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Elliot Wave Theory – Practical Tips

Elliot Wave Theory – Practical Tips

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Elliot Wave Theory – Essential for Binary Options Trading

Elliot Wave Theory was discovered by Ralph Nelson Elliott of course. And it is now so called after his namesake! Ralph Elliott analysed stock data for over 75 years. He discovered that although the stock market seemed to behave rather chaotic, it actually had a flow to it!

Who Was Ralph Nelson Elliot? Creator of the Elliot Wave Theory

When Ralph Elliot was 66 years old and probably too tired to continue riding the ebb and flow of the financial market, he decided to share his studies with the trading world! At this ripe age he published his studies in a book called “The Wave Principle”

What is the Elliot Wave Theory?

The Wave Principle according to Elliott, is a cycle in which the market generally trades. According to Elliott the market traded in waves. These waves are a result of repetitive cycles. What is very interesting about the Elliot logic, is that he took into consideration that the market acted not just on the technical analysis, but also took into account the emotional perception of investors.

Basically Elliot watched the outside market influences. He understood how the psychology of the mass investors reacted. Therefore, whereas so far we have always based our analysis on how market reacts on the technical side, he gave more importance to the “emotional” reactive of the market.

Elliot describes the upward and downward swings that occur in pricing as “waves”. They represent the mass psychology. But far more interesting, is that even though the analogy is based on emotions, there was still a collective pattern.

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What Made Elliot Waves Attractive to Investors? The Elliot Wave Theory Review

Well one of the most important factors, is that with his “Wave Theory” Elliot could justify and identify accurately and precisely moments when the price would most likely retract.

As we are well aware, trading is all about catching the “precise moment”. Elliot waves help us to come up with an accurate system of catching the Tops and the Bottoms of waves. In order to understand this system, a trader needs to understand fractals!

What are Fractals? How can they enhance Forex and Binary trading?

According to Wikipediafractal is a natural phenomenon or a mathematical set that exhibits a repeating pattern that displays at every scale. It is also known as expanding symmetry or evolving symmetry. If the replication is exactly the same at every scale, it is called a self-similar pattern. An example of this is the Menger Sponge.[1] Fractals can also be nearly the same at different levels. This latter pattern is illustrated in thesmall magnifications of the Mandelbrot set.[2][3][4][5] Fractals also include the idea of a detailed pattern that repeats itself.[2]:166; 18[3][6]

So here on one had we have previously been understand the genius of Fibonacci and his numbers, and now we are faced with another system that is based on Fractals.

Fractals are basically “self-similarities” They are really found all over nature. The perfect “nautilus shell” is a perfect fracture of self-similar numbers, just as the snowflake is!

CodeFibo The golden ratio diagram aka The divine code. Is the CodeFibo legit? Is CodeFibo safe?Why would Fractals be important to Trading?

The Elliot waves are based on the self-similarity rule of fractals.

Elliot wave Theory is based on several types of Waves.

Wave Type 1: Impulse Waves and the Elliot Wave Theory

We have established that one of the best markets to trade in would be a trending market. The Elliot theory shows that in a trending market we can observe a 5-3 wave pattern.

The first 5 wave patterns are the Impulse Waves or the general trend pattern.

The last 3 waves are the corrective waves also known as the Pull-Back waves.

In the pattern exhibited we can see that waves 1, 3, and 5 are what are motivating the trend and are therefore called “motive” waves.

On the other hand waves 2 and 4 are the pull-back waves and are therefore called the “corrective” waves.The Elliot Wave Theory - Fractal Waves

From the graphic above which is the STG/USD chart for September 2016 we can analyse the following:

Wave 1. The market here is making its first impulse wave establishing a downtrend. This is usually caused by a slow number of traders who are testing the market.   As we can see, the market was previously on an uptrend, and therefore Wave 2, sees the Bulls trying to retrieve their ground. The market pulls back with wave 2, but it is not strong enough to keep the market flowing back into an uptrend.

Wave 3 is usually the strongest of the waves, and this proves that the trend is now definitely set on a downtrend. The public in general trading has its attention on the trend and everyone is trying to ride the wave!

The ensuing wave, which is Wave 4 is considered to be the time when the “bears” in this case are cashing in on their profits. The price has already become quite expensive, and therefore it is time to cash up. Hence the retracement and the pull-back or the “corrective wave”.

The final wave is Wave 5 This is by far one of the most difficult waves, and one in which many traders get caught up and make mistakes. This is usually driven by TOO MUCH EMOTIONAL TRADING . The market is driven by hysteria.   In our previous post about Market Trends, we have identified, Sentiment Trading. The fifth wave relates directly to sentiment trading.

If you see the photo of some hot shot CEO of a major company, and you are following their stock value, this is the time you could cook up all the phantom reasons, why you should buy or sell. This is not the real evolvement of the market, but it is only based on sentiment. It may act out for a while, but the likelihood is that you will be trading in a very nervous market.

The chart below is a continuation of the earlier graphic and it shows how true the Elliot Wave theory played out in this instance.The Elliot Wave Theory

Corrective Wave Patterns – What are They? – Elliot Wave Theory

Breath in!! According to Mr Elliot there are no less than 21 corrective Wave Patterns! These range from simple to complex. So how on earth are we supposed to understand wave patterns?

Zig-Zag Formations

For starters, these rules apply both in an upward or a downward trending market. The first formations are called the Zig-Zag Formations. Zig Zag formations are steep! They seem to be going against the general market trend. In a Zig-Zag formation, it is likely that the first correction is not steep, but the second correction would be a much stronger wave.

Zig-Zag formations are by far the most common of corrective patterns. Zig-zag are made up of two motive waves, 1 and 3 and one corrective which is 2.

Corrective Patterns and Flat Formations

Flat formations are zig-zag patterns which are equal in size and the price of an asset keeps going sideways. This is especially true at the end of the fifth wave! Generally speaking the size of the previous wave will be equal to the next one.

The flat occurs when there is low momentum. Meaning there is not much activity in the market. It is made up of two 3-wave zig-zags that keep correcting each other – therefore forming a sideway pattern, and price oscillation from A TO BE AND BACK TO A!

Triangle Formations – In this case we have the zig-zag patterns which are converging into each other causing a funnel. Alternatively they start as a funnel and then open up into a cylindrical cone.

Triangles are corrective which are looking like an ending diagonal. They can expand and contract.

Elliot Wave Theory – What are Waves within Waves?

We started of this lecture by explaining that Elliot waves are fractals. Therefore each wave is made of sub-waves.

As we have witnessed in the earlier patterns we see that waves 1, 3, and 5 are made up of smaller waves in 2 and 4. Although waves 2 and 4 are corrective, they are not strong enough to overcome the general trend.

But remember one strong Maxim about the Elliot Waves “ Pattern Repeats Itself”

In real life, waves are never shaped too perfectly. And sometimes it is very difficult to give them proper labels. The more you study charts and design patterns, the easier it becomes to identify the 5 wave Elliot Pattern.

Does all this sound too complicated? Well let us simplify this in three very important cardinal rules.

Elliot Wave Theory – Three Cardinal Rules

  • Wave 3 should NEVER be the shortest impulse wave
  • Wave 2 MUST NEVER go beyond the start of Wave 1
  • Wave 4 SHOULD NOT cross into the same price area of wave 1.

If any of these rules do not follow, you may be looking at the hazy waters after wave 5 and there is no trending market!The Elliot Wave Theory

Like sins, cardinal rules should never be broken!!

A few other tips to keep in mind would include that Wave 5 may not move beyond wave 3.

Wave 3 is always the strongest and most accentuated.

Waves 2 and 4 can be plotted with the Fibonacci retracement levels and this would be their bounce off platform!

The Elliot Wave Theory The Fibonacci Retracement lines

Conclusion – How to Trade Binary and Forex Using the Elliot Wave Theory!

As we well know, picking cherries from the Top of the Tree, or harvesting the potatoes when they are ripe from underground is the key for our profits.

Therefore when we look at the Elliot Waves, what we need to understand is the “Timing” of when to pick the next trade up or down! Let us have a look again at the same chart, that we have been using all along in this argument.

If you have been closely following this lecture, you will understand perfectly well that you will have had at least 2 or 3 opportunities to profit in trading, by either “Selling” in Forex or taking a “Put” option in Binary Options.

Timing is a crucial phenomenon, but armed with great tools like the Elliot Wave Theory, it becomes a self-fullfilled prophesy!The Elliot Wave Theory

Remember always the Cardinal Points of the Elliot Wave Theory. You will need to find a situation that will play out. NEVER FORCE A TRADE!

The cardinal rules are very clear. Wave 2 should NEVER close below the start of Wave 1 in a downtrend or vice verca.

And Waves 2 and 4 will frequently bounce on the Fibonacci retracement lines.

If you can understand this, and catch Wave 3 at its opening stage, then you are practically guaranteed to be looking at a successful trade!

Now here is a Quick Cheat List to Help you Summarize the Elliot Wave Theory

  • We have seen that Elliot Wave Theory is based on Fractals. Each wave is split into parts which are similar copies of each other. Self-similarity waves.
  • Trending market acts itself out in 5-3 wave patterns.
  • The 1-3-5 wave pattern is called the Impulse Wave.

  • The 2-4 pattern is called the Corrective wave
  • Although in theory there are 21 types of corrective patterns the fundamental ones are zig-zag, flat and triangles
  • There are three Cardinal Rules in the Elliot Wave Theory

  • Wave 3 should NEVER be the shortest impulse wave
  • Wave 2 MUST NEVER go beyond the start of Wave 1
  • Wave 4 SHOULD NOT cross into the same price area of wave 1.

As a trader you will need to understand that trading will never happen in exactly the text book classic fashion. It is much easier to understand historic information that has already followed out, than to predict the future.

However, going back in history, and knowing that history repeats itself, is a sure way of becoming more and more familiar with identifying the times when the Elliot Wave Theory plays out, and use it for your trading benefit in the future.

 

 

 

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Comment(1)

  1. Thank you Sheriff. This information is valuable for day trading. I have not come across a site that gives so much trading information as this one and explanation is easy to understand

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