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Ralph Nelson Elliott was an American accountant who discovered the universal law of price movement in financial markets in the 1930s. Studying quote charts, he discovered that the price moves according to certain patterns — waves that are repeated over and over again on all time frames.
Based on his discovery, Elliott developed wave theory, which allows one to predict future price movements with high accuracy. Today Elliott principle is one of the most popular technical analysis tools among traders and investors around the world.
Basic postulates of Elliott wave theory
- The market develops cyclically, through alternating bullish and bearish trends.
- According to Elliott’s theory, each market cycle is formed from 8 waves of different directions. Five of them move towards the main trend and are called impulse. Three waves that go against the trend are called correctional.
- For ease of analysis, impulse waves are designated by numbers from 1 to 5, and corrective waves by the letters A, B and C.
- The Elliott wave principle is fractal: it can be seen on all scales, from large monthly charts to minute time frames. Each impulse wave, upon closer examination, itself consists of five subwaves, and each corrective wave consists of three.
- To analyze the proportions between waves, Elliott suggested using numbers from the Fibonacci sequence. Thus, the third wave often turns out to be 1.618 times longer than the first (this is the so-called “golden ratio”). And the fourth wave, as a rule, rolls back exactly 38.2% or 50% of the length of the third.
- Another interesting property of waves that Elliott discovered is their self-similarity on different time frames. The hourly candlestick chart can exactly repeat the pattern that formed previously on a daily or even weekly scale. This allows us to analyze the potential for movement in junior TFs, taking into account the balance of power in senior ones.
Basic Elliott Wave Patterns
According to the theory, the price forms several typical patterns both in trend movement (impulse waves) and in flat/correction:
- Impulse (1-2-3-4-5) — classic trend pattern. Waves 1, 3, 5 — movement along the trend, waves 2 and 4 — corrections.
- Zigzag (ABC) — the simplest correction pattern. Consists of 3 waves: two impulse in the direction of correction (A and C) and one against (B).
- Flat (3-3-5) — a correctional model of 3 waves, where A and B are three-wave zigzags, C is a five-wave impulse.
- Triangle (ABCDE) — a trend continuation pattern after a protracted correction. The price forms 5 converging waves inside the triangle, followed by an impulse exit.
Examples of using Elliott waves in trading
Let’s look at several real cases of how, using wave analysis, it was possible to predict price movements and open profitable trades.
Example 1: Impulse on the Bitcoin chart In the period from December 2018 to June 2019, the price of Bitcoin formed a classic five-wave upward impulse.
- Wave 1: growth from $3200 to $4200
- Wave 2: correction to $3400
- Wave 3: powerful impulse to $9200
- Wave 4: pullback to $7400
- Wave 5: Final push to $13,800 Once the impulse ended, there was a deep pullback, opening up a shorting opportunity. Either from the end of wave 5, or after the formation of an A-B-C correction.
Example 2: Zigzag on the EUR/USD chart At the beginning of 2020, a downward zigzag formed on the daily chart of the EUR/USD pair.
- Wave A: decline from 1.1500 to 1.0650
- Wave B: correction to 1.1150
- Wave C: the main impulse down to 1.0500 By opening shorts on the breakout of the low of wave A, it was possible to catch the trend in wave C and get about 450 points of profit (4.5 figures).
Example 3: Triangle on the oil chart In the summer of 2019, a symmetrical triangle formed on the 4-hour chart of Brent oil. The price completed 5 waves inside the figure, followed by an upward impulse breakout.
- Wave A: $60 — $64.50
- Wave B: $64.50 — $58.50
- Wave C: $58.50 – $66
- Wave D: $66 — $57
- Wave E: $57 — $61.50 By opening a long position from the lower border of the triangle around $57.50 with the goal of breaking through wave C ($66), in a few days it was possible to earn more than 10% of the deposit.
Results
Elliott wave principle — a powerful tool for market analysis and forecasting. Understanding the structure of price movements and the ability to determine the current price position in the general cycle open up enormous opportunities for building profitable trading strategies.
The main advantages of wave analysis:
- Provides insight into the global market picture and long-term trends
- Allows you to find entry points and targets for transactions at different scales
- Combines with other types of analysis (indicator, volumetric) to confirm signals
- Applicable on any markets and timeframes
But like any other method of analysis, Elliott waves are not a panacea. Price models can be ambiguous and can be interpreted in two ways. Often the waves look stretched or compressed, and the proportions are distorted. Therefore, the Elliott principle must be used in conjunction with other approaches to technical and fundamental analysis.
And of course, learning wave theory takes time, effort and practice. You need to analyze hundreds of charts, observe the development of different patterns, and get better at counting waves. This is the only way to train observation and intuition, and learn to correctly interpret market signals.
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