Elliot Waves Indicator Explained, Including Theory, Rules And Analysis Of Waves

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Elliot Waves Explained

Elliott waves are a great tool for binary options traders because they allow deep insights into what drives the market while still keeping things simple.

Elliott Waves Definition

The Elliott wave theory is a technical analysis tool that can help you understand the movements in long trends and the relationships between different chart periods.

Let’s look at both advantages individually.

Elliott waves distinguish between two market phases:

  1. A motive phase, and
  2. A corrective phase.

During the motive phase, the market moves in the main direction of the trend. It is what pushes the trend forward.

  • In an uptrend, the motive phase points upwards.
  • In a downtrend, the motive phase points downwards.

During the corrective phase, the market moves against the main direction of the trend. The Elliott wave theory predicts that motive phase consists of three smaller sub-movements – three movements in trend direction, and two against it between those movements.

According to the Elliott wave theory, a motive phase during an uptrend would look like this:

  1. Upwards movement,
  2. Downwards movement,
  3. Upwards movement,
  4. Downwards movement,
  5. Upwards movement.

Corrective phases consist of three movements – two movements against trend direction, and one in trend direction.

In an uptrend, the corrective phase would look like this:

  1. Downwards movement,
  2. Upwards movement,
  3. Downwards movement.

Every motive phase is followed by a corrective phase which is followed by a motive phase, and so on until the trend ends. Downtrends follow the same rules as uptrends, just in reversed order.

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Elliot Wave Indicator:

Elliot Wave Rules

Every movement in an Elliott wave consists of a smaller trend.

  • Each upwards movement consists of a smaller uptrend.
  • Each downwards movement consists of a smaller downtrend.

These trends follow the same rules as the larger trends. They consist of a motive phase and a corrective phase, which consist of five and three movements, respectively, and each of these movements is made up of smaller trends.

Trading Elliot Wave Analysis

According to the Elliott wave theory, you can start from a daily chart and work your way down to shorter periods. The Elliott waves predict the direction of the shorter periods, when a movement ends, and when a new one starts. To find a trading opportunity for binary options, you have to work until you reach a period of minutes or one minute. Wait until the market has completed a motive phase or a corrective phase and then predict that it will now turn around. You can make this prediction with high/low options, or, especially when a motive phase is about to start, with one touch options or ladder options.

The strategy would like this:

  1. Start with a daily chart. Identify the main market direction, and whether the market is currently in a motive phase or a corrective phase.
  2. Identify whether the market is currently in an upwards or downwards movement. Then switch to a shorter time frame and find the trend that represents this movement.
  3. Repeat the process until you reach a time frame which you can trade with binary options.
  4. Wait for the current movement to end, and predict the next one.

This strategy is based solely on Elliott waves, which is risky.

Most traders either add other indicators to the strategy to find the perfect trading opportunity or add Elliott waves to the current strategy to improve their timing. Either way, Elliott waves are a simple-to-understand tool that can nonetheless allow deep insights into the market.

Ending Diagonal

Elliot waves can often throw up familiar patterns which keen observers have then gone on to specifically name. One important signal is the ‘ending diagonal’. The pattern is formed as a wedge shape when converging waves are annotated with lines. When found towards the end of a strong long term trend, this pattern signals a reversal. The pattern is a very effective indicator, and is popular among elliot wave users.

The Leading diagonal is a similar pattern, found earlier in the wave structure. This however, normally indicates continuation of the longer trend – rather than a reversal as with the ending diagonal.

Elliott Wave Theory

What Is Elliott Wave Theory?

The Elliott Wave Theory was developed by Ralph Nelson Elliott to describe price movements in financial markets, in which he observed and identified recurring, fractal wave patterns. Waves can be identified in stock price movements and in consumer behavior. Investors trying to profit from a market trend could be described as “riding a wave.” A large, strong movement by homeowners to replace their existing mortgages with new ones that have better terms is called a refinancing wave.

Elliott Wave Theory Basics

Origins of Elliott Wave Theory

The Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1930s. After being forced into retirement due to an illness, Elliott needed something to occupy his time and began studying 75 years worth of yearly, monthly, weekly, daily, and self-made hourly and 30-minute charts across various indexes.

The theory gained notoriety in 1935 when Elliott made an uncanny prediction of a stock market bottom and has since become a staple for thousands of portfolio managers, traders, and private investors.

R.N. Elliott described specific rules governing how to identify, predict and capitalize on these wave patterns. These books, articles, and letters are covered in “R.N. Elliott’s Masterworks,” published in 1994. Elliott Wave International is the largest independent financial analysis and market forecasting firm in the world whose market analysis and forecasting are based on Elliott’s model.

R.N. Elliott was careful to note that these patterns do not provide any kind of certainty about future price movement, but rather, serve in helping to order the probabilities for future market action. They can be used in conjunction with other forms of technical analysis, including technical indicators, to identify specific opportunities. Traders may have differing interpretations of a market’s Elliott Wave structure at a given time.

Key Takeaways

  • Elliott Wave Theory is a method of technical analysis that looks for redcurrant long-term price patterns related to persistent changes in investor sentiment and psychology.
  • The theory identifies waves identified as impulse waves that set up a pattern and corrective waves that oppose the larger trend.
  • Each set of waves is itself nested within a larger set of waves that adhere to the same impulse/corrective pattern, described as a fractal approach to investing.

How Elliott Waves Work

Some technical analysts try to profit from wave patterns in the stock market using the Elliott Wave Theory. This hypothesis says that stock price movements can be predicted because they move in repeating up-and-down patterns called waves that are created by investor psychology.

The theory identifies several different types of waves, including motive waves, impulse waves, and corrective waves. It is subjective, and not all traders interpret the theory the same way, or agree that it is a successful trading strategy. The whole idea of wave analysis itself does not equate to a regular blueprint formation, where you simply follow the instructions, unlike most other price formations. Wave analysis offers insights into trend dynamics and helps you understand price movements in a much deeper way.

The Elliott Wave principle consists of impulse and corrective waves at its core.

Impulse Waves

Impulse waves consist of five sub-waves that make net movement in the same direction as the trend of the next-largest degree. This pattern is the most common motive wave and the easiest to spot in a market. Like all motive waves, it consists of five sub-waves; three of them are also motive waves, and two are corrective waves. This is labeled as a 5-3-5-3-5 structure, which was shown above.

However, it has three rules that define its formation. These rules are unbreakable. If one of these rules is violated, then the structure is not an impulse wave and one would need to re-label the suspected impulse wave. The three rules are: wave two cannot retrace more than 100 percent of wave one; wave three can never be the shortest of waves one, three, and five.

Corrective Waves

Corrective waves (sometimes called Diagonal waves) consist of three, or a combination of three, sub-waves that make net movement in the direction opposite to the trend of the next-largest degree. Like all motive waves, its goal is to move the market in the direction of the trend.

Also, like all motive waves, it consists of five sub-waves. The difference is that the diagonal looks like either an expanding or contracting wedge. Also, the sub-waves of the diagonal may not have a count of five, depending on what type of diagonal is being observed. As with the motive wave, each sub-wave of the diagonal never fully retraces the previous sub-wave, and sub-wave three of the diagonal may not be the shortest wave.

These impulse and corrective waves are nested in a self-similar fractal to create larger patterns. For example, a one-year chart may be in the midst of a corrective wave, but a 30-day chart may show a developing impulse wave. A trader with this Elliott wave interpretation might thus have a long-term bearish outlook with a short-term bullish outlook.

Elliott recognized that the Fibonacci sequence denotes the number of waves in impulses and corrections. Wave relationships in price and time also commonly exhibit Fibonacci ratios, such as

38% and 62%. For example, a corrective wave may have a retrace of 38% of the preceding impulse.

Other analysts have developed indicators inspired by the Elliott Wave principle, including the Elliott Wave Oscillator, which is pictured in the image above. The oscillator provides a computerized method of predicting future price direction based on the difference between a five-period and 34-period moving average. Elliott Wave International’s artificial intelligence system, EWAVES, applies all Elliott wave rules and guidelines to data to generate automated Elliott wave analysis.

Introduction to Elliott Wave Theory

Ralph Nelson Elliott developed the Elliott Wave Theory in the 1930s. Elliott believed that stock markets, generally thought to behave in a somewhat random and chaotic manner, in fact, traded in repetitive patterns.   In this article, we’ll take a look at the history behind Elliott Wave Theory and how it is applied to trading.

Waves

Elliott proposed that trends in financial prices resulted from investors’ predominant psychology. He found that swings in mass psychology always showed up in the same recurring fractal patterns, or “waves,” in financial markets. 

Elliott’s theory somewhat resembles the Dow theory in that both recognize that stock prices move in waves.   Because Elliott additionally recognized the “fractal” nature of markets, however, he was able to break down and analyze them in much greater detail. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves.   Elliott discovered stock index price patterns were structured in the same way. He then began to look at how these repeating patterns could be used as predictive indicators of future market moves. 

Market Predictions Based on Wave Patterns

Elliott made detailed stock market predictions based on reliable characteristics he discovered in the wave patterns. An impulse wave, which net travels in the same direction as the larger trend, always shows five waves in its pattern. A corrective wave, on the other hand, net travels in the opposite direction of the main trend. On a smaller scale, within each of the impulsive waves, five waves can again be found. 

This next pattern repeats itself ad infinitum at ever-smaller scales. Elliott uncovered this fractal structure in financial markets in the 1930s, but only decades later would scientists recognize fractals and demonstrate them mathematically. 

In the financial markets, we know that “what goes up, must come down,” as a price movement up or down is always followed by a contrary movement. Price action is divided into trends and corrections. Trends show the main direction of prices, while corrections move against the trend.

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