The trading training lessons that you can read are not based only on analysis of the use of indicators. As we taught a week ago, they are also based on methodologies that study patterns of price behavior or market cycles, such as the Wyckoff theory. Let's continue the lessons on trading training by talking about the theory of Elliot Waves and the benefits they can bring us for our analyses.
What is the Elliot Wave theory?
This theory is actually one of the simplest that we are going to learn in our trading training, since it has no degree of complexity. In the 1920s, an investor named Ralph Nelson Elliot He realized that markets traded in repetitive cycles, rather than unpredictably. This could be determined thanks to the mass psychology of the markets. Investors who are part of these markets share the same anxieties and hopes, which is why markets normally move due to the herd effect. This theory is based on the fact that the rises and falls of mass sentiment always repeat the same patterns of behavior. These upward and downward oscillations are known as “waves”.
Elliot waves can be bullish or bearish. Source: Novatos Trading Club.
How do Elliot waves work?
Elliot waves are made up of two sections, an impulsive one followed by a corrective one. The impulsive section is formed with 5 waves, compared to the 3 waves of the corrective section. We are going to see in depth how the waves of each section are formed.
Impulsive stretch
The first wave makes an upward movement. We will delimit it later, when it makes a correction greater than 50%. In this wave we have to apply what we learned in trading training on chart figures. The first wave will be in the break of a guideline, and the second in a trend change figure. Next, the second wave is the correction of the first movement, approximately at a minimum of 61.8% and a maximum of 76.4% with respect to the maximum point of the first wave. The third wave is then confirmed by surpassing the high level marked in wave 1, rising approximately 61,8% from the high of wave 2. It is usually the strongest of the 3 impulsive waves (waves 1, 3 and 5), therefore the largest. She will never be the least impulsive of the three. Afterwards, the fourth wave is defined as the 38% retracement from wave 3, which can never be less than the maximum of the first wave. Finally, the impulsive section concludes by surpassing the third wave, with a projection of 61,8% from the maximum of the third wave. This wave is characterized by significant volume growth, which is not accompanied by a rise in prices.
Guidelines to correctly define the impulsive section of Elliot waves.
Corrective section
The corrective leg of Elliot waves is a little more difficult to identify but not impossible. They usually form on breaks of bullish trends. The first wave of a corrective leg (A) is defined with a retracement from the fifth wave, above the fourth wave. Normally it can reach the maximum of the third wave. When this first corrective wave forms, volatility and volume increase. Next we see a correction from the first corrective wave, between 50 and 75% from the first corrective wave. This wave is the second corrective wave (B). Finally, we can observe a path of between 50 and 61% from the second corrective wave. With this movement the third and final corrective wave (C) is formed.
We can categorize Elliot waves between impulsive and corrective.
How do we identify Elliot waves on a graph?
Elliot waves, as we mentioned at the beginning of this trading training, is a theory based on the observation of price behavior patterns. But they do not assure us with certainty that these wave formations follow at the same rate the impulsive or corrective cycles typical of Elliot waves. We can support ourselves by drawing a bullish/bearish trend to determine if the waves are respecting the rules to form the wave legs. At the same time, we can rely on other indicators such as volume or RSI to analyze if they really respect Elliot's theory.
The automatic Elliot wave indicator directly defines the path of the waves. Source: Tradingview.
If you find that the task of identifying Elliot waves is difficult, you can use the automatic Elliot waves indicator in Tradingview to automatically identify Elliot waves. As we see in the chart above, the Elliot wave cycles have been respected and the price has later gone downwards. Thanks to Elliot waves, we could have determined the beginning of this bear market in the cryptocurrency.
Conclusions from this trading training
After having reviewed this old but wonderful theory about the cycles of price impulses and corrections, we want to remember that these theories can be invalidated in times of extreme volatility in a market. In our analyzes they can provide us with a confirmation signal of a possible trend reversal. Of course, they do not assure us with certainty that said reversal will be fulfilled. We recommend combining what you have learned in this trading training with other indicators or theories that we have previously related in order to be able to operate with the greatest possible precision.