What and How to Trade Forex Using Elliott Waves

What and How to Trade Forex Using Elliott Waves

Elliot Wave Theory (Elliot Wave) is a technical analysis that is often used by traders and analysts to predict the direction of trend movements by observing the market cycle in the form of waves. The basic principle is to identify the psychological reaction of the traders to changes in market price movements.

This theory is quite old, created by a genius named Ralph Nelson Elliott (1871-1948), a professional accountant in the 1930s. Elliot argued that overall market price movements formed a specific pattern, and always repeated within a certain period. Practitioners at that time called it the Elliot wave, or what analysts and traders now call "waves" only.

In his famous book "The Wave Principle", Elliot writes that prices are driven by market participants in a cycle that is always repetitive. The psychological state and collective emotions of market participants form a wave swing up and down, and if we are used to doing the swing analysis, it will be easy to predict the direction of future market price movements, because basically the nature or characteristics of market participants are the same: greed and fear.

Although Elliot's theory was based on price movements in the stock market (because at that time the forex market was not yet traded), it could be applied well in all types of markets, including forex.


Wave Pattern 5-3

Elliot's wave theory states that a price movement trend (both uptrend and downtrend) always consists of a pattern of five waves in the direction of the trend (waves 1-2-3-4-5), followed by three corrective waves (A-B-C waves).

Elliot called it the "5-3 wave pattern". As shown above, each wave motion can be broken down into smaller sub-sections with the same 5-3 wave pattern. And each sub-section can be broken down into smaller sub-sections with the same wave pattern, and so on. Wave patterns that have this property are called "fractals", or they can be broken down into smaller, exact parts.

To find out Elliot's rationale, we will first look at what happens to the five-wave pattern in the direction of the trend (figure below, for uptrend).

Elliott wave theory

The first five waves in the direction of a trend are called impulsive waves. In this pattern, the first, 3rd and 5th waves move in the same direction as the main trend, while the 2nd and 4th waves are impulsive wave corrections.

Please distinguish between the terms "correction" wave 2 and 4 with the correction wave A-B-C (described in the next section). The following is a brief explanation of the events in each impulsive wave, according to Elliot's market analysis at that time (the stock market), but in principle it can be applied also to the forex market and all other types of markets.


1. First wave (red)

Stock prices start to rise, usually caused by a small number of investors or traders who feel that the stock price is very cheap and this is the right time to make a buy order. This causes the stock price to rise.

2. Second wave (green)

At this point, those who have previously bought the stock are of the opinion that the price must have been too high (overvalued), and sell the stock. This causes the stock price to fall, but not to the previous lowest level because more are holding their long positions.

Just like us traders in general, because of psychological factors, we do not necessarily cut-loss for granted when only experiencing a loss that is relatively tolerable, or may not have touched our Stop Loss level (if using Stop Loss).

3. Third wave (blue)

This is the longest and strongest wave. The stock immediately attracted the attention of investors and traders who had not had time to buy. What's with the stock? They are curious and immediately scramble to own the shares. Of course the price soon soared so strongly that it exceeded the highest level of the first wave (break high).

4. 4th wave (orange)

Those who bought in the first wave felt that the share price must have been too expensive. Instead of "missed profits", they immediately sell it. But as shown in the picture, the waves are short, which means that many are still holding the stock, especially buyers who entered the 3rd wave.

5. 5th wave (purple)

These stocks are increasingly attracting the attention of masses of traders and investors. How can the price soar? Then more and more are buying these shares. Some call this phenomenon hysteria.

We often read or see in the media a stock analyst who seemed to laugh at those who did not participate in buying certain shares, and gave various analyzes that favored these shares. That's when the real overvalued. Traders and investors who are full of experience will certainly sell the stock immediately until an A-B-C wave pattern occurs.


Elliot's wave theory states that a price movement trend always consists of a pattern of five waves in the direction of the main trend, followed by three corrective waves. In this section, three A-B-C correction waves and various formations are often described when trading.

A-B-C Correction Wave Pattern

The formation of 3 correction waves always follows 5 waves in the direction of the main trend (figure below).

Elliot Wave Theory

1. Correction wave pattern formation

According to Elliot's observations, the formation of corrective wave pattern formation that can occur on the market there are 21, but what often happens is in fact there are only 3 wave pattern formations namely zig-zag formation, flat formation, and triangle formation as shown below.

Elliot Wave Theory

2. Zig-zag formation.

The zig-zag formation is the steepest pattern of falling prices compared to the main trend (waves 1-5). Usually wave B is the shortest compared to waves A and C. Zig-zag formation can occur 2 to 3 times and is continuous, but always in the order A-B-C, A-B-C, and so on.

3. Flat formation

Flat formation is a simple sideway wave form with generally the same wavelength. Wave B is in the opposite direction to A and C. Under certain circumstances the wavelength B can be longer than A, or the peak of wave B exceeds peak A.

4. Triangle formation

Triangle wave formation is a formation with a shape like a flat wave but is limited by a converging trend line (getting smaller like in the picture above), or divergent (widening). In general, triangle formations consist of 5 waves. 5. Wave formation in a wave
As explained in section 1, Elliot's wave patterns are "fractals", or can be broken down into smaller and exact parts. In this case each wave always consists of sub-waves with the same formation form (figure below).

Elliot wave theory

Waves number 1, 3rd and 5th consist of five smaller impulsive waves (in the direction of the main trend), while the 2nd and 4th waves consist of smaller corrective waves. These patterns always repeat themselves.

Just to note, Elliot's wave theory names each category according to the wave size as: grand supercycle, supercycle, cycle, primary, intermediate, minor, minute, minuette and sub-minuette. A grand supercycle wave consists of a supercycle wave consisting of cycle waves and so on.

Following are examples of Elliot wave formations in market price movements:

Elliot wave theory

As shown in the picture above, in reality the shape and formation of a wave is not perfect or exactly the same as the ideal situation as in the previous examples.

If not trained enough, we will have difficulty when starting to assume the category of a wave. For example, in an uptrend, where should we start determining the first wave? Or if we have assumed the first wave, why doesn't the 4th wave formation appear at all? For this reason, there are rules and practical instructions so that we can easily identify Elliot wave formations in a trend.


As is known, the main factor for successfully applying Elliot's wave theory in trading is the ability to correctly identify waves. According to Elliot the market always moves with the formation of five impulsive waves, followed by three corrective waves. There are three main rules used in practice to identify Elliot wave formations in a trend like the following:

Elliot wave theory

According to Elliot, the main rules above absolutely must be met. If there are five impulsive waves that do not comply with these rules, then another starting point must be found to start identification again from the beginning. In addition there are some additional rules that are not absolutely required to be met:

  • sometimes the 5th wavelength does not exceed the 3rd wave.
  • 3rd wave is the longest.
  • 2nd and 4th waves often move retrace according to Fibonacci Retracement rules.

With proper identification, we can anticipate entry and exit levels according to the rules above.


Example of Using Elliot's Wave Theory in Trading

In the following example, we begin to identify the uptrend by determining the starting point of the first wave until the 2nd wave retrace occurs:

Elliot wave theory

To determine the correct entry point, we refer to the rule that the second wavelength does not exceed the beginning of the first wave, then we check Fibonacci retracement levels. We can wait until the Fibo Retracement level shows a reaction or continues the uptrend direction.

Elliot wave theory

In this case, at the 50% Fibo Retracement level, the price moves back towards the uptrend. We can buy entries around the 50% Fibo Retracement level.

Elliot wave theory

Note: if it turns out that the 2nd wavelength exceeds the starting point of the first wave, then the identification that we have done is wrong. Here's another example on downtrend price movements:

Elliot wave theory

In the picture above, a flat formation appears on the A-B-C correction wave. From the candlestick formation, we determine the entry sell level and the stop loss level.

Elliot wave theory

Note: if it turns out that the 2nd wavelength exceeds the starting point of the first wave, then the identification that we have done is wrong. If the example above turns out to be true, the possibility could be as follows:

Elliot wave theory

Because the wave formation that occurs in real market price movements is not exactly the same as theory, traders must often practice reading the real market wave formation in order to get the correct interpretation of Elliot wave formations.

 

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