Updated: Jun 13, 2019
“…action in the same direction as the one larger trend develops in five waves…”
-Elliott Wave Principle by Frost and Prechter
As R. N. Elliott observed in his book Nature’s Law – Wave patterns occur when price is trending. These waves form larger and smaller versions of themselves, otherwise known as being fractal in nature. Wave Principle aims to identify trend, counter-trend along with the maturity of a trend. Knowing counter-trend movements can give the trader an opportunity to position themselves in the direction of the primary trend – the path of least resistance. Elliot Wave Principle has both impulsive and correctional wave patterns that adhere directly to Fibonacci proportions. The general rules for an impulsive wave are as follows:
1. Leg 2 cannot exceed / retrace the beginning of wave 1
2. Leg 4 cannot enter the price area of wave 1
3. Leg 3 cannot be the shortest impulsive wave out of 1, 3 & 5
Importantly, behavioural psychological traits are found and best explained by the 5-wave impulsive moves of Elliott. Wave one is barely obvious at first since movement in price has originated from a non-trending market environment. Fundamental news is generally negative and crowd sentiment bearish. The second corrective wave is still very bearish where confirmations for the downward movement is used as justification for the poor forward looking fundamentals. Wave three is generally seen to be the largest move – where analysts begin to revise to a bullish case for fundamentals. This is what primarily creates the momentum for the third wave being the largest. Traders looking to enter on a correction miss the opportunity and feelings of ‘Fear-Of-Missing-Out’ set in – traditionally this is the point where ‘the-crowd’ joins the trend. Wave four is recognised by the market as being clearly corrective in nature and is viewed as a great place to ‘buy the dip’ since the potential for higher moves is widely recognized by traders. The final leg wave five has extremely positive broad universal sentiment across almost all market participants and traders. During this period prices are at all-time highs where bearish forecasts are ridiculed and disregarded. Unfortunately, this is the period where most retail investors buy into the market. Furthermore, technical momentum indicators whilst nearing the end of the wave begin to show signs of divergence where price action cannot sustain current levels and the market becomes over leveraged and prone to a reversal.
“…reaction against the one larger trend develops in three waves...”
Correctional waves also often follow a Fibonacci retracement structure generally in an AB=CD pattern or an extension of 1.618 times of wave A. These three legs A, B & C provide opportunities to enter the longer trend. Corrective patterns are sometimes more complex than impulsive moves and have a wider variety of shapes such as a zigzag, expanded triangle/double triangle or a combination of both. As a trader it is important to establish where we are in a trend by combining Wave Theory with traditional technical indicators to increase your likelihood for a highly probable trade.
There can be times in the market where point ‘B’ of the ‘ABC’ correctional wave exceeds the 5th wave of Elliott and creates Divergence in price action. Traders typically view this point as a ‘fake-out’ where they short the ‘B’ wave retracement and get stopped out above point 5 of Elliott on their protective stop-loss.
However this creates a second opportunity to short after point ‘C’ had been reached as a cover trade. As you can see with the USDJPY there was then a pullback to the 61.8% retracement level with a long candlewick showing that the bulls could not sustain price action at these levels. An Elliott Wave trader would view this as a key point of entrance and once price action has moved in the trader’s favour then the stop-loss can be moved above the entrance candlestick to improve risk-to-reward ratio.