyclical. This movement can be split into segments (waves) that consistently connect the minimum and maximum price rates. This is shown on the chart as a structure made up of three corrective waves and five bullish waves.
Impulsive waves of the bullish phase are numbered 1, 2, 3, 4, 5, whereas the corrective waves are lettered A,B,C.
Ralph Elliott claimed that the market is made up of a large number of participants whose behavior can be predicted. Each of the five market phases is clearly explained in terms of psychology:
1 – the beginning of growth. Market growth is often triggered by good news, which can eventually lead to the start of a bullish rally. Typically, during this phase the majority of traders have not yet recognized the opportunity, and the trading volume is still quite low.
2 – correction after a period of growth. Some traders take profits at a local peak and put pressure on the price.
3 – a new wave of growth. The third wave's price peak is always higher than the first wave's. The third wave is always the longest. This is because most traders have already done their research and want to profit from a growing price of the asset.
4 – corrective wave. Another phase of correction after a long growth. At this stage, most market participants take profits at high levels.
5 – the final phase of growth. Investors and traders who did not manage to make profits during the first and third waves, are often the most active in the market during this wave.
The theory includes mathematically defined wavelength characteristics. You can see them in the table below. When trading, it is important to keep in mind that these characteristics do not always work perfectly.
Wave size ratio according to Elliott Theory
Wave analysis can help you to determine profitable entry points, and the use of wavelength criteria can help you to exclude a lot of misleading signals.
How to use the Elliott Wave Theory in trading
As we know that the bull trend is divided into five waves, with the first, third, and fifth phases rising, long and medium-term positions are optimal at those stages. Short positions will be prioritized during the second and fourth waves of growth.
Wave analysis has the advantage of working ahead of time, whereas technical analysis usually works with a delay.
This means that a trader who uses this theory must first assess the current wave and then look for profitable entry points (most often, the beginning of the first and third waves of a growing trend). Furthermore, the theory helps to determine the possible range of price movement, since the waves have established characteristics.
Opening positions after getting the confirmation of the beginning of the third wave is one of the low-risk trading strategies, according to the Wave Theory. If we know that during the third wave the maximum asset price is set higher than during the first wave, then the breaking of the previous peak will give a good stimulus for ongoing growth. In this case, it makes sense to place an order just above the peak of the first wave.
The safest moment to place a buy order is the top of the first wave and the middle of the second
Another trading strategy is known as “reversal.” The trader predicts the approximate point of the wave's end by knowing the wave's characteristics in advance. At this point, he places an order to profit from a movement in the opposite direction of the current trend.
The Elliott Wave Theory, like all other analysis techniques, provides the most reliable and accurate signals when used on longer time frames.
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