You'll have heard of Elliott waves - but do you know how to use them? On this blog, we break down everything you need to know about Elliott waves, how to spot them, and some trivia as to why they appeal to both analytics and creatives...
Got your trading plan in order? If you haven't, no problem - here's your ultimate checklist for what to include.
What is the Elliott Wave Principle?
Ralph Nelson Elliott discovered a principle which he believed could explain and model human behaviour in the financial markets. One of the basic tenets of this principle is that human behaviour, just like nature itself, occurs in patterns and as such can be studied and defined.
He based his studies on research conducted studying the stock market and established that market price patterns occur in waves. Just as with nature, there are periods of growth and decline.
He classified these waves into two main categories: impulse waves and corrective waves. The impulse waves occur during periods of growth, and corrective waves occur during periods of decline. Impulse waves are made up of five waves denoted in numbers, while corrective waves consist of three waves and are usually denoted with letters.
Fig 1. A depiction of the Elliott Wave structure
Types of Elliott Wave patterns
R.N. Elliott identified thirteen patterns of wave formations in his study of the stock markets. They are classified into the two broad categories of motive/trend and corrective/counter-trend.
The motive waves are also called trend waves because they move in the direction of the major trend. All motive waves have five sub waves. The motive wave patterns are:
- Leading diagonal
- Ending diagonal
- Single zig zag
- Double zig zag
- Triple zig zag
- Running flat
- Horizontal flat
- Expanding flat
- Contracting triangle
- Ascending triangle
- Descending triangle
- Expanding triangle
Fig 2 An expanding/impulse wave observed on EURUSD (Chart Source: tradingview.com)
Fig 3 A flat correction wave formed on the EURNZD currency pair (Chart source: tradingview.com)
Fig 4 Descending triangle pattern on CHFJPY (Chart source: tradingview.com)
Brushing up on your reading? Here are 6 of the best forex books to dig into>>
How to identify Elliott waves
The key to marking Elliott waves is to follow the rules given as a guide by R.N Elliott himself and then modified by others over the years. So if you’re wondering, “How in the world are we supposed to figure out and label the waves correctly?”, follow these rules.
Rules for marking Elliott waves
For impulse waves:
- Wave 2 never retraces more than a 100% of wave 1
- Wave 4 never retraces more than a 100% of wave 3 and never overlaps wave 1
- Wave 3 always travels beyond the end of wave 1
- Wave 3 cannot be the shortest of the three impulse waves
- Wave 2 and wave 4 must display alternation in as many ways as possible
Any wave that does not obey the above rules is classed as a corrective wave.
Did Elliott hand us the magic keys to Wave City of Financial Freedom? Let’s see!
Where can the Elliott wave principle be applied?
The Elliott wave principle can be applied to all markets and financial charts and to all time frames, though each market has its own features that characterise it. Some markets may be known to have more of a diagonal pattern, while in some, they are rarely seen.
As for time frames, price occurs as a fractal. So a wave pattern on a daily time frame is made up of sub wave patterns in the one hour time frame, which in turn is made up of patterns on the 15 minute chart and so it goes on down to the 1 minute chart. So it can be applied by all types of traders, from position traders to scalpers.
Fig 5 An impulse wave seen on a 5m Chart (Chart Source: Tradingview.com)
Fig 6 Elliott wave count on the German 30 Index aka DAX (Chart source: Tradingview.com)
Learn from the experts: Lex van Dam is a Dutch investment manager, and the creator of the BBC's Million Dollar Traders. Read our Q&A with him here>>
Why bother with the Elliott wave principle?
One major point to note about the Elliott wave principle is that it sees the charts as a model of human behaviour. A support point is the beginning of a buying wave, which indicates that a large volume of buying orders came in at that point, and this moved the market in the upward direction. In the reverse, a resistance point is the beginning of a selling wave, indicating a consensus by market operators to sell there.
Using the Elliott wave, a trader can find the beginning of these moves, and therefore participate in the move early, resulting in low risk trades and high returns. In simple language: more money!
Can I make money using the Elliott wave principle?
With committed study of chart patterns, knowledge of the Elliott wave rules, good analytical skills and most importantly patience, anyone can make consistent profitable returns using the Elliott wave principle. Good accuracy and fewer losses can be achieved by combining the Elliott wave with other tools. These tools could be technical or fundamental - or a combination of both.
The Elliott wave principle could be combined with a tool such as the Relative Strength Index to predict market bottoms or tops. If a trader suspects that a fifth wave is ending, thereby leading to a change in direction, they can deploy the RSI tool to get a confirmation by checking for divergence.
A trader can check the news for fundamentals which could indicate a shift in the market. For instance, if the Fed (the FOMC) is expected to increase interest rates, this could mean a rise in the value of the USD against other currencies. So, if a trader suspects a climax in the current trend, they could get confirmation from this announcement.
Generally, fundamentals play a great role in determining the timing of market shifts. Hence it is advisable for a trader to keep an eye on the economic calendar for big announcements that could move the markets.
In summary, the Elliott wave principle has the potential to put lots of money in a trader’s account. The consistency and scale on which that happens depends on the trader.
How much do traders REALLY make? Take a look at our blog on the average trader salary>>
Advantages of the Elliott wave
Magnitude and strength of current wave
“I have often found that the Elliott wave structure of a market on a smaller time scale is a good clue as to the current health and probable future trend of a market” – Hank Pruden
The Elliott wave principle in combination with Fibonacci ratios can help traders determine the length of a current trend in the market. This could help in pointing out whether or not a move in price is a just a correction or a major trend. This could be useful to traders using mechanical strategies to understand the current market cycle.
Appeals to both analytics and creatives
According to Pruden in his book The Three Skills of Top Trading, a good trading system should appeal to both the analytical and creative parts of the brain. The Elliott wave principle fulfills both. How? Good question. The Elliott wave principle involves calculations using the Fibonacci sequence to predict market reversal points.
This is a left brain function. The wave’s forms and structures drawn on the charts appeal to the right side of the brain which is responsible for pattern recognition. So we see that applying the wave principle engages both sides of the brain - this is the beauty of the Elliott wave.