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Have you ever observed that the price chart never moves in one perfect straight line? Price movements always look like twists and turns shaped like waves. Well, in 1920 there was a trader who observed this, the result of his reflection is known in the trading world as the Elliott wave theory according to the name of its inventor Ralph Nelson Elliott.
Not only beginner traders, but many experienced traders admit that it is difficult to use the Elliott wave theory. Here's the full explanation. But before that, you can download the GIC Mobile application on the Play Store or App Store to be able to trade on GIC.
Table of Contents
What is the Elliott wave theory?
Elliott wave theory or Elliott wave is a technical analysis used to predict the direction of trend movement by observing the market cycle in the form of waves. This wave was the result of the reaction of market participants and reflected the psychology of the market at the time. Well, market movements, whether up or down, according to this theory, always appear in recurring patterns.
This wave is a reflection of the imbalance in market sentiment which ultimately causes the price to lead in one direction only. If the line looks up, then the situation and market conditions are feeling euphoria, and vice versa, if the line looks down, it means that the trader is in a panic, so it continues to push the price until it continues to decline. While a corrective wave is when an equilibrium point is reached after a price imbalance occurs during a period of corrected impulse waves.
The speed of price movement is the most influential factor in this corrective wave. The faster the price goes up, the greater the potential for a downward correction in the price. On the other hand, if the price declines so quickly, then the potential for an upward correction will be more open. Although the Elliott wave theory is based on stock price movements (because the forex market was not traded when it was discovered), the Elliott wave theory can be used in all types of markets, including forex.
Simply put, the basic principle of wave theory is to identify the psychological reaction of traders to changes in market price movements. According to the inventor of this theory, Ralph Nelson Elliott, price always has a tendency to always move in two conditions, namely impulsive waves and corrective waves. An impulsive wave is a price movement in one direction over a certain period.
This wave is a reflection of the imbalance in market sentiment which ultimately causes the price to lead in one direction only. If the line looks up, then the situation and market conditions are feeling euphoria, and vice versa, if the line looks down, it means that the trader is in a panic, so it continues to push the price until it continues to decline. While a corrective wave is when an equilibrium point is reached after a price imbalance occurs during a period of corrected impulse waves.
The speed of price movement is the most influential factor in this corrective wave. The faster the price goes up, the greater the potential for a downward correction in the price. On the other hand, if the price declines so quickly, then the potential for an upward correction will be more open. Although the Elliott wave theory is based on stock price movements (because the forex market was not traded when it was discovered), the Elliott wave theory can be used in all types of markets, including forex.
Before continuing on how to use this elliot wave, you can register to join an Affiliate IB or invite your friends to trade so that you can get income and other bonuses to use in trading with GIC.
Five Waves Pattern (Motif and Korektif)
In the Elliott model, market prices alternate between an impulsive phase, or a motive phase, and a corrective phase on all trend timescales. The impulse is always subdivided into a set of 5 low-degree waves, alternating again between motives and corrective characters, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces than waves 1 and 3.
In Figure 1, waves 1, 3 and 5 are motive waves and they are further divided into 5 smaller degree impulses labeled as ((i)), ((ii)), ((iii)), (iv)), and (v)). Waves 2 and 4 are corrective waves and are further divided into 3 smaller degree waves labeled as ((a)), ((b)), and ((c)). The 5 waves move in waves 1, 2, 3, 4, and 5 forming a larger degree motive wave (1) The corrective wave divides into 3 smaller degree waves, denoted as ABC.
Corrective waves start with a counter-trend impulse of five waves (wave A), a retrace (wave B), and another impulse (wave C). 3 waves A, B, and C form a corrective wave of a greater degree (2) In a bear market, the dominant trend is downward, so the pattern is reversed—five waves down and three waves up.
Wave Degree
The title Elliott Wave is the language of Elliott Wave to identify cycles so that analysts can identify the position of waves in the overall progress of the market. Elliott acknowledged 9 degrees of waves from the degrees of the Grand Super Cycle typically found in weekly and monthly time frames to the degrees of Subminuette found in hourly time frames. The above scheme is used in all EWF charts.
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How Elliott Waves Work
Some technical analysts try to profit from wave patterns in the stock market by using the Elliott Wave Theory. This hypothesis says that stock price movements are predictable because they move in a repetitive up-and-down pattern called waves created by psychology or investor sentiment.
This theory identifies two different types of waves: motive waves (also known as impulse waves) and corrective waves. This is subjective, meaning that not all traders interpret the theory in the same way or agree that it is a successful trading strategy.
Unlike most other price formations, the whole idea of wave analysis itself is not the same as a regular blueprint formation where you simply follow the instructions. Wave analysis offers insight into trend dynamics and helps you understand price movements in a much deeper way.
Photo by Julie Bang © Investopedia 2020
The Elliott Wave principle consists of impulse waves and corrective waves at its core.
How to use Elliott wave for trading?
In the Elliott wave theory, there are basically eight waves that are formed and are always repeating. These eight waves consist of the main trend which includes five waves i.e. waves 1-2-3-4-5, while the correction consists of three waves that are in the opposite direction to the main trend i.e. waves A-B-C. Elliot calls it a 5-3 wave pattern. Each wave motion can be broken down into smaller sub-parts with the same 5-3 wave pattern.
Each sub-section can be broken down into even smaller sub-sections with the same wave pattern. Wave patterns in the Elliott wave theory that can be broken down into smaller parts and are exactly the same are called fractals. You can understand better by looking at the image below.
Eight Elliott Waves[/caption] Based on this fractal fractional pattern, Elliot divides the wave scale from largest to smallest into grand supercycle, supercycle, cycle, primary, intermediate, minor, minute, minuette, and sub-minuette. As explained earlier, the movement of five waves in the same direction as the trend is called an impulsive wave.
In the pattern, the 3rd and 5th waves move in the direction of the main trend, while the 2nd and 4th waves are corrections on impulsive waves. However, corrections in impulsive waves are different from corrective waves A-B-C. To make it easier for you, here is an explanation of impulsive waveform and corrective wavemotion. To better understand the elliot wave, you can take the Preliminary Test from GIC regarding how far you are in trading itself.
Impulsive wave-action
1. The first wave
In the first wave, usually the price of assets will tend to start to rise, investors or traders feel that the price of assets is very cheap and at an appropriate number so this is the right time to place a buy order. This is what causes asset prices to rise.2. Second wave
During the second wave, investors or traders who have bought the asset, feel that the price is too high and decide to sell the asset. This caused the price to fall, but not to the previous low as many held short positions.
At this moment, you can see that if the psychological factor plays a big role, many traders and investors do not make a cut loss (the act of selling) because the losses they experience are still tolerable or have not touched the stop loss level (the lowest price limit value) that they have determined if they use a stop loss.
3. Third wave
This wave is the longest and strongest wave. In the third wave, many investors and traders who have not yet bought feel interested and curious to own the asset. After that, the price of the asset will rise, tending to rise to exceed the highest level in the first wave.
4. Fourth wave
During the 4th wave, investors and traders who had bought the asset in the first wave felt that the price was too expensive, and then sold it to get maximum profit. However, as you can see in the picture, the 4th wave looks short, that is, there are still many who are holding the asset, especially those who bought the asset in the third wave.
5. Fifth wave
In this wave, the asset is increasingly attractive to traders. The price will certainly soar because more and more people are buying. This phenomenon is commonly known as hysteria.
Experienced traders and investors will immediately sell the asset before the A-B-C corrective wave pattern occurs. The following is an explanation of corrective waves. After knowing about impulsive waves, you can take the time to conduct an internal survey so that we can find out about GIC user satisfaction.
Corrective waveform
1. Zig-zag formation
The zig-zag formation on corrective waves is the steepest bearish pattern compared to the main trend which is waves 1-5. Wave B is usually the shortest wave compared to waves A and C. This formation can occur two to three times and occur continuously, but always in the same order, namely A-B-C, A-B-C.
Zig-zag Formation
2. Flat formation
This formation is in the form of a sideway wave with the same wavelength. Wave B has a position in opposite directions to A and C. Under certain conditions, the wavelength of B can be longer than A, or the peak of wave B exceeds the peak of A.
Flat Formation
3. Triangle formation
A triangle formation is a formation with a flat wave-like shape but bounded by a convergent trend line (getting smaller as shown in the image below), or divergent (getting wider). This formation usually consists of five waves.
Triangle Formation
You can see the example chart below to see the use of the Elliott wave indicator in forex trading in both bullish and bearish conditions. Since the Elliott wave indicator is a theory, you can use it on any trading platform or application including MT4 and MT5.
Example of an Elliott wave during a bullish trend
Example of an Elliott wave during a bearish trend
Rules of Elliot Wave Theory
There are three rules that you can't break if you want to use Elliot Wave Theory. Here are the three regulations:
- Impulse wave number 3 should not be shorter than waves number 1 and 5.
- The start of impulse wave number 2 should not be lower (if bullish) or higher (if bearish) than the start of impulse wave number 1.
- Impulse wave number 4 should not touch the highest limit (if bullish) or the lowest limit (if bearish) on impulse wave number 1.
What does Elliott's wave theory have to do with Fibonacci?
Also Read :
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Fibonacci Retracement: Definition and How to Set the Indicator |
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Miscellaneous Fibonacci Technical Indicators |
If you are studying the Elliott wave theory as one of the analysis techniques, surely you will often find a connection between the Elliott wave theory and Fibonacci. In a book titled Nature's Law, Ralph Nelson Elliott, explains that the numbers in the Fibonacci series are the mathematical basis of the principle of wave movement.
Technical traders who trade using the Elliott wave theory always apply Fibonacci retracements to find out the limits of correction levels in waves 2, 4, A, and C and Fibonacci extensions to find out the limits of wave expansion before corrections occur in waves 3 and 5.
Traders will usually look at all the Fibonacci retracement and expansion levels because they cannot predict which retracement level will get a response from the market so that the price will move again in the direction of the main trend or which expansion level the market will respond to to start the correction phase.
Not only that, in order for the confirmed signal to be valid, traders can also use technical indicators such as oscillator indicators such as RSI and stochastic as well as price action observation as signal confirmers.
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