Welcome to this edition of trading with the Elliott wave theory. We will take you through what Elliot discovered and show you how to identify the waves, what they mean, and how to trade with them. As you will find out, it is essential to find the best forex broker in the world for you. That is easy when you read our forex broker reviews. You can then use the Elliot Wave for forex, commodities, stock and CFD trading.
Alright, where should we start? Back in the old days of the forex market, there was this genius. His name, Ralph Nelson Elliot. He was a whiz at finance, and he came up with the Elliott wave theory.
It is used in all kinds of financial markets, including CFD trading. If you are new to the market, before we get into this, you should read the forex broker reviews we provide so you can get the best forex broker in the world for you.
Back to Elliot. He started by analyzing about 75 years’ worth of data from the stock markets, and then he discovered something. In all that apparent chaos of the data, there was some order.
He was 66 when he hit the analysis jackpot. He had collected enough evidence and was ready to share his findings with the world. He wrote a book called ‘The Wave Principle.’ It changed everything about the market.
What Elliot Found
According to his findings, the market’s randomness and chaos, actually had repeating cycles. He pointed out that they were emotions of investors caused by influences from outside the market itself. Nowadays, external influences are Bloomberg, CNBC, ESPN, and others.
The predominant psychological frame of mind at the time of these seemingly random fluctuations was responsible for the order he saw.
That is how we started using the Elliott wave in forex, stock and CFD trading, among other markets. He also explained that the downward and upward movements in price as a result of the collective psychology of the market always show up in patterns that repeated themselves.
These patterns in the upwards and downwards trends are what he called 'Waves.' That is why we know them as Elliott wave to this day. According to Elliot, if you could correctly identify the repeating patterns in the prices, you could be able to predict if the price would go up or down next.
That fact is what makes the Elliott wave so appealing and predominant in the forex, stock, and CFD trading markets. It is a way to be precise in identifying where the price will most likely reverse in the future.
Summarily, his Elliott wave system us a method for any trader to catch the bottoms and the tops. In the midst of chaos, this clever man found the answer.
Pretty impressive, if you ask us.
Fun Fact: Like most geniuses, he named it after himself. Of course, he wouldn’t …who? That is why we call it The Elliott wave Theory.
Understanding Fractals Before Elliott Wave
Before we get into the whole trading with Elliott wave thing, let us look at something significant in this topic. You will have to know what fractals are first. In short, fractals are structures that can be split into parts, each of which is very similar to a copy of the whole thing.
This is a property that mathematicians call self-similarity. The same property makes snowflakes look like they have smaller copies of themselves within themselves, the more you zoom in. Shells, clouds, and lightning bolts are all fractals.
So, where do they factor into this? Well, one of the properties of the Elliott waves is that they are fractals. Like clouds and seashells, they can be subdivided into smaller Elliott waves, similar to the overarching whole.
Fun Fact: Traders who use and are experts in Elliot Wave are called Elliotticians.
Understanding Impulse Elliott Wave
Mr. Elliot demonstrated that a trending market moves in a 5-3 wave pattern. We call the first 5-wave pattern, the impulse waves, and the last 3-wave pattern, corrective waves. In that pattern, waves 1,3 and 5 are motive. That means that they go along the overall trend, and waves 2 and 4 are corrective.
Do not mix up waves 2 and 4 with the ABC corrective pattern (we will get to that in a while).
Here’s the 5-wave pattern:
Does it look confusing? Do not let it intimidate you. So, let's color-code each wave to make sure that we can distinguish them.
There we go. Now it looks beautiful and attractive. Let us describe what happens during each wave to make sure that it sinks in. We will use stocks as an example here. But, you can use it for anything, including trading currency, bonds, commodities and CFD trading too.
- Wave 1- The stock's initial move is up. It's the result of the small number of people who, for some reason, feel the stock price is cheap enough to buy. The price rises.
- Wave 2- Here, the first wave people consider the stock overvalued and take profit. The stock goes down. However, it will not reach the previous low before other people think 'it is cheap enough to buy.
- Wave 3- This is the strongest and longest-lasting wave. The stock is now in the eye of the public. Most people know about it now and want to buy it. The price goes much higher this time. It is higher than wave 1.
- Wave 4- Traders take profits because now, the stock is overvalued again. This wave is weak because there are a lot of people 'bullish' on the stock, and they wait to buy 'on the dips.'
- Wave 5- At this point, most people get on the stock. Usually, they are driven by hysteria. At this point, whoever owns that company or the CEO, gets their face on a magazine or something. The traders give the weirdest and sometimes most ridiculous reasons to buy the stock and will flip out if you disagree. At this point, it is at its most overpriced point.
After that, we get what we call the ABC pattern (it is coming up anytime now).
Pro Observation: In the Elliott wave theory, one wave is always longer than the other two. As Elliot would put it, one of the three impulse waves (1,3 or 5) is still extended.
Understanding Corrective Waves
This is the next part of the Elliott wave theory. The 5-wave trends are usually reversed or corrected by the 3-wave trends, which counter them. When tracking the corrective waves, we use letters instead of names to label them.
Look at this:
The Elliott wave works on the bearish markets too. It does not just describe uptrends. That is the reason why the 5-3 waves can look like this also:
According to Elliot, there are about 21 corrective patterns (we call them ABC patterns too). They can be simple and gradually get complex. You cannot memorize all of that, and that's fine. The thing about Elliott wave is that they are easy to grasp when you know these basics we are teaching you.
They are all made up of three primary and straightforward formations. Once you understand these formations, you do not have to memorize 21 of them. So, what are the formations we need to know? Well, here they are:
Formation 1: ZigZag
The zigzags are very steep movements in the price. They go against the dominant trend. Wave B, is the shortest when compared to waves A and C. here is what that looks like:
The zigzag patterns can happen twice or thrice in a correction. Just like every other wave in the Zigzag pattern, they can be broken up to form the 5-wave.
Formation 2: Flat
The flat formations occur as sideways corrective waves. In the flats, the lengths of these waves are generally equal. The B wave reversing A, move, and the C wave undoes the B wave move.
Here is what they look like:
One thing to remember is that the B wave can sometimes extend beyond where the A wave begins. So, it is not always that they are equal.
Formation 3: Triangle
The triangle formations are corrective and are bound by diverging or converging trend lines. The triangles are the product of 5-waves that move in opposition to the trend, in a sideways direction. The triangles can be symmetric, ascending, descending, or expanding.
If you know all this, you will be fine and able to understand the Elliot Wave and how they manifest.
The Fractals Part of The Elliott Wave Within an Elliot Wave
We said that Elliott waves are fractals. They are all made of sub-waves. To make it easy, you need to visualize this so, here’s another pretty picture to help with that process.
Waves 1,3 and 5 are made up of smaller 5-wave patterns each, and the thing is, they repeat like that TO INFINITY. Like, if you zoomed in, they would just be fractals for the smaller waves and so on, FOREVER.
To label them quickly, the Elliott wave theory has a series of categories that help you label them from the largest to the smallest. Here is how that breaks down:
- Sub-Minuette- Minutes
- Minuette- hours
- Minute- days
- Minor- weeks
- Intermediate- ranges from weeks to months
- Primary- ranges from a few months to 2 years
- Cycle- a year to several years
- Supercycle- 40-70 years
- Grand Supercycle- several centuries
Do not think about the cycles too much. The thing is, they go on forever, and you should not really be concerning yourself with that. Just focus on the main ideas, and you will be able to trade with the Elliot Wave for the stock, forex, or CFD trading, with ease.
The Elliott wave in real life is not shown in perfect lines as you see in our examples. It is a bit more complicated than that, but it should not worry you either. The principles are the same, no matter what it looks like.
To make sure that you do not get the wrong idea, let’s look at what an Elliot wave looks like in real life when you are doing forex, stock, or CFD trading.
There it is. So, let's learn how you can quickly and accurately identify the waves, so you can apply this knowledge to trade using Elliott wave. Get your surfboard; we are going surfing.
The Three Cardinal Rules Governing The Elliott Wave Theory
Trading with Elliott wave is all about being able to accurately and correctly identify the waves. You need the right eye and three rules, which you can never break. They will help you label waves.
Here they are:
- Wave 3 can never be the shortest impulse wave
- Wave 2 can never go beyond the beginning of wave 1
- Wave 4 can never cross in the same price are that wave 1 is in
There it is. If you know these, you can identify the parts of the wave and, in that way, know what you are looking at.
And now, the Elliott wave trading guidelines. Unlike the cardinal rules, these are not absolute:
- Wave 5 does not move beyond the end of wave 3. We call this truncation
- Wave 5 often goes beyond the trend line drawn from wave 3, parallel to a trend line that connects the start of wave three and wave 5.
- Wave 3 tends to be long, sharp and extended.
- Wave 2 and 4, often bounce off levels indicate by Fibonacci retracements.
That's all you need to know about that part. Let's look at the scenarios now.
The Way You Do Stock, Forex, Commodities and CFD trading With The Elliott Wave
Here are the things you should be able to do:
- Know how to pinpoint where waves 3 and 5 start. They are the trend continuation waves in the 1-2-3-4-5 impulse wave formation.
- Know how to detect when the pullbacks start to happen after waves 1 and 3. They are essentially Waves 2 and 4. It is advisable not to trade against the trend. So, these waves are not for when to trade but for when not to trade.
- Know how to determine the end of the impulse wave setting and the start of the ABC corrective wave.
Pro Tip: Do not forget that the trend continuation of waves 1,3 and 5 within the impulse waves, have 5 component subwaves and the retracement waves of 2 and 4, usually have 3 component waves.
The best way to learn how to spot the Elliott wave is by trading using them. We recommend that you start trading on demo accounts that will show you what you need to know about the market’s real data.
The best way to find demos to use is to read our forex broker reviews to find the best forex broker in the world for you. If you can do that, they will provide you with a demo account that you can then use to train and learn.
When you see what they look like in real life, you will have no trouble employing them in forex, commodities, and CFD trading, among other markets.