Lesson 2: Introduction to Elliot Wave Theory

Technical analysis sounds like a lot. Well, it really is a lot. There are tons of indicators, patterns, and even theories that revolve around the technical market.  

Among the common theories used in technical analysis is the Elliot Wave Theory. By using this theory, Elliot Wave analysts predict the price movement of the currency pairs by looking at the repetitive patterns of five waves. 

These five patterns are mainly made through the psychology of traders, primarily emotions like greed and fear, and if you can correctly identify these, you can predict where the price will likely go next. 

Lesson Highlights

• Ralph Elliot’s Elliot Wave Theory suggested that market trends follow fractal movements. Essentially, it argues that market patterns are repetitive across different scales or timeframes.
• Elliot waves move in a 5-3 wave patterns, which are called Impulse Waves and Corrective Waves. The first five waves are impulse waves, while the following three are corrective waves.
• The Elliot Wave theory is mainly supported by trading psychology. It follows the notion that market sentiment causes these fractal or look-alike movements.

What is Elliot Wave Theory 

First, let's define the waves we're talking about here.  

If you look closely at the price chart, you can see a wave-looking pattern. That's the wave here, the upward and downward swings in the market.  

So, wave analysis? Is it the same with the Dow theory?  

Both theories look at the price movement in terms of waves. However, the difference between the two is that Elliot Wave found an interesting market phenomenon known as fractal movement.  

In Elliott Wave Theory, the idea of fractal movement suggests that the same patterns repeat at different scales or timeframes within the market.  

But what does this mean? 

This means that the pattern observed in a smaller timeframe could also be observed in a larger timeframe.  

For example, a five-wave pattern followed by a three-wave corrective pattern can be observed not only within a single trading day but also within longer timeframes spanning weeks, months, or even years.  

This fractal nature implies that the same Elliott Wave patterns can appear at various degrees of scale, from the smallest intraday movements to the largest historical trends. 

Still confused? Well, just keep in mind the general concept of the Elliot Wave; "There is a repetitive nature of market patterns across different scales or timeframes." 

Here are the main waves you need to know when using this theory in your market analysis.  

Impulse Waves and Corrective Waves 

In his theory, Ralph Elliot pointed out that a financial market (like forex) moves in a 5-3 wave pattern. He called these patterns or waves as; 

1. Impulse Waves: The starting 5 waves 
2. Corrective Waves: The following 3 waves 

Essentially, with 5 waves, the impulse wave is the easiest Elliot pattern to spot in the price chart. The 5 waves consist of two types of wave groups: 3 Motive and 2 Corrective waves.  

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Look at the chart pattern; that's what an impulse wave should always look like. Here are the rules:  

1. Wave 2 can't retrace more than the beginning of Wave 1 
2. Wave 3 cannot be the shortest wave of the three impulse waves, 1, 3, and 5 
3. Wave 4 does not overlap with the price territory of Wave 1 
4. Wave 5 needs to end with momentum divergence 

What are Fractals 

Look at shells, snowflakes, clouds, and a triangle filled with other triangles (just try to imagine it!) 

What have you noticed about their structure? Their parts kind of look like one another, right? Well, that is why we call them fractals.  

In its most basic form, fractal is a mathematical concept that points to a pattern that repeats itself at different scales or sizes. When you zoom in or out on a fractal, you'll see similar shapes or patterns that resemble the original structure. 

This property is called self-similarity, where each part of the fractal looks like a miniature version of the whole.  

In Elliot Wave theory, the wave patterns of the market are fractals. Like snowflakes, Elliot waves are divided into smaller, similar-looking waves.  

Trading Psychology and Elliot Wave Analysis 

According to Ralph Nelson Elliot, the market emotions triggered by outside factors (such as news releases) and the predominant market psychology cause the market to move in a repetitive cycle. 

With his theory, he mainly pointed out that the upward and downward swings caused by market sentiment always showed up in the same repetitive patterns. 

Once you get to analyze the market psychology, apply the theory, and identify the five wave cycles, you can enjoy having a reference about where the price will go (or not go) next.