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Elliott Waves theory is the result of one person, Ralph Elliott, that found that people's behavior, or human nature, is the cause for various patterns that appear in the underlying price of a security. In plain English, market psychology or crowd trading is best represented under the Elliott Waves theory.
The idea behind the theory is that market is traveling in sequences, or waves, or cycles, and these are all forming on different degrees. According to Elliott, these cycles are formed out of impulsive and corrective waves, as every impulsive move needs to be followed by a correction.
So far, everything looks simple and straightforward, but be careful as this is the danger behind Elliott Waves. While it is looking like a simple concept, is one of the most complex ones ever developed. To have an idea about this statement, imagine that an impulsive wave is a five-wave structure. In other words, if the market is advancing in a strong move, it should do that in five waves.
However, out of those five waves, two of them are corrective in nature. After the whole impulsive wave is completed, it should be corrected by a three-wave structure.
Therefore, a cycle is having three impulsive waves of a lower degree and minimum five corrective waves of different degrees! And this is just the beginning, as things will complicate even further we go into more details.
Any Elliott Waves analysis should start from a very simple question regarding the move intended to be analyzed. Is this an impulsive or a corrective wave?
This is the very basic differentiation Elliott made between different moves the market can make. Further, there are multiple types of impulsive and corrective waves, and every type offers an educated guess about the move that follows.
The power of Elliott Waves theory is just this: it allows to correctly identify future price action based on patterns that formed in the past. There is no other trading theory that allows for such a thing to be done, and now you understand why everyone is interested in understanding and trading with it.
An impulsive wave is a five-wave structure and is always labeled with numbers. That is, 1-2-3-4-5.
Out of these five waves, the 1st, 3rd and the 5th ones are impulsive on their own, while the 2nd and the 4th ones are corrective. The whole five-wave structure needs to respect all the rules of an impulsive move as defined by Elliott, while the same thing is valid for each of the 1st, 3rd, and 5th waves.
So powerful is this statement, that if the 3rd wave, for example, is not an impulsive move on its own (of a lower degree, of course, as being part of a different cycle), then the whole 1-2-3-4-5 pattern is not impulsive. If it’s not impulsive, it can only be corrective, as there is no other possibility.
One of the very basic rules of an impulsive move is calling for the 3rd wave to never be the shortest out of the impulsive waves of a lower degree. In other words, if you compare the length of the 3rd wave in an impulsive move with the ones of the 1st and the 5th wave respectively, the 3rd wave should not be the shortest. Never!
Another one calls for at least one wave to stand out of the crowd, or to be longest when compared with the other impulsive waves in the five-wave structure. Most of the times the 3rd wave is, but on the Forex market, there is also possible to see the 1st wave and 5th wave extensions.
The example above shows a so-called 3rd wave extension impulsive move (the 3rd wave is the longest, and this means it is the extended wave) as defined by Elliott. Keep in mind that out of these five waves, the 2nd and the 4th ones are corrective.
Corrections, or corrective waves, are either simple or complex one. Simple corrections are defined as being triangles, zigzags or flat patterns.
In an impulsive move, as stated above, corrective waves are the 2nd and the 4th waves. Again, simple or complex ones.
However, also the move that follows the whole impulsive wave is a corrective wave of the same degree like the impulsive wave is. And again, this correction, too, can be either simple or a complex one.
As it can be seen on the chart above the corrective waves of a lower degree are illustrated as being part of the impulsive wave on the left side, while the corrective wave of the same degree like the previous impulsive wave follows on the right side. Both corrections, of the same degree or lower, can be either simple (a zigzag, flat or triangle) or complex (combinations of the three possibilities, having minimum an intervening x-wave).
Things can be further explained and structured in a logical way but this is not the purpose of this article. The idea behind it is to show the very basic structure of an Elliott wave cycle, what makes it and what are the things to consider.
Trading with Elliott Waves is subject to a top/down analysis, as this is the only way to keep an eye on different cycles for different degrees as defined by Elliott. It means that any count must start from the biggest timeframe possible (monthly or even bigger charts), and slowly but surely come down to a timeframe that allows a trade to be taken.
It is not recommended to count waves lower than the hourly timeframe as they will sub-divide in so many different sub-cycles of a lower degree that it becomes virtually impossible to be able to keep pace will all price changes. Therefore, four-hour and hourly timeframes are the maximum subdivisions recommended.
Keep in mind that these are the very basic things to know about trading with Elliott Waves theory. While it may seem like a lot to consider, the rewards trading with this theory is far greater than the effort put in forecasting future prices.