Does the Elliot wave theory really work

Elliott wave theory explained simply

You are here: Home> Blog> Elliott Wave Theory Simply Explained

02 November 2017

Ralph Elliott had developed a theory in the late 1920s that had caused turmoil in international financial markets.

Course courses are a result of human behavior, he wrote in his book. From this the so-called Elliott wave theory developed. The luminaries Alfred Frost and Robert Prechter contributed to the further development. However, like other instruments of chart analysis, the Elliott Wave Theory is also controversial. Because scientific studies have shown that a precise prediction of price developments is simply not possible.

Forex trading is more about having a functioning risk management system than regularly being right. Every trading system should have a solid risk management system. Of course, at the end of the day, the plan has to be implemented consistently. Only the right risk management, which is your responsibility, shows how powerful your trading system is.

The Elliott Wave Theory enables any trader to have a high risk / reward ratio. Not only do traders know how the price will ultimately perform, they also take the time component into account.

There is no holy grail for a successful trader, but the two components “price” and “time” are important parameters on the way to financial freedom. Knowing where and when the price will go makes the difference between good and excellent trades.

In the following we describe the basic principles of the Elliott Wave Theory, what is important and how you can use it to polish up your risk-reward ratio.

The basics of the Elliott Wave Theory

Elliott had found that the markets move in certain cycles that can be broken down into so-called waves and that repeat themselves regularly. Very quickly he began to subdivide waves into two basic forms: the so-called impulse waves and correction waves.

Impulse and correction waves indicate the main direction of price development. Impulse waves consist of five recognizable price movements. Each wave is given a number: 1-2-3-4-5. Correction waves, on the other hand, are marked with letters. They usually consist of three recognizable price movements.

It was Elliott's strong belief that the market moves in cycles of varying degrees. A complete market cycle consists of a five-part impulse move, followed by a three-part corrective move.

The cycles of varying degrees appear everywhere. Waves 1, 3 and 5 are called impulse waves, while waves 2 and 4 are corrective waves because they correct the previous upward movement.

However, the above first wave also has a further five-wave structure of a next lower rank, which in turn is divided into waves of an even lower rank. And waves 3 and 5 also have waves of a lower rank.

This is exactly what makes the Elliott Wave Theory a rather complicated method of trading in international financial markets. It is therefore necessary that you learn the basics of the Elliott Wave Theory correctly right from the start.

Trading the third wave

According to Elliott, the third wave is the longest and therefore most profitable opportunity. According to Robert Prechter, these points inevitably lead to breakouts, continuation gaps, expanding volume, exceptional breadth, important trend confirmations under the Dow theory, and continued price action.

Stretched waves typically need to be longer than 161.8% of the other unstretched waves. The second wave should correct between 50% and 61.8% of the first wave. The expansion wave, i.e. the third wave, is usually the wave of an entire sequence and occurs most frequently.

This results in the perfect trade. In a bullish impulse move, you simply place a limit order between the 50% and 61.8% Fibonacci retracement of the first wave. Profit-taking then occurs on the 161.8% Fibonacci expansion, starting from the end of the second wave. You place your stop loss just below the beginning impulse.

Trading the fifth wave

One of the most powerful rules of this theory is that the first wave should never be as long as the fifth wave. They are also less dynamic than the third wave. Knowing this, traders can take advantage of the fact that they already know the length of the first wave and the dynamics of the third wave.

Therefore, Elliott Wave traders simply need to measure the length of the first wave and project it onto the end of the fourth wave, the corrective wave. The fifth wave should be shorter than the first wave.

However, not every length will work. So keep in mind: the fifth wave should be roughly 61.8% of the first wave. When that happens, go short within a bullish five-wave structure where they are targeting the 38.2% Fibonacci retracement of all momentum movement.

Trading a flat pattern

So-called flat patterns are often pronounced in the correction waves. Elliott has identified no fewer than ten such patterns.

However, all types have one thing in common: wave b must correct at least 61.8% of wave a. This is more than enough to place a trade.

Therefore, the key to success is the interpretation of wave a. Is it an impulse or a correction? A flat pattern consists of an a-b-c structure. In addition, waves a and b are corrective in nature, and only wave c has a five-wave structure. If wave a has no momentum, it can only be a correction. As a consequence, the rule with the 61.8% Fibonacci retracement is used.

conclusion

These three possibilities show only a fraction of the trading setups they have with Elliott Wave Theory. The truth is that this wonderful theory offers a position opportunity for every single move in the marketplace.

Therefore, you will forecast the right side of the price chart by analyzing the left side of the chart. Real Elliott Wave traders never count the current market price.

The correct approach is to let the market confirm the previous pattern first. All in all, the fundamentals of the Elliott wave theory are based on a pattern recognition approach.

Traders should therefore take a top-down approach by first analyzing the monthly chart or even larger timeframes. Then you can work your way up to the daily chart or even lower to choose a trade.

If counting in the higher units of time makes sense and follows Elliott's rules, the theory reveals future price movements because it reflects human behavior. In no other theory do they turn off the emotional component as they do in the Elliott Wave theory.

Rules for the Elliott Wave Theory

Believe it or not, there are actually only three rules that you need to follow when interpreting Elliott waves. While there are many guidelines, there are only three real rules that are irrevocable. Guidelines, on the other hand, are subjective in their interpretation. Rules only apply to a five-wave structure. Corrections, which are often of a more complex nature, allow more room for interpretation.

Rule 1: Wave 2 can never fall below the beginning of wave 1

Rule 2: Wave 3 can never be the shortest of the impulse waves

Rule 3: Wave 4 can never overlap with wave 1.

Wave 2 can never fall below the beginning of wave 1. It is an incorrect count if the price falls below it. While wave 3 is typically the longest of the three impulse waves, there are specific rules that it can never be the shortest. 1 or 5 can be longer than wave 3, but both cannot be longer than wave 3. According to Elliott, wave 3 must cross the high point of wave 1. If this does not succeed, it is a wrong count. The third and final rule is that wave 4 can never overlap with wave 1, which means that the low point of wave 4 must not fall below the high point of wave 1. Such an injury would mean a recount.

Guidelines for Elliott Wave Theory

There are numerous guidelines, but in this article we will only focus on three essential ones. In contrast to rules, guidelines have a greater scope for interpretation and they are subjective in nature.

Guideline 1: If wave 3 is the longest pulse wave, wave 5 is roughly the length of wave 1.

Guideline 2: Waves 2 and 4 are corrective waves. They differ in their shape. It is therefore very unlikely that two identical correction formations will arise in the same sequence. As a rule, wave 2 forms a steep ZigZag. Wave 4, on the other hand, appears predominantly as a sideways movement.

Guideline 3: After a five-wave structure, corrections (a-b-c) usually end at the low of wave 4.

The first guideline is useful for predicting the end of wave 5. Even if wave 5 is longer than wave 3, wave 3 could still be longer than wave 1. Chart technicians can project wave 5 to wave 5 as soon as wave 4 draws to a close. In an overall uptrend, chart technicians project the length of wave 1 onto the low of wave 4 to define an upside target for wave 5. Conversely, the same applies to a decline in a five-wave structure.

The wave alternation of the second guideline will help you determine the correction length. After a steep zigzag on wave 2, chart technicians should expect a relatively flat correction on wave 4. If wave 2 moves sideways, investors have to allow for a relatively steep correction of wave 4.

The third guideline will help determine the end of wave 1 after a correction to wave I. Waves I and II are waves of a higher rank. Waves 1-2-3-4-5 are lower ranked waves within Wave I. Once the Correction of Wave II begins, charters can estimate its end by examining the end of previous Wave 4. In a larger uptrend, wave II is likely to end near the low of wave 4.




Advantages of CDFs?

Low capital investment
No commissions
Possibility to bet on rising and falling prices

Compare platforms

  • Buy, sell and store more than 50 cryptocurrencies on one of the leading cryptocurrency exchanges in Europe.
  • Visit Bitvavo

Prices