What is Elliott Waves Theory?
Elliott Waves theory is one of the most famous trading theories of them all and it is well known by traders around the world. It has been developed in the early 1900’s by Ralph Elliott and his findings were based on studies of the stock market.
Before going into more details regarding this wonderful trading theory, it is worth mentioning that the findings of Elliott were based on the stock market. All the rules and principles Elliott documented were based on the stock market in the 1920’s and, to quite some extent, his trading predictions turned out to be extremely accurate.
Elliott’s general belief was that the market is moving in repetitive cycles and the reason for this to be the very human nature. Therefore, market psychology plays an important role in any upward or downward move, and this was the very starting point the whole theory is based on: interpreting the upward and downward swings the market makes.
The most important Elliott’s finding was the fact that, no matter if the move is to the upside or to the downside (bullish or bearish), it is unfolding in five parts. And just like that, the waves concept appeared.
According to Elliott, the market advances/declines in five-waves structures, and such a decline is always being followed by a three-waves correction in the opposite direction. This is the Elliott Waves theory: five-waves structures followed by a three-waves correction.
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Elliott Cycles and Logical Process
Elliott named any five-waves structure as an impulsive wave (some people are referring to it as a motive wave as well, but the idea is the same), and it should be labeled with numbers. Therefore, an impulsive wave will be labeled with 1-2-3-4-5.
The three waves correction that follows is called a corrective structure. Corrections are always labeled with letters: a-b-c.
Putting the two paragraphs together, the whole theory can be summarized as a 1-2-3-4-5 advance/decline should be followed by an a-b-c move in the opposite direction. This is what the Elliott Waves theory is and the overall concept is amazingly simplistic.
However, it is just an illusion. It is correct that this is the base for the overall trading theory, but Elliot identified a variety of cycles of different degree that, combined together, form the patterns needed to forecast the future direction of the market.
Defining a Cycle
Based on what was mentioned so far, an Elliott cycle is formed out of a 1-2-3-4-5 advance or decline, followed by an a-b-c correction. One cycle is therefore formed out of an impulsive wave that is followed by a correction.
Such a cycle is the cornerstone of the whole Elliott Waves theory and a proper analysis involves multiple cycles of different degrees. This is where the theory gets complicated as, at one moment of time, different degree cycles may end up in the same place, or may start from the same place.
Any Elliott Waves analysis should start from the biggest timeframe possible and then slowly but surely continuing the analysis all the way down to the hourly chart. This means different cycles of different degrees are going to be labeled, starting with the bigger cycle on the monthly chart (or even yearly charts if there is enough data to base the analysis on), and then coming down to the lower timeframes where cycles of lower degrees can be identified.
An analysis like this is being called a top/down analysis and the name comes from the fact that the analysis is made from the bigger to the lower time frame. This way, a trader knows exactly where the count left and how to project future price levels.
Elliott Waves Logical Process
So far the Elliott Waves principle is a simple one to understand and the overall idea makes sense considering that markets are acting and reacting to a multitude of outside stimulus. After all, the whole theory is based on an action and reaction to different market conditions.
However, above all, counting waves with Elliott Waves theory is a subject of a so-called logical process that should govern a traders’ analysis. This logical process should start from the very first division Elliott made: impulsive and corrective waves.
In other words, before even labeling a specific wave (or move the market makes), a trader should answer the following question: did market made an impulsive or a corrective wave? The answer to this question is a crucial one as from this moment on the whole analysis will be divided into two different paths.
If it is an impulsive move, then such a move must respect the rules of an impulsive wave, starting with what kind of an impulsive wave it is, its location, extensions, distance to be traveled and even the time is taken for it to unfold. All these are taken into consideration and are part of this logical process.
On the other hand, if the move is considered to be a corrective one, then the next thing is to decide what kind of a correction is: a simple or a complex one. If it is a simple one, the trader should focus on it to be confirmed, as this is mandatory. Complex corrections will have even more ramifications in the overall analytical process.
Putting Everything Together
To sum up, this Elliott Waves introduction article, impulsive and corrective waves of different degrees are coming together to complete a technical analysis picture that allows a trader to forecast future price changes.
These price changes are derived from an analytical thinking that takes into account various factors, with the most important one being market psychology. Elliott Waves theory is all about psychology and it is the only trading theory that allows a trader to come closer to what is considered to be the holy grail in trading: putting a time to a price target.
Due to its complexity, the theory fits perfectly into the Forex market as this market is the most complex one in the world. The fact that the patterns described by Elliott are repetitive in nature and consider crowd psychology and human nature makes is the perfect theory to analyze foreign exchange moves.
Because of this, the Elliott Waves theory is well represented in our Forex Trading Academy. For anyone involved in trading financial markets, and Forex, in particular, Elliott Waves theory is a must.
Other educational materials
- Defining Impulsive Waves
- Defining Corrective Waves
- Use the Fibonacci Extension Tool in Elliott Waves Theory
- Different Fibonacci Levels Important When Trading with Elliott
- Trading Different Types of Extended Waves
- Bill Williams – How to Use Williams Indicators When Trading Forex