Elliot waves theory was proposed by the accountant and business expert Ralph Nelson Elliott in his study entitled “The Wave Principle” published in 1938, and it can be applied to any type of financial assets, commodities, stocks, oil, gold and others.
Elliott began monitoring the stock market in the hope of understanding price behavior, as a result he pointed out that the market, being the outcome of psychological beliefs of market participants, it follows certain laws.
Elliott waves theory is mainly based on the periodic laws in psychology concerned with human behavior and it is among the most important theories used in Managed Forex Accounts, Forex Trading Signals, and it is among subjects discussed in the Training Course. This theory states that prices are either rising or falling, and these two cases represent the only phases of prices according to Elliott theory. According to Elliott, the behavior of prices in the market can clearly be observed as shown in figure 1 below. Elliott proposed the division of waves into 5 surges waves where prices move very actively and causes the continuation of the trend ascending or descending like waves 1, 3, 5 and А, С in figure 1 below, and corrections, which are characterized by the price movement in the opposite direction, like waves 2, 4 and В in same drawing
Elliott based this theory on the principle of the division of the waves, in the sense that each wave is part of the longest wave, and is at the same time several smaller divided waves. Usually, each wave is divided into 3 or 5 waves but this is not always the case. The division period depends on the length of the trend.
The main principle in the Elliott waves theory is that all price moves are composed of five main waves, and three corrective waves, which can be seen in figure 2. Each of these main or corrective waves can consist of smaller waves like for example, wave 3, which is composed of 5 shorter wavelengths and it is what creates the impulse wave in opposite direction. The longest cycle, according to Elliott, called PAL Super-cycle, and is composed of 8 Super-cycle waves, which in turn consists of eight sessions, which are composed of several other waves. In this way an analyst can easily identify the main and corrective waves and their relativity; whenever the drive of the price movement is stronger, the corrective movement is stronger too, and vice versa.
Elliott wave theory was criticized because it lacks a clear definition of the beginning and the last wave. It is worth mentioning here that the identification of correction waves in this context may be easier using the Fibonacci numbers theory.
Fibonacci series provides a computational basis for the Elliott waves’ theory, and play an important role in building a full market cycle as described in it. Each session of the Elliott courses consists of the total wavelengths that fall within the Fibonacci numerical sequence. Usually using Fibonacci in the Elliott waves theory is as follows: movement in a certain direction should continue until it reaches the stage of compatibility with the Fibonacci numerical sequence and then reverses its direction.
For example, if prices did not change direction at the first level of Fibonacci, this change should not occur until the second level is reached. Similarly, should the trend continue for up to the forth level of Fibonacci days if the trend has not changed on the third level of Fibonacci, and so on. This is the basic pattern of the trend movements whatever time frame is used, daily, weekly, monthly or otherwise, and in general, the wave’s length will equal one of Fibonacci’s values at 0.382, 0.50, 0.618, or 1.618 of the length of the main wave. Using these wave rules, it is possible to calculate the lengths and to a certain extent the timing of the waves
It should be noted here that this is only the “ideal model” theory, which does not exist. In reality, one can not predict the behavior of prices that accurately every time. In fact, Elliott noted that deviations can occur in all waves and that real market individual waves barely evolve in the same normal form as thought of Elliott’s waves. The classical relationship between waves listed above correspond to an error rate equals to 10%, which could be considered as short-term effects of news or technical factors.
The properties of the waves
Price waves in this theory are similar to a road map. Each wave has a set of characteristics that are based on the behavior of the market participants, and when used with other tools related to the behavior of Elliott waves they can help in determining the beginning and last wave along the approximate length on each wave
The relationship between the waves
Lengths for these waves are measured from top to bottom as a percentage of the main wave.
Calculation of the wave |
Wave |
It’s the wavelength that will be calculated upon |
1 |
0.382, 0.5 or 0.618 of the length of the first wave |
2 |
0.618, 1.618 or 2.618 of the length of the first wave |
3 |
0.382 or 0.5 of the length of the first wave |
4 |
0.382, 0.5 or 0.618 of the length of the first wave |
5 |
0.5, 0.618 or one of the length of the fifth wave |
A |
0.5 or 0.382 of the length of wave A |
B |
0.5, 0.618 or 1.618 the length of wave A |
C |
The characteristics of each wave are as follows:
- Wave 1: As a general rule, this wave represents a strong change in direction or a break out of major support or resistance levels.
- Wave 2: and when prices are moving rapidly away from the level achieved with great difficulty in the first wave. Prices could fall to almost 100% of the first wave movement, but without penetrating the beginning level. Usually this wave form correction of 60% from the first wave with a relative stability in prices.
- Wave 3: This is the most important wave for followers of Elliott waves. Before the beginning of the wave, it will be noticed that growing optimism about the continuity of the current trend (the first wave) and price stability when testing this trend’s support or resistance levels. Prices start to move with the increase in the trading volume for the longer shaped Elliott waves, and is usually equal to 1.618 of the first wave’s move.
- Wave 4: It is the most difficult to identify because they are usually equal to 38% of the third wave and the depth and length of this wave is relatively small. The fourth wave should not exceed the second wave.
- Wave 5: Usually this wave is determined by using the momentum indicator, as prices are still in the same direction and the trading volume declining to a disproportionate level with the level of prices. Usually it reflects the price trend is strong at the end of this wave.
- Wave A: It is in the opposite direction of the main wave, and it fully reflects the wave correction in the opposite direction. It is very similar to the first wave, but it will not penetrate the level achieved at the end of the fourth wave of the movement of the main wave.
- Wave B: Often resemble the fourth wave and is also very difficult to identify, but it will not penetrate the level at the end of the fifth main wave.
- Wave C: A strong corrective wave to convincing levels to follow the general trend or the beginning of a new direction. This wave is characterized by extreme caution when traders and is characterized by high momentum. Usually five mini-waves are formed in this wave to reach its extension to 1.618 times the third wave.