From Forex Round Up
We get asked about Ralph Elliott's wave theory all the time. Now some people think it's a load of old rubbish. But others love it. It's a little like Marmite.
Personally, I reckon it has its uses. As a predictive tool for both entering and exiting trades, once you've mastered it, Elliott wave theory can be very effective. And we'll be exploring it more in future issues of Forex Round Up.
But today, I'm writing to anyone who is brand new to this. I'm going to talk to you about some basic Elliott wave counting.
Now, it's worth mentioning from the off that many books have been written on this vast subject. So it would be quite presumptuous to think a short article like this can do it justice and cover all the bases.
At the same time, even a slight appreciation of the basics of wave counting in accordance with key rules is still a very powerful piece of knowledge. Where you take it from there is up to you. We'll give you what you need.
Let's get started...
Looking for the waves
So the core concept of Elliott wave is the repetition of clearly defined and countable wave cycles.
These cycles are divided into two categories, impulse waves and corrective waves.
They can be broken up in many different ways, however, we will just cover the basic 5-3 pattern as shown below in white:
(Click on the image for a larger version)
This chart shows the typical 5-3 wave, with a five wave impulse pattern up (1,2,3,4 and 5), followed by a three wave correction (A, B and C).
There are very few hard rules in Elliott Wave and they are outlined as follows:
1. Wave 2 can never exceed the start of wave 1 - This just means that if the retracement of wave one moves beyond the start of wave one (ie. a greater than 100% retracement) then the cycle has failed and should be recounted an alternative way.
2. Wave 3 can never be the shortest impulse wave - Although the third wave is normally the longest wave in the cycle it does not have to be, but it definitely can not be the shortest of the impulse waves.
3. Wave 4 can never overlap wave 1 (except within a diagonal triangle). A similar concept to rule 1 but the exception for this rule is for drawing triangle formations, so the exception will be ignored for the purpose of this tutorial.
Another key aspect of Elliott Wave to note is the fractal nature of the wave. This means that each wave cycle can be made up of smaller wave cycles, all adhering to the same principles.
The whole thing can also itself make up waves within an even larger cycle and so on and so on. An example of this is shown in the above chart, with an alternative wave 3 and 4 shown in red and made up of a five wave impulse wave and a three wave correction.
It is also possible for some waves to be broken up into further three or five wave combinations. However outlining the various combinations is something more complex to discuss at a later date.
So if we apply these principles to a real chart, we are able to make some basic predictions based on Elliott Wave counting to suggest future market behaviour:
(Click on the image for a larger version)
Here it is not yet clear if the A wave is correct (having been broken into a three wave count) or if A should be C having completed the cycle. We will have to see how it turns out.
When making trading decisions based on Elliott Wave, it soon becomes clear which waves should be paid the most attention. Since wave 3 is usually the largest wave in the cycle, entering a new trend on the first retracement is often the most advantageous trade and statistically most likely to give a good risk reward.
Likewise, trying to enter into the same trade for a wave five continuation, the risk/reward is most likely to be reduced and the entry less accurate, increasing the risk further. It is also very helpful to know when a wave five has completed so that profit can be taken before the correction.
This example is just touching the surface of Elliott Wave. However it can be a very effective method of predicting market behaviour once the finer points of these techniques are mastered.
I'll be revisiting Elliott Wave techniques again soon in my free email newsletter Forex Round Up.
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