Elliott Wave Theory: Beginner’s Guide
Impulsive and corrective waves, precise chart patterns, ABC correction and theory conditions
Developed in 1930s by Ralph Nelson Elliott, Elliott Wave Theory is a part of technical analysis and is used to predict future price movements based on technical data and chart patterns. As the name suggests, the theory observes repeating cycles of impulsive and corrective waves, corresponding with current trend of the market.
The theory has become fairly popular, not only in cryptocurrency space, but also in stock markets or on forex. Combined with other technical indicators, patterns or theories, Elliot Waves give a pretty solid foundation for a successful trading strategy.
How do Elliott Waves work?
Visualized, the concept of Elliott Waves (in an uptrend) looks like this:
There are 5 waves in the motive phase and then 3 waves in the corrective one. This is also why sometimes the name 5–3 pattern is used instead.
The motive phase overall corelates with the current trend, and the corrective phase (not-surprisingly) goes against it.
When taking a closer look at the motive phase alone, we can separate the 5 waves into impulsive and corrective ones. Waves 1, 3 and 5 are impulsive, meaning they represent investors’ money pushing in the direction of a current trend. The impulsive rushes are interrupted by corrective waves 2 and 4, which prevent the market from overheating and provide additional buying/selling opportunities (depending on the direction of current trend).
Following the peak of wave 5, the pattern slides into a corrective phase, which consists of 3 waves, labelled A. B and C. One can think about this second phase as a cooldown for the whole market, which is healthy and means that the price action isn’t driven by hype or FOMO.
In theory, Elliot Waves are continuous, meaning after the end of corrective phase, the market continues in the direction of the current trend and starts to form a new motive phase.
An important thing to note is that Elliott Waves are also fractional, which means that one wave (e.g. wave 3) on a 1d timeframe can be in itself a whole motive phase on 1h timeframe, for example. Or that a corrective wave, like wave 2, on a bigger timeframe (1d) consists of whole corrective phase when inspected on smaller timeframes (1h, 2h…).
We have hopefully now established what Elliott Waves are and how they work, however there is more to the concept than that. How do you determine if a pattern that looks like Elliott Wave actually IS Elliott Wave?
There are several conditions the pattern should meet in order to be considered valid:
- Wave 3 should be the longest of all impulsive waves and it definitely can’t be the shortest one. (In other words, wave 1 and 5 can’t be longer than wave 3.)
- Wave 2 is usually around 60% of wave 1 and it definitely can’t retrace more than 100% of wave 1.
- Wave 4 is usually 30–40% of wave 3.
- Peak of wave 4 shouldn’t go under the peak of wave 1.
- Peak of wave A shouldn’t go under the peak of wave 4.
Keep those in mind and hopefully you will never be wrong when trying to recognize a valid Elliot Wave pattern.
Incorporating EW into a trading strategy
As already mentioned, Elliot Wave theory works best when combined with other indicators, at least from my experience. E.g., combining it with Fibonacci sequence for determining wave peaks more precisely can be very useful.
Just as a disclaimer: I don’t provide financial advice; the purpose of this article is purely educational and informational. What you do with the information falls on your own responsibility.
However, when taking Elliot Waves at face value, the trading idea is pretty simple. If we assume an uptrend, you would sell at the peaks of impulsive waves and use the corrective waves to buy for lower price. In a downtrend, the actions would be reversed.
Or, if you aren’t sure whether you truly are in an Elliot Wave pattern, you can wait for the whole motive phase to form, using the above-mentioned conditions for confirming pattern’s validity, and then short the corrective phase (or enter a long position, if in downtrend).
Those were the basics of Elliot Wave theory, which is otherwise fairly complex topic. Thank you for reading.