Having become one of the main tools for analyzing the market situation in the stock market, the Elliott Wave Theory has also become widespread among traders working in the foreign exchange market. The main reason for the high interest of forex traders in wave analysis was its fundamental principle, described by Ralph Elliott in his book The Wave Principle, published in 1938.
The essence of wave theory
Having left his job as a financier due to illness in the early thirties of the last century, Ralph Nelson Elliott paid special attention to the stock market, having achieved significant success, concluding contracts for the change in the value of the Dow Jones.
And first of all, he succeeded due to the fact that he identified one very important pattern: the cyclical repetition of events created by the “crowd”. As Elliott himself noted, those instruments that are least subject to the influence of fundamental facts emanating from a single center are susceptible to the manifestation of this cyclicality. That is, in his opinion, the trading of individual stocks was less suited to the application of the wave theory than the composite index.
Thus, we can see that decentralized cryptocurrency assets are the best fit to describe the type of assets that fall under the wave analysis. Ralph Elliott’s observations on how wave theory works in a decentralized market confirms its widespread use from 1971, when currencies were floated at the Bretton Woods Conference, to early 2009, when, for the first time since the abolition of the gold exchange standard, the exchange rate switched to manual management by central banks.
At the same time, traders in the stock market who work with numerous indices, such as: Dow Jones, S&P 500, NASDAQ, RTS and others, actively use wave analysis.
Introduction to wave analysis
The topic of wave analysis is quite extensive. To study it, entire faculties were created in the United States and Europe that study the cyclical behavior of the “crowd” in the financial markets. But we will try to convey the meaning and basic postulates of this type of market analysis within the framework of this article.
One of the basic rules of technical analysis that history repeats itself, most likely, was taken from the Elliott Wave Theory. Indeed, within the framework of the wave theory, protracted growth cycles are replaced by price fall cycles, forming waves. And for these cycles, Elliott identified a number of patterns that formed the basis of his view of the market.
Regularities of wave theories
- Momentum is an upward movement accompanied by a rise in the price in the analyzed time period.
- Correction is a downward movement accompanied by a fall in price in the analyzed time period.
- The higher the period, the stronger the trend – absolutely all textbooks on technical market analysis speak about this principle. It implies that if you observe a fall on the H1 timeframe and an increase on the D1 period, then the upward trend is more powerful than the downward trend.
- A trend tends to change – this means that sooner or later a moment comes when growth is imperceptibly replaced by a fall, and vice versa.
All these patterns can be clearly traced on the price chart by dividing it into wave movements.
Components of wave motion according to elliott’s theory
- Impulse waves – The standard wave movement, according to the theory, consists of five main waves and three reversal waves. So, it is customary to consider waves 1, 3 and 5 as impulsive waves, which are the forming force of the trend.
- Corrective Waves – Waves 2 and 4 are waves of a downtrend that trigger corrections in the market.
- Reversal waves – according to the theory, they are marked with the letters A, B, C. These waves appear on the chart as a result of the complete formation of the main 5-wave movement, which is considered complete and, as a rule, precede a trend reversal.
At the same time, according to the theory, the waves on the chart are not built in a chaotic manner, but are formed according to strictly defined rules.
Rules for formation of elliott waves
- Waves move from level to level.
- Waves in a longer time period absorb waves of shorter periods.
- The first wave is not suitable for opening deals.
- The second wave is no more than 50% of the length of the first wave.
- The third wave is the best time to enter the market.
- The length of the third wave is one and a half times the length of the first.
- The fourth wave cannot go below the top of the first wave.
- The fifth wave indicates the end of the trend.