Elliott wave is a very important tool in the theoretical foundation of technical analysis. It helps traders see the market behavior with an extremely high accuracy rate. However, this theory is also extremely complicated so traders need to take a long time to study and master it. Therefore, in this article, I will help you understand what the Elliott wave is and how to trade with it effectively. Let’s follow along.
What is the Elliott wave?
Elliott wave is one of the theories invented by American professional accountant Ralph Nelson Elliott in the 1930s. According to this theory, he discovered that the market does not move chaotically but “runs” according to a cyclical law due to human psychology.
Currently, in new financial markets such as Crypto or Forex, this theory is still applicable.
The Elliott wave is represented by repeated wave patterns. Basically, Elliott describes the behavior of crowds in detail and their essence is greed, fear, hope, and bigotry. These are all mentalities that never change over time.
According to the father of the Elliott wave, if there is no bullish or bearish movement in the market, this is considered a “dead” market. It should be remembered that the Elliott wave is a pattern that helps investors forecast the price trend as well as indicate what stage the market is in. From there, traders can identify better entry points, shorter stop loss and longer take profit points.
Elliott wave structure in trading
After understanding the concept and meaning, the next factor that Forex traders need to learn is the structure of this wave pattern. Specifically, the Elliott wave indicates that the market trend moves in two phases.
– The first stage is the impulse wave
– The second stage is the corrective wave, also known as the retracement wave.
Impulse wave pattern
The impulse wave pattern consists of the first 5 waves as shown in the picture. Waves 1, 3, and 5 are bullish and waves 2 and 4 are bearish. The lengths of these waves should be equal, and the characteristics of these waves are as follows.
Wave 1 represents the period when the market started to move up. This is because some investors see the price as the right time to buy. So they placed buy orders causing the price to push up.
Wave 2 is formed when the trader stops buying and closes the order because the profit has reached the target. This is what causes the price to drop a bit but won’t drop as low as the bottom 1.
Wave 3 is formed when the price has a slight increase, which is a favorable opportunity for many other investors to enter the market, causing the price to be pushed higher. This is also usually the strongest and longest wave.
Wave 4 occurs when many traders take profits because they realize that the market has risen enough. This wave is considered weaker than the previous waves because many traders expect the price to go higher to enter the order at a better price.
Wave 5 is the period when most people “rush” into the market to buy massively. This makes the price more expensive than ever.
In particular, one thing you need to pay attention to is that in 3 impulse waves 1, 3, and 5, there is always one wave that is wider than the other two, usually wave 3 or 5.
Corrective Elliott wave pattern
After the impulsive wave phase is the correcting wave pattern (retracement). It consists of price actions that go against the current main trend. For example, when the market is moving in an uptrend, corrections can be either sideways or down.
If the impulsive wave pattern numbered the waves in order from 1 to 5, the corrective waves are alphabetically denoted as a, b, and c.
Note: Corrective wave pattern structure is never more than 5 waves, usually 3 waves.
Corrective waves have 3 basic patterns including the Zig-zag pattern, Flat pattern, and Triangle pattern, which are the source of the development of the remaining 18 patterns.
This pattern consists of price moves that go in the opposite direction of the previous market’s dominant trend. Specifically, wave A and wave C are usually longer than wave B.
On the other hand, during a correction, the market may appear 2-3 consecutive Zig-zag patterns. And within each wave of the Zig-zag pattern, we can divide them into impulsive wave patterns (5-wave patterns), this is called a wave within wave pattern.
The flat pattern is a familiar horizontal moving retracement waveform (sideways). With this pattern, the length of each wave is relatively equal. In which, wave A and wave C are in the same direction but opposite to wave B. In some cases, wave B can surpass the original peak of wave A.
This triangle pattern has slightly different characteristics from the triangle price pattern that you have learned in technical analysis. Specifically, the pattern above is made up of two support and resistance levels that can either diverge or converge. It consists of 5 waves moving within the confines of two trend lines, moving within the trend sideways.
The shape of the triangle pattern is quite diverse. it can be an expanding triangle, isosceles triangle, ascending triangle, or descending triangle…
Three key rules when trading with the Elliott wave
When trading using the Elliott wave theory, investors are required to adhere to the following 3 rules.
- 1st rule: Wave 3 is always the longest of the 3 impulse waves 1, 3, and 5.
- 2nd rule: Wave 2 must not fall below the starting point of wave 1.
- 3rd rule: The bottom of wave 4 must not reach the top of wave 1.
In addition, when trading with the Elliott wave pattern, some characteristics may change depending on market movements.
- In some cases, the top of wave 5 may not surpass the top of wave 3.
- Wave 3 is usually extended and very long.
- Waves 2 and 4 often break out of the Fibonacci Retracement points.
Elliott Wave trading strategy
The Elliott wave trading strategy is probably the most anticipated part and also the most important topic in today’s article. So let’s refer to the following standard trading method.
Step 1: Market analysis
Suppose, you recognize an Elliott wave moving in a downtrend as shown in the picture below. In which, corrective waves a, b, and c are moving in the sideways phase; then gradually form a flat pattern. So, the market can only form a new impulse when wave c ends.
Step 2: Enter the order
At the start of wave c, as shown in the picture, you can enter a sell order. Here is considered a potential entry point to help you catch a new impulse wave.
Step 3: Set stop loss and take profit
The stop loss is a few pips above the top of wave 5, which is the highest point of the bearish correction of wave A.
The take profit will be twice the distance from the entry to the stop loss.
Corrective wave is a tool to help investors identify opportunities to open orders to catch a stronger wave later. Furthermore, when the correction moves in the uptrend, which means the price will move higher, this is a good time to enter a buy order. Similarly, we will enter a Sell order to make a profit when the correction wave goes into the down phase.
Relationship in trading between Elliott wave and Fibonacci
In 1930, Nelson Elliott researched and invented the wave principle. However, this principle has not been applied to practical trading because it is very difficult to find the entry point. At that time, many investors thought that the Elliott wave was a mere theory and not highly applicable.
It was not until 1940 that he incorporated the Fibonacci sequence into the Elliott wave pattern. This helped him overcome the previous disadvantages of the wave principle. Since then, the Elliott wave theory has been well-received and adored by many investors. An American billionaire businessman once asserted that the Elliott wave theory is one of the “four bibles of business”.
Thereby, it can be emphasized that the relationship between the Elliott wave principle and the Fibonacci sequence is extremely close. Specifically, the Elliott wave theory creates a backbone and the Fibonacci ratios are metrics that help measure both the range of price movements and the time to end. This combination is considered by many traders to be a scientific association.
With the above sharing, hopefully, you have somewhat understood the concept of the Elliot wave as well as how to apply this wave theory to forex trading in the most effective way. However, you should remember that the Elliott wave is essentially a theory, not an indicator in technical analysis. Therefore, in addition to book theory, to successfully use the Elliott wave in real trading on the Forex market, you need to practice a lot beforehand in the demo account.
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