The best thing an aspiring trader can do is study well and sharpen his skills before entering the market. Most do the opposite; they enter the market first and then do their homework.
A trader should be aware of different strategies, tools, techniques, and working of the market. He should apply them to his trading and then choose the best one for him.
But because not everything is for everyone!
We would suggest you try and experiment with these tools, strategies, and techniques on a virtual trading account.
What? Where are the strategies?
Here!
But, today, we would talk about one of the most challenging trading tools. The Elliott Wave Theory! Don’t worry! We’ll make it easier for you.
In this article, we would discuss; what is Elliott wave theory, how and who developed this tool, what are its components, then, some essential guidelines and rules; and, finally how to trade using it.
Let’s start!
What is the Elliott Wave Theory?
Elliott wave theory is a technical market analysis tool which says that prices in any trading market repeat its pattern over time. Traders can use this technique to predict the costs, entry & exit points, high and lows, and other collective factors.
This theory works on the principle of human psychology and behaviour, which repeats itself over a particular kind of situation. Investor sentiments and mass psychology are the two main factors behind these repeating patterns.
He denoted the repeating patterns as “waves”, and further divided waves into two categories, i.e. impulsive waves and corrective waves.
How Elliott Wave Theory Developed?
Elliott’s theory was developed in 1930, by Ralph Nelson Elliott, after the 1929 Great Recession. He was an accountant and named this theory after him. He studied the 75 years of the stock market price chart in different yearly, quarterly, monthly, weekly, daily, and hourly time frames.
The theory did not get any recognition until 1935 when Ralph made some strange exact predictions about price lows. However, he made it clear that his tool doesn’t make any predictions. Instead, it works on the probability of market action.
Another exciting thing is Ralph’s theory got inspired by the Dow Theory, which works with a similar principle. But, he further added human psychology, nature, and sentiments in his approach. He broke down and analyzed the market in much greater depth and detail, than Dow’s Theory.
He later published a book on this theory titled, The Wave Principle, in 1938.
Basic Principle of Elliott Wave Theory
We first need to understand the two types of waves which Ralph proposed:
- Impulsive Waves: The bigger wave which moves in the direction of the trend.
- Corrective Waves: Waves which run against the market trend.
Now, the Elliott Theory says, prices move in a 5-3 wave direction, in which the five-wave pattern denotes impulsive, while corrective waves move in a three-wave pattern. In simple words, these waves are prices in the chart, and investor psychology repeats the same up and downtrend over time.
He denotes five impulsive waves as 1, 2, 3, 4, & 5, where 1, 3, & 5 are with the trend, and 2 & 4 are the counter-trends. Similarly, corrective waves as A, B, & C; and corrective waves move against the impulsive moves.
Elliott’s theory was developed in 1930, by Ralph Nelson Elliott, after the 1929 Great Recession. He was an accountant and named this theory after him. He studied the 75 years of the stock market price chart in different yearly, quarterly, monthly, weekly, daily, and hourly time frames.
The theory did not get any recognition until 1935 when Ralph made some strange exact predictions about price lows. However, he made it clear that his tool doesn’t make any predictions. Instead, it works on the probability of market action.
Another exciting thing is Ralph’s theory got inspired by the Dow Theory, which works with a similar principle. But, he further added human psychology, nature, and sentiments in his approach. He broke down and analyzed the market in much greater depth and detail, than Dow’s Theory.
He later published a book on this theory titled, The Wave Principle, in 1938.
Basic Principle of Elliott Wave Theory
There are two types of waves which Ralph proposed:
- Impulsive Waves: The more significant wave which moves in the direction of the trend.
- Corrective Waves: Waves which run against the market trend.
Now, the Elliott Theory says, prices move in a 5-3 wave direction, in which a five-wave pattern denotes impulsive, while corrective waves move in a three-wave pattern. In simple words, these waves are prices in the chart, and investor psychology repeat the same up and downtrend over time.
He denotes five impulsive waves as 1, 2, 3, 4, & 5, where 1, 3, & 5 are with the trend, and 2 & 4 are the counter-trends. Similarly, corrective waves as A, B, & C; and corrective waves move against the impulsive moves.
But Wait! The thing doesn’t just end up here.
There are specific guidelines and rules in this theory. These rules are critical and form a significant part of price predictions.
Rules & Guidelines of Elliott Wave Theory
There are three golden rules in Elliott wave theory. These are as follows:
Rule #1
Wave 2 cannot go below or above wave 1. The first wave is a trend-friendly wave, and the second is an anti-trend wave. Now, if the first wave rises or diminishes by some individual points, then the second wave should diminish or rise (depends on the first wave), by less than the first wave points. If not followed, then re-start counting the patterns.
Rule #2
Wave 3 cannot be the smallest of all impulsive waves. Moreover, wave three should be the longest but, if not that, at least it should not be the smallest of all.
Rule #3
Wave 4 and Wave 1 should not have any common graph area. It means both the waves should not overlap anywhere.
Now, understand all these rules below in the chart.
Guidelines
Elliott’s wave guidelines are so important that it can accurately tell you when you should enter and exit the market.
Let’s move to the three guidelines now:
Guideline #1
If Wave 3 is longest, then wave one and wave five would almost be equal.
This guideline would be useful for setting the target of wave five, a.k.a. When to exit or enter the market. If it is an uptrend market, then wave five would denote the highest point and vice versa.
Guideline #2
The pattern of wave two and wave four will be the opposite. If wave 2 is flat, then wave four would be very sharp and vice versa.
This guideline can help in predicting wave four and then wave five so that corrective actions can be taken.
Guideline #3
After the impulsive waves, the corrective waves end near the 4th impulsive wave low.
It is a good indicator of when to enter the market.
Confused…? Just look at the figure!
So, these were the rules and guidelines of Elliott’s wave theory. We repeat, if any chart is not satisfying any of the rules, then this theory would not apply there. Till now, you must have got fascinated by this fantastic technical tool for entry and exit. Remember, this tool is quite confusing, and only successful traders use this, and if you want to be one of them, then you must not miss the next part!
Now, you know everything about Elliott’s wave theory, except one thing. How to trade using Elliott’s wave theory? Let’s continue on this!
How to Apply Elliott’s Wave Theory in Trading?
1. Identify the Trend: The foremost thing the trader needs to do is identify the potential trend. Only after trend identification, you’ll be able to apply this tool. There are several strategies and techniques available through which you can identify a potential trend. One of the apparent trends starts with support and resistance levels. Do keep an eye on them!
But, here are the best techniques to identify a potential market trend.
2. Start Count: Once the trader identifies the trend, now it’s time to start the counting. Don’t ask now, why count and not trade. Because this is the confirmation step that the trend is starting soon! Do not be in a hurry; earn slowly.
Observe your way till wave two here.
3. Trade: Now it’s time to ride and take the benefits. After you observed wave one and saw that wave two is forming, remember rule no. 1 and make your entry as the wave two ends.
Traders can use other analyzers too like Fibonacci and candlestick.
4. Watch Profits: After investing, now see your money grow here. As we know wave 3 is generally the longest, you’ll make most of the profit here.
After this, wait till wave 5, and do not worry about the wave four downfalls. Remember, everything is going as per plan.
5. Walk out with the Profits: Now, be ready to take the benefits out. Use rules 2 & 3 to predict wave 5, and take out the required earnings.
Remember to take the profits out before the corrective wave hits the chart.
So, this was the complete overview of Elliott’s wave theory. We started with the history and slowly covered all the things and ended up trading using this tool.
Finishing Up
Elliott’s wave theory is a very fantastic technical analysis tool. It has gained popularity over time and is indeed very useful. But, the stock market is an unpredictable place, and does this tool guarantee success here? No! A big NO! It is one of the most sophisticated trading tools today. Not only beginners but many experienced traders also avoid using it too.
However, it is developed after several years of research and development and uses mathematical calculations as well as human intentions to predict prices. Thus, its underlying value should not be doubted.
Sometimes the count might end up at waves 3 or 4.
Sometimes, the trend might continue too after wave 5.
Anything is possible!
But, in most cases, if the rules are satisfying, this tool would work.
And, as the most successful traders have taken advantage of it, you must too.
