Elliott Wave Theory

Elliott’s theory of the wavy principle of price movement in financial markets may be or may not be liked by theorists and practitioners of exchange trading. The indisputable fact is its popularity.  Any self-respecting company that prepares traders will not miss the study (at least the basics) of wave analysis , because a lot of  trading strategies are tied to wave cycles.

Where will the wave lead?

The Elliot Code was decoded long ago and clearly annualized.  It grew a whole galaxy of authors. But there is no answer for only one rhetorical question: why Elliott’s theory has not yet enriched traders. It’s hard to believe that among 97% who crash on all kinds of players’ exchanges, there were no anybody whose deep knowledge of the waves behavior laws (not oceanic ones, though Elliott also claimed that) did not reduce this depressing statistics (there is more than one million citizens with high technical degree among practicing traders ).

Nevertheless, the wave analysis of the Forex market (other exchanges are not left behind), like an ocean wave, draws new supporters into its ranks. Hence, not all the ideas of Ralph Elliott and his faithful successor Robert Precter are solved (or solved by 3 percent of successful stockbrokers, in whose ranks the new generation of «wave people» seeks to get in).

You can twist the theory of Elliott as a Rubik’s cube, but the main characteristics of it are not going to be changed (5 waves up and 3 down or vice versa), just as the game cube does not become a ball. The attempts to find a practical benefit consist of the perfect combination: wave theory + X (possibly + Y and + Z). There are other analytical tools meant by unknown quantity.

Another reason why the skeleton key does not work is the difference between  interpretation of the wave models. Not everybody can catch the wave (identify the true model on the figure).

Elliott’s code. The beginning of the way

Wave theory, by its own complexity, does not pretend to be a quantum physics (amd is also applicable to determining the movement of prices), but it does not deserve to be studied in the framework of the review article. A simplified view will only bring harm. Go on a cruise in search of the Grail, imagining yourself on a cruise liner and in fact be on a ragged raft is about such a perspective awaits those who decide to saddle wave analysis, armed with the knowledge of several drawings and names of waves and their models. The real benefit can be obtained if you read (not screen) at least one book of wave analysis and its use in trading strategies (for example, the book written by D. Voznoy «Elliott Code — Wave Analysis Forex»).

Wave theory. Strokes of the portrait

The Elliott Wave Theory asserts that the behavior of the majority in the market («the crowd») can be predicted with the help of waves. In such a way the future direction of the price movement is determined. Research of wave models allows us:

• to work with any trading tools on the currency market and the stock exchange;

• to use the analysis of the market on all time frames;
• to work on the trend and on adjustments;
• to determine stop-loss and take-profit levels;
• to create a universal trading strategy, based on, or in the wave analysis basis.
• to find the peak values of prices, regardless of the mood of the market (bearish or bullish trend);
• to identify significant levels of support and resistance;

Wave cycle

The classical model of Elliott waves consists of two sets: impulse and corrective waves. Impulse waves (Elliott’s main, but Frost’s and Precter’s adopted) determine the main trend, go along the vector of the higher wave. Waves are different in length (for example, 3rd is more often elongated), which helps to determine the integral nature of the model. The difficulty lies in the fact that it is not always possible to identify a wave (it is easy to be confused and see the impulse wave on a downtrend as a corrective on an uptrend, or vice versa). Correction waves are directed against the superior one.

The whole design is represented by 8 waves, which are usually denoted by numbers and letters. See Fig. (black 1.3.5 are impulse in a downtrend, 2.4 are corrective («five»). Reds are a corrective «three», where, «a» and «c» are impulse, and «b» is correctional).

Rules for determining the wave model:

• If the wave 2 fell below the beginning of the 1st, then the model is not sucsessful.
• The wave 3 should not be the least of all impulse.
• The wave 4 should not intercross with the 1st wave on the vertical axis.

There is a high possibility of the following scenario:

• If the wave 3 confirms its size (the longest among impulse ones), then the wavelengths of the 1st and 5th are approximately equal;
• The slopes 2 and 4 of the corrective wave are different;
• The waves a, b, c do not intercross the boundaries of the beginning of the 5th wave.

Brief characteristics of waves

1. The wave marks the break of the previous trend and the beginning of the reversal.
2. The wave is the first correction (rollback).
3. The wave is not a tsunami, but close to it. This wave takes a confident and considerable profit.
4. The wave means who slept, that did late. The last entry on the wave 3 will end with an entry in the correction. The most delicious piece of the trend is
5. The wave is the last effort of the current (for the time frame under research) trend. You can earn money, but the level of profit is in the fog.

The wave theory of Ralph Nelson Elliott is inextricably linked to fractal theory (the fractal market analysis method exists as an independent unit). The theory of similar repeating structures in wave analysis is represented by subwaves (any large wave consists of smaller completed fractals).

Real gourmets of wave models (they are thoose, who become themselves not only on one book, and not during the period of one year)also  make profit  on countertrends. They open transactions on correctional waves. Here there are some subtleties.  «Wave people» consider corrective waves in detail and distinguish various types of corrections that affect the decision to open a position: simple (zigzag), complex (flat, irregular, triangular).

Beginners are not supposed to swim against the stream (at the stock exchange they are not recommended to play against the trend).

Indicator assistants

Elliott Wave Prophet — an indicator is interesting in that it draws sections of the figure, on which the wave model has not yet formed.

Elliott Wave Oscillator — the oscillator identifies the 3rd wave, which is the most valuable for conducting transactions. Built on two moving averages (periods 5 and 35), recalls MACD. The graph is displayed as a histogram.

Watl is an indicator for wave counting. Has a special algorithm for calculating impulse waves, identifying the required levels.

Theory of Elliott and Fibonacci tools

Fibonacci numbers are used for mathematical analysis in substantiating the Elliott theory. Fibonacci tools (levels, grid) are widely distributed in various indicators for technical analysis, but for determining wave corrections, their role is the most significant. With the help of a correction grid  it is easier to determine the entry point on the trend, and the grid of extensions helps to determine the target levels (take-profit, stop-loss).

Patterns formed by waves of Elliott

On the analysis of price behavior by patterns, many trading systems were built. The main figures that can be recognized in the waves of Elliott are:

• triangles;
• pennants;
• truncation;
• zigzag;
• wedges;
• double pass, etc.

Examples of trading strategies for Elliott patterns

The horizontal triangle. The triangle is constructed along two lines, which are formed by price peaks at the maximum and minimum price levels. The entire wave structure of the figure consists of three wave zigzags. Transactions are opened only after the formation of the figure. Purchases on an uptrend are recommended after the rebound of price from the support  (the lower limit of the triangle), sales are recommended after the rebound from the resistance (the top line of the triangle).

Zigzag. Has a 3-wave structure. Waves A and C are impulse waves  (5-wave). Positions can be opened after identifying the zigzag and the first wave of «overlap» in the direction of the main trend. Both models are correctional and work on impulses which are directed towards the trend.

Critics of wave analysis mark out the subjectivity in the assessment of wave models and the inability to predict future price movements as major drawbacks (the method allows only historical events to be assessed).

In 1984, one of the creators of modern wave theory, R. Precter, proved the vitality of his offspring by winning the US championship in trading with a profit of 444%.