What is Elliott Wave Analysis and How to Utilise it

Elliott wave analysis is the study of recurring wave patterns on a price chart, driven by investors’ sentiment, to speculate future market movement. It was developed by Ralph Elliott.

Let’s closely look at its framework and how to implement it:

Types of Elliott Waves

Elliott proposed that complete market cycles unfold in a repeated 8-wave pattern. It consists of 5 waves in the direction of the larger trend (known as impulsive/motive waves) followed by 3 waves moving against the main trend (termed corrective wave). He asserted that this fundamental 5-3 wave combination forms a complete trend cycle.

Motive wave

As mentioned before, an impulsive wave has five sub-waves. Three in the direction of the main trend (waves 1, 3 and 5), and two corrective waves (W2 and 4) that move against it. Waves 2 and 4 are smaller pullbacks within the larger trend structure. Wave 3 is usually the longest and the most powerful (often driven by market momentum/participation).

Let’s dissect the 5-wave pattern in an uptrend:

Wave 1: The first upward movement in the market. A few people who think the price of target currency is low, buy it, thus triggering this movement.

Wave 2: This wave goes downward; the opposite direction of the previous swing. We notice this bearish market because early buyers now sell the asset, take their profits and exit. But despite this, the new price does not fall to the previous low. Many traders still view this new level as a fair price to buy.

Wave 3 is like wave 1, but stronger. As price shoots up, more people begin to join in, along with big market players.

Wave 4: As prices became very high in W3, some of the early investors sold and took their gains. So here (in wave 4), we see the price nosedive. But the fall is not that strong. The reason is some traders still expect an uptrend or still view the asset at that level as “fair/discounted price”.

Wave 5: Many market participants buy here. The trend is very clear and nobody wants to miss out. This new spike intensifies because of FOMO trading. This swing is believed to be a trap to create liquidity.

(For a downtrend, we see the opposite psychology of the uptrend: 1st downward movement happens due to initial sellers. W2 is buyers taking profits, causing an upward bounce. W3 is a strong & accelerated downward movement as more sellers join in. Wave 4 is some sellers take profits, resulting in a shallow upward bounce. And lastly, W5 is the final downward plunge driven by panic selling).

Corrective Wave

Formations that go against the dominant trend. They function as a pause or retracement. We will talk about the three main families of corrective patterns: Zigzags, Flats, and Triangles:

Zigzag: Visually, B is the shortest wave. B must not retrace beyond the start of A. Wave C usually extends beyond the end of A.

Flat: A sideways structure. B retraces a big portion of A (often near or beyond its start). C is a five-wave impulse that most times ends near or slightly beyond the end of A.

Triangle: Unlike other corrective patterns, the triangle is made up of 5 waves (labeled ABCDE). These waves move sideways. It is a brief moment of pause before the primary trend resumes. It can be ascending, descending, expanding, or symmetrical in shape. It often forms before the final wave in an impulse or correction (W4 or Wave B respectively).

How to use Elliot Wave analysis to your advantage

1. The first thing is to recognise the five-wave impulsive, and three-wave corrective patterns on your chart across multiple timeframes.

2. After you have identified the current wave count, anticipate the next possible price behaviour. If a 5 wave is completing, then a corrective three-wave should be expected next. Knowing where you are in the progression is important.

3. Also, knowing the character of the waves can help you position wisely. Understanding that Wave 2, for instance, cannot retrace more than 100% of 1, or that W4 cannot overlap wave 1’s price territory, can help you determine invalidation points. It can help you know your entry and exit zones.

4. You can also use fibonacci ratios (like 0.382, 0.50, 0.618) to project potential environments for waves, and to tell likely reversal areas within a wave. For example, W2 often retraces a fib. percentage of 1, and W3 most times extends to at least 161.8% of W1.

N/B: These situations are not hard rules, but guidelines to help you navigate the market. Use this technique of analysis with other indicators to have a more objective picture.

FAQs

What are the advantages of Elliott wave analysis?
It can help traders in trend and reversal identification. Also, it offers a structured method for examining price patterns.

Is Elliott wave theory accurate?
It may not always be 100% accurate because it is based on pattern recognition & crowd psychology. But with experience, and when used with other tools, it can improve the probability of speculating rightly.

What are the limitations of the Elliott wave theory?
The theory is subjective. Different people can interpret wave counts differently. And for beginners, it can be complex to learn or apply.

What is the best indicator for Elliott wave?
Fibonacci retracement and extension tools are good for measuring wave lengths and targets. Moving averages can be excellent for confirming trend direction. RSI or MACD can help you spot divergence (or wave momentum).