Elliot Wave Theory

Elliot Wave Theory is designed to unlock the secrets of financial market development. It is one of the strategies that allow you to successfully trade in such markets, in particular at Forex. This article gives the principles of the Elliott theory, according to which you can continue further the study of such a complex, but interesting strategy.

What are Elliott Waves?

Elliot Wave Theory is a mathematics-based theory that allows one to determine the behavior of a society or financial markets using established models. Elliot believed that the development and change in the behavior of society or traders can be predicted using wave theory.

Elliott Waves can be used to trade in the financial markets, as they apply to any goods and assets. To do this, it is necessary to recognize wave patterns in the price chart that are constantly repeating.

History

Wave theory was developed by Ralph Nelson Elliot in the 30s of the 20th century. Studying changes in prices in the stock markets, he came to the conclusion that they all occur according to the same scenarios (models). All identified models, and he counted 13, have the same shape, but can be different in amplitude and time.

Elliot in 1938, together with financier Charles Collins, published the book Wave Principle. After 12 years, Elliot wrote his main book, The Law of Nature. The Secret of the Universe ”, which became the starting point for the study of the wave theory of not only financial markets, but of humanity as a whole.

What is the wave theory? Basic principles

In order to analyze the Elliot waves , you need to know the principles and postulates of this theory, as well as the legend:

1. Any model has the same construction. First, there is a movement of prices (shown in green on the chart), and then correction of these prices (on the chart, in red).
2. All waves are subdivided only into impulse (motion waves) and corrective (price correction waves). They follow each other. For example, after impulse wave 1 is correctional wave 2.
3. The price movement or trend movement is represented by five waves. Three of which are pulsed, i.e. cause a price movement, and two correction, directed in the opposite direction from the impulse. Elliot designated these waves with numbers 1,2,3,4,5. Below are the Elliott waves on the chart.
   
4. After the completion of the trend movement, a period of correction of such a movement necessarily follows. Which consists of two impulse waves and one correctional wave, they are designated as A, B, C.
5. Each wave consists of smaller waves that have the same structure as larger waves. Now the wave chart is as follows. Based on this model, it is easy to predict what will happen next with the price and make a forecast for the Elliot wave.
   
6. All waves are interconnected, none of them exists separately from the others. Every wave has a certain structure and takes a certain place in the model.
7. All wave models are interconnected, thereby they create models of large sizes, and those, in turn, are other models.

Fibonacci mathematics and its connection with wave theory

Leonardo Fibonacci was a great Italian mathematician. Among his many works, only one sequence of numbers 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc., revealed by him, will be of interest in the key of the article. There are a lot of interesting things in this numerical sequence:

• When adding the two previous numbers, the following number is obtained: 1 + 1 = 2, 1 + 2 = 3, 2 + 3 = 5, 13 + 21 = 34, etc.
• By dividing the number by the previous one, we get about 1, 618.
• When dividing the previous number by the next one, approximately 0, 618 or 61.8% always come out, this is the so-called "golden ratio".
  

The "golden section" is a division of a segment in which a large part of the segment will relate to the entire segment as well as a small segment to a large one. Objects having such a shape have always been considered ideal, although not proportional, and the "golden section" itself is a kind of standard. In the world, the golden ratio is found everywhere, and allows you to determine the development of both animal and plant, and financial markets. To understand the connection between the Elliott waves and the golden ratio, consider an example.

In the figure, 4 large waves, the 1st and 3rd (pulsed), and the 2nd and 4th (corrective) are highlighted. If you look deeper, the impulse wave contains 5 small waves, and the correctional wave 3 waves, add them, and we get 8. The sequence continues if you count even smaller waves, their number is 34, and so on. Here you can clearly see the numerical Fibonacci sequence.

So, the theory of waves of Elliot and Fibonacci are interconnected. Using Fibonacci discoveries, you can determine the continuation of the trend or the end of the correction, which is very important.

Rules for the formation of waves in a trend impulse

There can be no truths in wave theory, since there are no axioms in the financial markets themselves. But there are rules that apply to most situations and allow analytics on Elliott waves. And the violation of at least one should make you wonder if the model is correctly superimposed on the pricing schedule. These rules include:

1. Wave 2 cannot fall to the level of the beginning of wave 1. The characteristic size for wave 2 is approximately 38% - 61% of wavelength 1. The development of wave 2 is due to market uncertainty. This is one of the most important and invariable rules; a correctional wave cannot reach and be larger than the impulse wave that precedes it.
2. Wave 3 should not be the smallest among waves 5, 3, 1 i.e. pulsed. Its final level must be higher than the final level of wave 1. In exceptional cases, wave 3 may be shorter than other waves, but it must be remembered that this is more an exception, and a possible overlap of the model is possible.
3. Wave 4 is quite difficult to determine, since often its size is only 38% of wave 3. Wave 4 does not approach the price range of wave 1 (2).
4. Wave 5 in most cases reaches a level higher than wave 3. It is 38% larger than wave 4.
5. Waves 4 and 2 should differ from each other in one or several criteria: different nominal stroke size, different internal structure, formation time, rollback level.
   

Signal lines

One of the main assistants in determining the beginning and end of an impulse, as well as the beginning and end of waves, are signal lines that pass through certain points of the model.

1. The first signal line can be seen by drawing a line through the starting point of wave 1 and the top of wave 2. The rule of this signal wave: waves 1, 2 and 3 should not cross this signal line. Purpose: the line allows you to determine the starting point of waves 3 and 1, the end of wave 2.
2. The second signal line is formed by drawing it through the tops of waves 4 and 2. Rule: waves 5,4,3 cannot cross this signal line. Exception: wave 5 may cross the signal line in the Thermal Impulse.
   

A, B, C - correction

There are a lot of correction models, divided into simple and complex, but the main ones are:

• Zigzags. It is characterized by jumps in prices in the opposite direction from the period of the impulse. Wave B is shorter than waves A, C. Correction can consist of several zigzags.
• Range. It is characterized by lateral movement.
• Triangles. Have a movement against the impulse or sideways, often consist of 5 waves. There are ascending, descending, expanding, symmetrical triangles.

Elliott Wave Indicators

Since the theory itself is complex and involves a large share of subjectivity, it is impossible to come up with a universal indicator. Despite this, various indicators are created and improved for the simplified analysis of Elliott waves. In any case, using them, a person should personally monitor the situation on the market and have a good knowledge of the theory of Elliot and Fibonacci waves. The indicators are easy to install and all have rules of use. The most famous are: Elliott Wave Prophet (EWP), Watl, Elliott Wave Oscillator (EWO), Elliott_Waves.

1. EWO determines the strength of the pulse, but is not able to accurately determine the beginning of the wave.
2. Watl clearly and fully draws charts, but to use it, you need to study the instructions for the indicator.
3. EWP draws waves well and even tries to predict further price developments, but often the forecasts are not correct.

Each Elliott Wave Indicator has both advantages and disadvantages. They should be considered as assistants in determining the waves, but in no way accurate forecasts.

Elliott Wave Theory

There is enough criticism of Elliot's theory, but it all boils down to a few points:

• The analysis of Elliott waves is diverse and often depends on the subjective opinion of a particular trader. Each trader sees the situation in his own way, which means that the wavelengths are seen in different ways. Which leads to a difference in strategies.
• The complexity and complexity of the method. In textbooks, everything seems much simpler, but in practice, the waves are not so beautiful and clear. It is difficult to determine what wave the financial market is on.
• There are a lot of books and studies on the Elliott wave theory, so it can be difficult for a beginner to understand. In addition, many researchers offer their interpretation and their conclusions on the theory of Elliot.

It is impossible to predict the behavior of the financial market only on one wave theory; it is also necessary to take into account the economic, political and social aspects.