About Elliott Wave Theory
Elliott based part his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Thus Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns he had identified.
Definition of Elliott Waves
There have been many theories about the origin and the meaning of the patterns that Elliott discovered, including human behavior and harmony in nature. These rules, though, as applied to technical analysis of the markets (stocks, commodities, futures, etc.), can be very useful regardless of their meaning and origin.
Simplifying Elliott Wave Analysis
When the analysis is not clear, why not find another market conforming to an Elliott Wave pattern that is easier to identify?
From years of fighting this battle, we have come up with the following practical approach to using Elliott Wave principles in trading.
The whole theory of Elliott Wave can be classified into two parts:
Elliott Wave Basics
— Impulse Patterns
The initial stages of the Wave 3 rally are
slow, and it finally makes it to the top of the previous rally (the top of Wave
At this time, there are a lot of stops above
the top of Wave 1.
Traders are not convinced of the upward trend
and are using this rally to add more shorts. For their analysis to be correct,
the market should not take the top of the previous rally.
Therefore, many stops are placed above the top of Wave 1.
Wave 3 rally picks up steam and takes the top of Wave 1. As soon as the Wave 1
high is exceeded, the stops are taken out. Depending on the number of stops,
gaps are left open. Gaps are a good indication of a Wave 3 in progress. After
taking the stops out, the Wave 3 rally has caught the attention of traders.
The next sequence of events are as follows:
Traders who were initially long from the bottom finally have something to cheer
about. They might even decide to add positions.
traders who were stopped out (after being upset for a while) decide the trend is
up, and they decide to buy into the rally. All this sudden interest fuels the
Wave 3 rally.
This is the time when the majority
of the traders have decided that the trend is up.
Finally, all the buying frenzy
dies down; Wave 3 comes to a halt.
Profit taking now begins to set in. Traders who
were long from the lows decide to take profits. They have a good trade and start
to protect profits.This causes a pullback in the prices that is called Wave 4.
Wave 2 was a vicious sell-off; Wave 4 is an
orderly profit-taking decline.
While profit-taking is in
progress, the majority of traders are still convinced the trend is up. They were
either late in getting in on this rally, or they have been on the sideline.
They consider this profit-taking decline an excellent place to buy in and get even.
On the end of Wave 4, more buying sets in and
the prices start to rally again.
The Wave 5 rally lacks the huge enthusiasm and
strength found in the Wave 3 rally. The Wave 5 advance is caused by a small
group of traders.
Although the prices make a new high above the
top of Wave 3, the rate of power, or strength, inside the Wave 5 advance is very
small when compared to the Wave 3 advance.
Finally, when this lackluster buying interest dies out, the market tops out and enters a new phase.
An impulse pattern consists of five waves. With the exception of the triangle, corrective patterns consist of 3 waves. An impulse pattern is always followed by a corrective pattern. Corrective patterns can be grouped into two different categories:
Simple Correction (Zig-Zag)
Fibonacci Ratios inside a
A simple correction is commonly called a Zig-Zag correction.
by far, most commonly occur as fourth waves. One can sometimes see a triangle as
the Wave B of a three-wave correction. Triangles are very tricky and confusing.
One must study the pattern very carefully prior to taking action. Prices tend to
shoot out of the triangle formation in a swift thrust.
triangles occur in the fourth wave, the market thrusts out of the triangle in
the same direction as Wave 3. When triangles occur in Wave Bs, the market
thrusts out of the triangle in the same direction as the Wave A.
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