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Elliott waves: learn all about them
Now we have the Elliott Wave Theory, which was developed by Ralph Nelson Elliot. You need to know it for important market analysis and based on chart patterns.
Below we tell you all about Elliott Waves and how you can apply it to cryptocurrency trading.
What are Elliott Waves?
Elliott wave theory, developed by Ralph Nelson Elliott in the 1930s, is a form of technical analysis used to predict market movements based on repetitive wave patterns.
These waves are believed to reflect the psychological cycles of market participants, ranging from optimism to pessimism. The theory postulates that market prices follow specific, identifiable patterns, and traders can use these patterns to anticipate future price movements.
Elliott's theory is based on what he called “waves”, which are part of a fractal. According to Elliott, markets follow a specific pattern composed of:
- Bullish cycle: consists of five waves (1, 2, 3, 3, 4 and 5).
- Bearish cycle: consists of three waves (a, b and c).
There are different types of waves within this theory:
- Momentum waves: they move in favor of the main trend.
- Corrective waves: they move against the main trend.
Each of these waves also contains five smaller waves within it, creating an infinitely repeating pattern.
Elliott wave analysis identifies these wave patterns to varying degrees, allowing a detailed study of market movements.
Basic Structure of Elliot Waves
The theory is divided into two main categories: Impulse Waves and Corrective Waves.
Impulse Waves (or Driving Waves)
These waves follow the dominant trend and consist of five smaller waves. They indicate that the market is moving in a particular direction, either up or down. Within these waves, three of them (waves 1, 3 and 5) align with the general direction of the market, while waves 2 and 4 move in the opposite direction as minor corrections.
- Wave 1: First upward or downward movement of the market.
- Wave 2: Correction that recovers part of the gains or losses of wave 1.
- Wave 3: Often the strongest wave, showing a significant market move.
- Wave 4: Another correction before the final move.
- Wave 5: Last move in the same direction as wave 1.
Corrective waves
After the impulse wave, the market tends to correct, forming a three-wave pattern known as ABC correction:
- Wave A: A counter-trend move.
- Wave B: A minor pullback or retracement.
- Wave C: A final correction that usually completes the pattern.
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How to identify Elliott Waves?
As we explained above, Elliott Waves try to predict the psychology of traders, but also the direction of a price trend.
Traders use Elliott Wave theory to predict future market movements. By identifying where the market is in a wave cycle, traders can anticipate the next price movement, whether it is a continuation of the trend or a reversal.
The key to major success is understanding the rules that define wave development:
- Wave 2 cannot retrace more than 100% of wave 1.
- Wave 3 is usually the strongest and longest wave, and cannot be the shortest wave between waves 1, 3 and 5.
- Wave 4 does not overlap with Wave 1 in price, except in certain market conditions such as triangles.
These rules are fundamental in determining whether a pattern qualifies as an Elliott Wave sequence. Failure to comply with any of these rules invalidates the pattern and requires a re-evaluation of the wave count.
For example in the following image that exemplifies a Bullish Elliott Wave, you can see how the three rules above are fulfilled, where the key is to see the behavior of wave 3 and 4.
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Elliott Wave Applications
Elliott wave theory is used in several markets, such as the stock, forex and cryptocurrency markets. The goal of traders is to identify where the market is in a wave cycle to anticipate the next move, so it is most common in markets with high volatility. For example, detecting the completion of a corrective wave can signal the beginning of a new momentum wave, presenting a buying opportunity.
Although a powerful tool, Elliott wave analysis is often subjective and requires experience to accurately identify wave counts. In fact, there have been cases where all the identification criteria are met and the analysis is simply incorrect.
For that reason, many traders combine Elliott waves with other indicators, such as the relative strength index (RSI) or moving averages, to validate their wave counts and confirm market trends.
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