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Task №5. Wave analysis. Elliott wave principle

In this lesson, we will tell you the ABC of one of the most popular technical analysis methods – the Elliott wave principle.

Ralph Nelson Elliott, a professional accountant, developed wave analysis in the 1930s. In Central America, Elliott contracted a debilitating intestinal illness, which forced him into early retirement and he decided to dedicate himself to the analysis of stock markets. He noted that the price dynamic, which is supposed to be chaotic, actually unfolds in specific patterns that in their turn can be classified into even smaller patterns. In 1938, he published the results of his study in the book entitled The Wave Principle. Later, Elliott expanded his theory to apply to all collective human behaviors and published his most comprehensive work Nature's Law–The Secret of the Universe in 1946.

According to the Elliott principle, market prices follow some recurrent cycles. Prices change their dynamics based on crowd behavior. These cycles that a price repeats were called ‘waves’. To identify a further price movement correctly, you need to find out what wave pattern takes place.

Traders appreciated the advantages of the Elliott theory quite soon as it enabled them to find reversal points on their own.

Basics

The Elliott wave analysis divides the dominant trend into five waves, with three impulse waves going alongside the major trend and two corrective waves going against it.

The Elliott wave principle


This wave pattern is enumerated by 1 to 5. Once the pattern is completed, it is followed by a correction that includes two waves alongside the trend and one corrective wave. These three waves are labeled A, B, and C.

Waves


This is the classic theory interpretation. However, currently, there are some updated versions.

Take a look at the EUR/USD price chart. Here you can see a complete Elliott wave pattern. The red line shows main waves of the pattern; while the yellow line indicates smaller parts, which waves consist of.


To study the Wave theory basics in detail, we need to analyze each wave separately.

Waves broken down into smaller waves


Wave one starts moving upwards lead by a ‘motive’ from traders willing to buy a currency. It means the price starts rising. Then wave two follows it indicating that the market is full of buyers and the price has grown enough to fix profits. The price edges down but not lower than wave one. Wave three is usually the largest and most powerful. The currency receives the highest attention of investors amid the surging price. The price hits a high level, usually way above wave one. Wave four begins when the price is too high and market participants begin to close their deals. This wave is not as clearly defined as the others because some investors still hope for a further growth. Wave five is the final leg in the direction of the dominant trend. The price is too high and it signals a soon development of the ABC correction.

Once the five-wave pattern is completed, a three-wave corrective pattern begins. It is directed against the major trend. Elliott described twenty-one ABC patterns depending on the situation in the market. But they all can be simplified to three waves.

One type of the correction is called a zigzag correction. It is a sharp correction with impulse waves A and C and corrective wave B, which is usually much shorter than A and C. In the flat correction, the A and B waves are corrective, while the C wave is impulse. The correction is called ‘flat’ because the pattern moves sideways.

Triangles, or more commonly horizontal triangles, are patterns consisting of five corrective sub-waves that travel in a sideways pattern. Horizontal triangles can be classified as symmetrical or contracting (declining top, rising bottom), descending (declining top, flat bottom), ascending (flat top, rising bottom), and expanding (rising top, declining bottom).

The waves can be further broken down into more waves. Elliott categorized the waves according to their relative size (degree): grand supercycle, supercycle, cycle, primary, intermediate, minor, minute, minuette, and subminuette.

At first sight, the Elliott wave principle seems complicated, but there are three rules that will ease its understanding and ensure correct analysis. First, wave three cannot be the shortest among other impulse waves (waves 1 and 5). Secondly, wave four does not overlap with the price territory of wave one. And third, wave two never retraces more than 100% of wave one.

Violations of the wave rules

Fibonacci sequence

In his works, Elliott stated that “the Fibonacci Summation Series is the basis of the Wave Principle”. The Fibonacci sequence is as follows: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 etc.

As you can see, every next number is the sum of two previous numbers: 3 + 5 = 8; 5 + 8 = 13; 8 + 13 = 21; 13 + 21 = 34 and so on. Each number in this sequence is approximately 1.618 times greater than the preceding number. For example: 34/21 = 1.618. The number of 1.618 is called the Golden ratio. The ratio obtained by dividing one number in the sequence by the next number equals 0.618. For example: 34/55 = 0.618. The number reciprocal for 1.618 is 0.618; and vice versa, 1.618 is reciprocal for 0.618 (1/0.618 = 1.618; and 1/1.618 = 0.618). The ratio obtained by dividing a Fibonacci number by the pre-preceding number equals 2.618, while the division of a Fibonacci number by the next after the following number gives 0.382. For example: 55/144 = 0.382. The number reciprocal for 2.618 is 0.382; and vice versa, 2.618 is reciprocal for 0.382 (1/2.618 = 0.382; and 1/0.382 = 2.618). In a similar fashion, the ratio obtained by dividing any number in the sequence by the number that is three places to the left equals 4.236. For example: 144/34 = 4.236. The ratio obtained by dividing a number in the sequence by the number that is three places to the right equals 0.236. For example: 144/610 = 0.236. The numbers 4.236 and 0.236 are reciprocal for each other (1 /4.236 = 0.236; and 1 / 0.236 = 4.236). The first two Fibonacci numbers are equal (1/1 = 1) and 0.5 is the division of the second number in the sequence by the third (1/2 = 0.5).

The Fibonacci sequence on its own does not matter in forecasting the length of market movements in terms of the price absolute value. What matters is the ratio (division) between the numbers in the sequence. Usually, the Fibonacci relations are viewed between every other wave than between the neighboring ones. So it is wave one that influences the length of wave three, not wave two. Targets found with the help of Fibonacci retracement are key support and resistance levels. This is correct even in case of a breach. The Elliott wave theory points to a form and structure of movements, while the Fibonacci sequence helps us measure their length. These principles together make a nice combo.

Let us consider in detail how Fibonacci ratios develop among wave formations.

Impulse waves

Among the three impulse waves, the end of wave three is the most difficult to predict as wave three can, rarely though, be shorter than wave 1. Forecasting where wave three will be completed is rather challenging.
If wave three is not shorter than wave one, wave three will be either equal to wave one or 1.618 times longer than it. Still, it is possible that wave three will become 2.618 or 4.236 times longer than wave one.

Wave five makes up 0.382 or 0.618 of the difference between the beginning of wave one and the end of wave three. Wave five is often 1.618 times longer than wave one. These statements are true in case waves three and one are not extended.

Wave extensions

Remember that in the five-wave move only one impulse wave will be extended (one, three or five). If an extension is seen in wave three, waves one and five look equal in length. As a rule, sub-wave three within wave three usually marks the center of wave three’s movement. If you witness a series of converging waves where no triangles are expected, then it is an extension. About 60% of all extensions take place in wave three. Thirty-five percent of cases are extended wave five and only 5% of cases are extended wave one. If wave one is extended, the next correction target will unfold in the area of wave two, not usual wave four.

Corrections within extensions are usually weaker. The standard retracement ratio to the preceding wave makes up 23.6%; and seldom, 38.2%. If wave two retraces less than 50% of wave one, extended wave three is on the cards. If wave five is extended in the five-wave move, then there is an 80% possibility that this cycle is wave three in a higher degree. If an extension develops in wave five, the wave’s length is 1.618 times higher than the distance between the beginning of wave one and the peak of wave three. Take a look at the picture below.

Extended wave five

Corrective waves

The main way of forecasting the depth of corrective waves is to multiply Fibo ratios (0.236, 0.382, 0.5, and 0.618) by the length of the preceding impulse wave. Elliott named eight corrective structures. Sometimes, corrective structures double or triple in long-term sideways consolidations. Doubled wave three is considered the most difficult structure. The double three is considered the most complicated combination. Double threes rarely occur at scales higher than hourly or ten-minute ones. If a correction begins with a complicated sideways pattern (flat correction or triangle), the retracement makes up not more than 38.2%; or seldom, 50%. This is true even for corrective wave two. The correction within 38.2% retracement of the previous movement indicates a moderate dominant trend, while a correction requiring some time to end leads to a sharp movement seen after the completion of the correction. Retracements of 61.8% take place in wave five more often than 50% ones. However, 50% retracements often happen in wave B within a zigzag. The completed zigzag does not mean that the whole correction came to an end as retracements can include complicated patterns. However, Elliott said that usually the simplest structures turn out to be the right answer. In the patterns like the double zigzag, the second zigzag ends way below the minimum of the first one (bullish market). In a bearish market, the second zigzag ends much higher than the first one’s peak.

Neither the Wave principle nor Fibo ratios will help you find the points where wave two will end. You could only define average levels to place stop orders. That is why you should better not trade in wave two. As a rule, wave two is simple (zigzag, double zigzag), while wave four is complex (flat correction, irregular correction, triangles, double or triple threes, etc.). Retracement in wave two is usually deeper than in wave four. Wave two tends to retrace 61.8% or more of wave one (if this does not happen, than 50% retracement is likely to develop). Traditionally, wave four retraces 38.2% of wave three.

Retracement in wave 2


Retracement in wave 4


A completed cycle of the Elliott wave, where the impulse five-sub-wave move is corrected by the three-wave pattern (three) represented by a zigzag. The correction ends at 61.8% Fibonacci ratio.

Let us make clear how Fibonacci retracement levels are built. First, draw a line between two extreme points (let us say, from a low to the opposite high). Then, draw nine lines crossing the trend line at Fibonacci rates: 0.0%, 23.6%, 38.2%, 50%, 61.8%, 100%, 161.8%, 261.8%, and 423.6%. Some lines may not fit the chart because of a chosen scale.

Often, after a sharp surge or slump, a price retraces most (or even the whole) of its previous movement. As a result, the price faces support/resistance at Fibonacci retracement or near it.

Understanding Fibonacci ratios:
In most cases, the first retracement ratio (23.6%) is marginal. The next ratio (38.2%) is relevant as the market often retraces from it. If the market rebound continues, the next important consolidation rate will become 50%. If the retracement continues to 61.8%, it may signal the end of the previous trend.

A complete cycle of the Elliott wave with Fibonacci lines is shown on the EUR/CHF chart. 23.6%, 38.2%, 50%, and 61.8% Fibo ratios are important levels pointing to possible changes in the price dynamic.

Questions for revision
  1. Name main corrective patterns.
  2. Name three main rules to follow when impulse waves are formed.
  3. Find a complete cycle of the Elliott wave on a price chart of some currency pair. Send a screenshot of it.
  4. What is the alternation in the Elliott wave theory?
  5. Name important support and resistance levels based on Fibonacci ratios.
  6. Draw Fibonacci rates on a chart of any currency pair. Track price behavior in relation to % Fibo ratios and describe the patterns.

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