If there’s one trading theory that fascinates investors, it’s the Elliott Wave Theory (Elliott Wave Principle). Despite being developed in the United States stock markets over three-quarters of a century ago, the theory can still be applied to any market today, FX market included.
Ralph Nelson Elliott was an accountant. He loved patterns and used a logical approach to everything in his life.
He developed the concept of a cycle, and each cycle has two parts:
- one impulsive
- one corrective
Elliott Waves Theory is named after the constantly forming waves of the sea.
So, if you have ever heard of Elliott investors counting waves, this is exactly what they do. Elliott established a complex logical process, claiming he had found “the secret of the universe” as his theory incorporated human sentiment like no other.
The main challenge in trading comes from psychological factors, and Elliott Theory incorporates both optimistic and pessimistic outlooks of different market cycles.
After all, the market is the sum of investors’ buying or selling actions. These actions influence supply and demand levels causing the price to move in bullish or bearish trends, or in tight ranges.
Elliott Waves 101
Throughout this forex trading article, we’ll cover the Elliott Waves Theory multiple times, from basic to complex concepts. This lesson aims to discuss the basics of the theory, so investors can form a general understanding of it.
The Motive Wave is the first half of an idealized Elliott Wave pattern. It always advances in the direction of the trend of one larger degree. Five smaller waves are seen in this pattern, which are labeled 1, 2, 3, 4, and 5. Even deeper within the Motive Wave, there are two types of smaller sub-waves: The Impulse Wave and the Diagonal Wave.
Waves 1,3 and 5 are called actionary sub-waves that advance. Waves 2 and 4 are called corrective sub-waves as the correct or move downward (opposite direction of the larger trend).
There are three rules that must be satisfied for the Motive Wave formation to form:
- Wave 2 always retraces less than 100% of Wave 1.
- Wave 4 always retraces less than 100% of Wave 3.
- Wave 3 always travels beyond the end of Wave 1 and is never the shortest wave.
The corrective wave is a three-wave structure that has its sub-waves labeled as A, B, and C. This is often misleading as not all corrective waves are three-wave structures.
As mentioned earlier, an Elliott cycle has an impulsive and a corrective wave; in other words, two market reactions labeled differently.
Elliott used numbers to label impulsive waves and letters to label corrective waves. According to Elliott when the market forms an impulsive wave, it does so in five separate waves. However, only three waves are needed to form a corrective wave.
Hence, the correct labeling of a market cycle under the Elliott Waves Theory is: 1-2-3-4-5 / a-b-c. The numbers show impulsive activity, and the letters, corrective activity.
Therefore, in a bearish cycle, the market declines in a five-wave structure and corrects in a three-wave structure.
So far, so good, however, the problem arises from the various degrees in which a cycle can be identified, depending on your time frame.
For instance, the 1-2-3-4-5 above may be the 1st wave of a larger impulsive wave pattern. And, the a-b-c in the image above could be the 2ndwave of the same impulsive wave pattern.
Alternatively, the 1-2-3-4-5 from above could be the a wave of a corrective wave pattern, and the a-b-c that follows could be the b wave belonging to the same corrective wave pattern.
Part One Summary:
- Elliott Waves Theory incorporates human sentiments like optimism and pessimism
- Investors label waves as impulsive and corrective
- Impulsive waves are five-wave patterns, corrective waves are three-wave patterns
- An Elliott cycle is formed out of an impulsive and corrective wave