In the 1920s, a person named Ralph Nelson Elliot published a book called The Wave Principle.
In this book, there is an analysis of the stock market for 75 years, combined with evidence to support his theory that markets move in repetitive cycles.
He called the swing up and down in price as "wave" and explained that these swings occur because of outside influences and investor psychology.
The Development History of Theory and Application of Elliott Wave Analysis
This analysis system is now known as the Elliott Wave, which was published in the title of the book "The Wave Principle". Broadly speaking, Elliott argues that markets are thought to behave chaotic or erratic, even though there are actually patterns in them. Furthermore, Elliott found that trading patterns on the market always move in a repetitive cycle.
Swing prices up and down are caused by a collection of collective psychology from traders and this swing is called 'Wave'. Interestingly, Elliott states that these waves will repeat themselves in repetitive patterns. From there, Elliott claims that Elliott Wave is able to help traders predict where the price will move in the future.
What Elliott put forward is no doubt made traders very interested.
It's as if it's very easy for traders to see the lowest price points to start pressing the buy button or the highest point where prices will most likely fall.
What Is Elliott Wave And How To Use It?
Before studying further, we must first know what "fractals" are. Fractals are also commonly used in the mathematical world to simulate natural geometric patterns. In short, fractals are structures, where each fraction of structure still represents the basic properties of the overall structure.
Elliott strongly emphasizes the role of fractals because he states that each Elliott wave can be divided into smaller waves.
Still confused with fractals? In the real world, fractals can be found in the structure of snow crystals. When enlarged with a microscope lens, small fractal fractions will appear forming a pattern similar to the overall crystal pattern (self-similar patterns).
Elliott states that the market moves in a trend consisting of wave patterns, or referred to as the 5-3 wave pattern. Where wave 5 (first phase) will be followed by wave 3 for the next phase
The meaning contained in each wave
Wave 1: Price makes an initial movement up. This is usually caused by a small number of people (for various reasons, whether real or figurative) feeling that prices are at the lowest, so this is the right time to buy. This causes prices to rise.
Wave 2: At this point, there are a lot of traders consider the price to be too high then act to take profit. As a result, the first profit taking makes correction occurred.
Wave 3: These waves are generally the longest and strongest trend. In this phase, fundamental news and technical trading signals have attracted many traders. As a result, prices will arise, usually, prices will rise higher than wave 1.
Wave 4: In this phase, some people take profits, and feel the price is nearing the peak. But there are some people who still feel that prices are still in an upward trend, so these waves tend to be still weak.
Wave 5: This is the phase where the price is too high to buy, and if the trend continues to keep rising prices is due to mere hysteria.
Note that the length of each wave is not always exactly the same as the comparison in the image, it can be longer or shorter, that's natural.
2. Elliott Wave Corrective ABC Pattern
Furthermore, Elliott explained that the wave pattern 5 (motif) above will be followed by wave 3, which is the ABC correction pattern. Look at the picture below:
Elliot stated in his theory that there are 21 corrective ABC patterns (as seen above), varying from simple to complex. You don't need to memorize it by heart, but it's important for you to understand three basic formations, namely: zigzag, flat, and triangle.
Zigzag Wave Formation
The zigzag formation is a formation that has a fairly steep price movement. This steep movement is usually against the dominant trend. Here are some of the traits that are often found in zigzag formations:
B waves usually have the shortest length compared to A and C.
The zigzag line occurs two or three times in a correction.
Flat Wave Formation
In this type of formation, the waves usually have the same length. Wave B will be in the opposite direction to wave A, while wave C will be in the opposite direction to wave B. They do not always have the same length, sometimes wave B can be longer than wave A.
Triangle Wave Formation
The triangle formation is a corrective pattern where the pattern is limited by two trend lines that approach each other or move away from each other.
The triangle formation is formed of 5 waves which move against the trend in sideways movements. These triangles can be decreased, ascending, expanding, or symmetrical.
REMEMBER: All of these waves also apply to a downward trend, you just turn it over. Elliot Wave Theory applies to bullish and bearish markets. The concept behind Elliot's Wave Theory is that you as a Forex player must have the ability to correctly identify waves. By building this very useful capability, you will be able to quickly see and recognize waves in the market and evaluate which market side you must trade, whether you have to open long or short positions.
Three Main Elliot Wave Theory Rules
When you analyze the market and try to label waves, there are 3 main rules that cannot be contested. If you label a wave incorrectly, the consequences can be very dangerous for you.
Main Rules Number 1: Wave 3 NEVER becomes the shortest impulse wave
Main Rules Number 2: Wave 2 NEVER passes the beginning of wave 1
Main Rules Number 3: Wave 4 NEVER intersects the same price area as wave 1
3 Wave Waves (Fractals)
As at the beginning of the discussion above, it is mentioned about fractals; the parts of the structure that is similar to the overall structure. This also applies to Elliott's wave theory. You will find the smallest 5-3 wave pattern in each wave as a whole. To make easy imagine, see the illustration of the image below:
From the picture above, there are 5-3 smaller wave patterns in waves 1, 3 and 5 and there are also smaller corrective wave patterns in waves 2, and 4. With the illustration example, we are easier to imagine the meaning of fractals. In conclusion, Elliott emphasizes that there are always waves smaller than each wave, and this pattern always repeats continuously.
Because of the fractal pattern, Elliot divides the wave scale from the largest to the smallest to:
Generally, traders only use two to three layers of fractals, for example, Intermediate, minor and minute at low timeframes to facilitate the process of reading trading signals. For example as in the example chart below:
The first picture shows 1 perfect cycle of the Elliott Wave, which is a pattern of 5-3 followed by an ABC correction pattern on the daily timeframe (D1). Next, in the second picture, fractals are clearly visible at smaller timeframes (H4):
How to Use Elliott Wave in Forex Trading?
3 easy steps to use Elliott Wave in forex trading. This can be used as a simple exercise that can be learned before you actually practice it in real trading.
Step 1: Identify Early and End Trends
To fulfill this first step, you must understand the structure of trends in forex, and when a trend ends and when a trend starts. Look at the following picture:
As can be seen in the picture, the rules:
If it is an uptrend, the price will cross the Higher High, then continue to move up.
If it is downtrend, the price will form Lower High, cross Higher Higher, then continue to decline.
Step 2: Start Calculating Elliott Wave Starting From Wave 1
The range between HL and the first HH is Wave 1 in an uptrend. While the range between HH and the first LH is Wave 1 in a downtrend. We can only confirm Wave 1, after the price forms Wave 2 with the rule:
In the uptrend, Wave 2 is unlikely to fall below the beginning of Wave 1. While in the downtrend, Wave 2 is unlikely to surge beyond the beginning of Wave 1.
Usually waves 2 and 4 will bounce at the 50% Fibonacci Retracement level.
If later you open a position, the initial position of wave 1 is a realistic value to use as a Stop Loss. Why? because if the price continues to move down, the identification of Wave 1 is wrong and our prediction is wrong.
Step 3: Trading Using the Elliott Wave Starting Wave 2
Wave 2 is a moment where you can start trading using Elliott Wave. Before that, drag a Fibonacci retracement from the highest level (High) or lowest (Low) on a chart.
Make sure that Wave 1 has been formed, Wave 2 has reached a certain Fibonacci Retracement level (such as Fibonacci 50%) or a Candlestick pattern that indicates a price reversal (eg Engulfing, Harami, Piercing Line, Shooting Star, Dark Cloud Cover, etc.). Open the position at that moment, as in the following picture:
If your prediction is right, then Wave 3 is a position where you can get the biggest profit, because it is usually the longest compared to the other five waves in the trading system using Elliott Wave.
However, after Wave 3 ends, you can still reap profits from Waves 4 and 5 after the formation is identified.