Born in Marysville, Kansas, Ralph Nelson Elliott (1871-1948) was an accountant who, after a thorough study of stock market data, developed “The Wave Principle”, a form of technical analysis that identifies trends in the financial market.
Elliott concluded that the market trades in repetitive cycles caused by the prevailing psychology of the masses followed by some laws. His theory is based on certain cyclical laws in the psychology of human behavior. Market fluctuations follow a repetitive pattern that he called “waves”, and his theory provides a way to correctly identify these patterns and locate points with a high probability of reversal.
But before studying Elliott waves, we need to understand what fractals are.
Fractals are forms in which the parts are similar to the whole. Everything in nature follows a pattern of shapes within the mathematical rules of its molecules. Everything has a summation sequence.
Fractals represent those objects in which the parts, separately, are similar to the general structure of the object. In a simpler way: it is when the part repeats the features of the whole.
The specific pattern of a figure will be repeated in each part of it. The difference is that this repetition is always on smaller scales.
Like nature, Elliott waves are factral and can be subdivided into small Elliott waves.
The 12345ABC Wave Patterns
Elliott classified the market trend movement with the 12345ABC wave pattern. This pattern consists of 5 waves called impulse waves, followed by 3 others, called corrective waves.
Within this pattern, waves 1, 3, 5 move according to the main trend, while waves 2 and 4 are corrective.
The asset makes its first directional move usually caused by a small number of traders.
In wave 2, traders evaluate their entrys and begin to make profit, causing a correction in prices. This correction occurs within wave 1.
This is usually the longest and strongest wave. The asset drew the attention of the mass public. A large number of traders start buying by making the asset price rise more intensely. This wave generally exceeds the peak created between wave 1 and 2.
Traders close long positions to execute profit. This corrective wave tends to be weak, as there are usually more people who are still optimistic about the asset and who are waiting to buy.
Wave 5 is driven by the hysteria movement. Many traders who missed previous waves buy this asset, believing it is still a good candidate for appreciation. However, wave 5 causes an overbought effect and makes the asset’s value saturated.
With the saturation in the asset value caused by wave 5 hysteria, the ABC correction movement occurs. The three letters represent the correction of the 5 initial waves and the end of the Elliott wave cycle. From the ABC correction, wave 1 starts a new cycle and is then repeated successively.
Elliott waves represent movement not only upward, but also downward, as shown below:
As Elliott waves are factral. Each wave is formed by a cycle composed of waves. As shown below, within each wave, there is a complete cycle of waves that can be seen in charts with less periodicity. For example, the main wave may be represented by candles on the 1-hour chart and the smaller waves on the 30-minute chart. Within the waves of 30 minutes, there are the waves of the 5 minute, 5 second chart, and so on.
The Three Fundamental Rules
To correctly identify the wave behavior, Elliott created 3 fundamental rules for validating the model. Are they:
1) Rule number 1: Wave 2 never recedes 100% or more from Wave 1. That is, if prices return to the level that marks the beginning of Wave 1, a new count must be started.
2) Rule number 2: The extension of wave 3 can never be the smallest among waves 1 and 5. That is, wave 3 cannot be the shortest when compared to waves 1 and 5, being often the longest. When wave 3 is smaller than wave 1 and wave 5, the count must be restarted.
3) Rule number 3: wave 4 does not reach the price level of wave 1. This rule means that, in a predominant upward trend, the bottom of wave 4 cannot exceed the top of wave 1
However, only the basis for closing prices should be considered for the application of this rule. That is, even if the maximum or minimum price exceeds the height of wave 1, the count can continue without being restarted, as long as the height is respected by the closing price.
Trading the Elliott Waves
Now that we have learned the theory and fundamentals of Elliott waves, we can determine the strategy for the entry and exit points.
After identifying the initial movement of the first wave, the concept of Fibonacci retractions can be used to help identify the end of wave 2 and the beginning of wave 3.
The price shows signs of a reversal on the 50% retraction of the Fibonacci lines. This may be the beginning of wave 3, which is a very strong buy signal. Keeping in mind rule number 1 determining that wave 2 can never go beyond the beginning of wave 1, the stop can be positioned below the previous low.
After the entry, the impulsive movement of wave 3 showed strength on the uptrend. The exit of this trade can occur at the beginning of wave 4, or for more aggressive traders, the exit can occur after the formation of wave 5.