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Elliott wave analysis, is a lens to view the market in an objective way.
let’s get into the meat of the matter to see what exactly is the wave principle.
What is Elliott Wave Theory?
Elliott Wave theory maintains that collective investor psychology shifts between optimism and pessimism as part of a natural cycle.
These mood swings create Elliott wave patterns in the price action.
The wave principle views the price movements of the market as being part of an overarching pattern. There are three main descriptive features of the wave principle.
1. The patterns exist at all degrees of trend, (from a yearly chart, down to a minute chart)
2. The patterns are fractals, that is, they are self-similar at all degrees of trend.
3. The patterns are hierarchical, meaning smaller degrees of the pattern link together to construct larger versions of the similar pattern.
Elliott wave model.
The wave principle states that the basic form of market price action is five waves in the direction of the trend and three waves against the trend.
Moves in the direction of the trend are labelled 1 through 5 and counter trend moves are labels as letters, usually A,B and C.
How can Elliott wave patterns be applied to trading?
These are EXACT price patterns I used for years to generate signals and steadily grow my trading account while taking minimum risk.
The most common statement in the investment world is 'the trend is your friend', wouldn't be great to be able to identify the trend.
Here are five areas where the wave principle can help identify the dominant trend.
1. Identifying the dominant trend.
Why is this information of any consequence?
It is far easier to trade in the direction of the dominant trend than to fight against it,
The trend is the path of least resistance.
If you can identify the trend then you can get on board and Elliott wave analysis will allow you to ride that trend until the end.
Below is a daily chart of the Euro Dollar cross rate.
You can see wave [A] down marked in black, followed by an ongoing corrective pattern called a contracting triangle which will complete wave [B] soon.
We know from the Elliott wave pattern that this will be followed by a wave [C ] down.
This wave should be equal in size to wave [A].
The wave model foresees much lower prices for this pair as the trend reasserts itself.
2. Elliott wave identifies countertrend moves.
The impulsive trend will unfold in five distinctive waves, which will then be followed by a three wave corrective move.
Knowing this will allow a trader to position themselves for when the larger trend resumes.
Below is the daily chart of USDJPY.
A very large three wave movement upwards is under way from the lows in 2011 the chart.
You can see wave [A] red completed in five waves, wave [B] down in three waves is complete.
Wave [C] up is about to begin as I write, and should carry the market above the wave [A] high.
While no method of market analysis is perfect, the Elliott wave model does give the practitioner a perspective for possible future action which gives you time to prepare and definite target zones to aim for.
3. Elliott wave identifies maturity of trend.
When oil was trading at $130 per barrel and going higher in 2008, was it a good time to buy into the market and believe all the hype?
Well, had elliott wave theory been part of you analytical tool belt, you might have noticed a very distinctive pattern emerging.
That being five waves up from the lows in 2002.
The Elliott wave trading model was screaming a sell signal! while the rest of the world only saw higher prices.
But the Elliott wave signal And then the decline began, an 80% freefall began in July that year.
4. Price targeting.
One useful element of elliott wave theory is its ability to provide price targets. When used in conjunction with Fibonacci proportions we can construct high probability price targets.
For example a common relationship between wave 1 and 3 is 1.618. And a common retracement level for wave 2 is .618 of the previous wave 1 advance.
These relationships allow us to create a high probability target for wave 3. And also allows us to protect our profits in case we are wrong.
5. Elliott wave theory provides specific invalidation points!
- Wave 2 can never retrace more than 100% of wave 1.
- Wave 4 can never enter the price territory of wave 1.
- Wave 3 is never the shortest wave.
If the price action breaks any of these rules then the count you are operating with, is wrong.
And you must go back to the drawing board.
The advantage of these rules is that you can use them to place protective stops or trail stops closer to the action, if the wave structure is not working out as planned.
Below shows a model of how a trend might develop, you notice the development of 5 waves up and then a retracement of the advance to the Fibonacci 0.618% decline level.
At this point a trader can turn bullish under the wave principle. As the price is expected to rise at least the same magnitude as wave (1). As wave (2) cannot retrace more than wave (1) a protective stop can be placed one point below the start of wave (1) ensuring that you will not risk any more than necessary.
As the price advances in another clear 5 waves to complete wave (3) up, a protective stop can be placed at the high of wave (1) for we know that wave (4) cannot enter the price territory of wave (1). Thereby protecting the profits earned.
From my experience, the wave principle can genuinely help you see how the market may be positioned within the overall pattern.
Elliott wave Theory will help you spot these big opportunity turning points before they happen!
And on top of that:
If the model is applied correctly it can increase the predictive confidence in the direction of future price moves to 80% and more.
All the while providing the practitioner with clear levels where the interpretation is incorrect.
Trading is hard work, no matter what methods you use.
Trading is intellectually challenging and emotionally draining. You will lose at this game more times than you will win. Every penny you earn will be hard earned, and every penny you lose will be easily lost, applying elliott wave theory to you analysis will help you to improve the odd's!!
Trading is not that easy, but then again nothing worthwhile is, so don’t give up easily!