Trading Academy

Lesson 36

Elliot Wave Analysis

Elliott Wave is a technical analysis technique published by Ralph Elliott, that claims that the markets move in repetitive cycles. According to this theory, the cycles are a reflection of the emotions of the investors caused by outside influences or the predominant psychology of the masses at a certain time.

The basic mechanism of Elliott waves is the following: within a bull or a bear trend, the market will develop sequences of 5 waves; three in the direction of the larger trend and two in a counter-trend direction. Waves 1,3 and 5 are called impulse waves, while waves 2 and 4 are corrective waves.

When a five-wave sequence has ended, it must be followed by a three-wave sequence of opposite movement, totaling eight waves and completing what is known as a “cycle”.

If this process continues, smaller waves become the components of their larger counterpart. If it reverses, larger patterns continually subdivide into lesser degrees. Therefore, all waves are both components of a larger pattern and are themselves a larger pattern that contains smaller component waves. This characteristic of the waves is called fractalization, which brings us to the definition of fractals: 

Fractals are structures that can be split into parts, each of which is a very similar copy of the whole. Let’s see a basic representation of the Elliott Waves and the psychology involved in it.

Wave 1 – is rarely obvious at its inception. Market psychology is predominantly bearish. The price move upwards is pretty insignificant.

Wave 2 – market rolls back (sometimes almost 100%, but not below its starting level) as investors take profits. 

Wave 3 – it is usually the largest and most powerful wave. Price rises quickly, and corrections are very shallow. By now, the price action has caught the attention of the mass public, and everybody wants to join. 

Wave 4 – marks a new round of profit-taking, as investors consider the price overbought. A lot of other investors are still bullish and can’t wait to “buy the dip”.

Wave 5 – this is the final leg in the direction of the dominant trend. At this point, a lot of average investors join the crowd, right before the top.  Contrarians start setting up a short position in what is now considered an overpriced context.

This structure serves as a guideline – markets will never move in textbook perfect fashion. But with enough patience and practice, anyone can identify and capitalize upon the Elliott Wave analysis.

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