If you like to plan your trades, having a global overview of what’s going on in the market at any time is always a good idea. In order to get that overview, technical analysts usually go through Elliott Wave analysis. This is probably one of the most complex tools in technical analysis, so it can be difficult to understand initially, but once you master the technique, the benefits will far outweigh the risks. Anyway, at the end of this article, we will provide an example of its application so you can get the idea of how to use it.
Who Was Elliott?
First things first: who invented this technique? It wasn’t the main character of Mr. Robot but Ralph Nelson Elliott, an American accountant who worked in Central America in the 1920s. While he was there, Elliott contracted an intestinal disease so he had to abandon his professional career and, in order to distract his mind, he decided to study the behaviour of stock prices.
In 1934, Elliott discovered that price action displayed on charts, instead of behaving in a somewhat chaotic manner, actually had an intrinsic narrative attached. Elliott saw the same patterns formed in repetitive cycles. These cycles were reflecting the predominant emotions of investors and traders in upward and downward swings. These movements were divided into what he called “waves”.
According to his observations, a trending market moves in a five-three wave pattern, where the first five waves, labeled by numbers, move in the direction of the larger trend. Following the completion of the five waves in one direction, a larger corrective move takes place in three consecutive waves. Letters (a, b and c) are used instead of numbers to label this corrective pattern.
This is how a five wave motive and a corrective phase pattern look like.
The first, the third and the fifth waves are also called “impulse” waves. Wave 2 is a correction of wave 1 and wave 4 is a correction of wave 3, and the entire sequence of wave 1 to 5 is corrected by an a-b-c sequence.
The patterns identified by Elliott occur across multiple time frames. That means that a completed five wave sequence on a small-time frame, let’s say, a 15-minute chart, may represent just the first wave of a larger sequence unfolding on a 60-minute chart, and so forth. In a macro sense, each unfolding wave pattern is part of a bigger wave pattern unfolded in the higher chart.
Therefore, you can consider Elliott waves as some kind of Matryoshka doll set, where a sequence of waves completes one wave of a higher degree, that is, a wave belonging to the next higher tier of wave sequences. In particular, the movement from wave 1 to 5 completes either a wave 1, 3 or 5 of the higher degree, while the a-b-c sequence completes either a wave 2 or 4 of the higher degree. You can clearly see this behaviour in the following chart:
Probably after reading the above paragraphs, they have reminded you of a concept called fractals! That is,
Elliott implicitly defined what was a fractal almost 50 years before Mandelbrot even coined the name.
Identifying Elliott Waves
Now that we have some clear understanding of what Elliott waves are, our main goal will be to take advantage of them to trade cryptocurrencies and make money. As you can imagine, identifying and labelling correctly the waves it’s a difficult task: when looking at real charts, the waves aren’t shaped perfectly and sometimes it’s difficult to label them. Therefore, it requires a lot of practice to master this technique but, fortunately, Elliott left some rules to help us:
- Wave 2 will not retrace past the starting point of wave 1. In practical terms, this means that in an ascending move, the price after the completion of wave 2 cannot be lower than the starting price of wave 1.
- Another rule states that wave 3 is usually -but not always- the longest and never the shortest of the whole sequence, and it always completes beyond the peak of wave 1.
- As another basic rule, the theory also says that wave 4 cannot overlap the end of wave 1. This is the same as to say that wave 4 can never retrace more than 100% of wave 3.
In the following figure, you can find depicted the wave formations disallowed by the above rules:
Extensions, Diagonals and Expanding Triangles
Besides the above rules, there are more variations which make the Elliott wave theory a little bit trickier. We will cover here the most basic forms, but there are a lot of them that you can find in the excellent book Elliott Wave Principle: Key to Market Behaviour written by Frost and Prechter.
The first variation that will be covered here is called extensions. An extension is an elongated movement in the direction of the main trend which may appear in one of the impulse waves, that is, in waves 1, 3 or 5. An ideal example of an extension can be found in the following chart:
Another variation of impulse waves are diagonals, which consist of five waves and occur at the end of a strong trend, especially when wave 3 has moved extensively in a short time. Diagonal waves can also be found in wave c of the correcting sequence, indicating the termination of the movement on a higher degree.
This formation is usually a wedge-like pattern, formed by two converging lines, as we can see in the following example:
Note that each one of the last five waves consists of three minor waves and not five waves as the usual structure. In a diagonal, wave 4 can overlap wave 1 in contrast to the basic rule. In these patterns, wave 5 tends to overshoot (or undershoot) the border trendline.
Finally, we have the expanding triangle formation. In this case, wave 5 fails to exceed the peak of wave 3, producing what is called a “5th wave failure” (see the figure below). This kind of pattern is usually a sign that a bottom or a top is in place and that the market will reverse against the current trend.
How does the Elliott Wave Theory Work?
As has been seen plenty of times in the markets, the price of any asset inevitably moves up and down in a wave-like motion. The Elliott Wave Theory divides that price action into trends and corrections. An upward or downward price action showcases the direction of a trend, while corrections will always move against the trend.
The trend is called an impulse/motive wave, and the correction is called a corrective wave. The main pattern Elliott brought to our attention was that the impulse wave tends to respond in 5 waves, which means that the market progresses in the form of 5 repeating waves. This impulse moves in one direction, followed by a larger corrective move in three consecutive waves. It is essentially a 5-3 wave pattern.
On the chart, impulse waves are numbered from 1-5, and the three corrective waves are lettered A, B, and C. Three of the impulse waves (1, 3, and 5) affect the directional movement. For example, if your crypto asset is moving upwards, these three waves will help us go up as well. The other two waves (2 and 4) are counter-trend waves. So if the market is moving upwards, these will go downwards and retract the price a bit.
What makes identifying the waves difficult for new traders is that the Elliott Waves can actually be present on several different time frames. You may see a pattern on the one-hour chart that might fit into a larger version of the Elliott Wave on the one-day chart, for example. From a bird’s eye view, you’ll notice that each unfolding wave pattern is part of a bigger wave pattern unfolded in the higher chart.
To help you out, there are three critical rules that apply here.
- Wave 2 never moves beyond the start of wave 1.
Remember that wave 1 is actionary, while wave 2 is reactionary. This means that the move upward is never retraced.
- Wave 3 is never the shortest wave.
We have three waves that move with the trend (1,3, and 5). When measuring the length of these waves, wave 3 is never the shortest. It is, in fact, often the most powerful wave.
- Wave 4 never enters the price territory of wave 1.
Wave 4 is one of the reactionary waves, i.e. one that moves against the trend.
A common strategy you’re going to see with impulse waves, and something that you can use in your trades is that you have impulse wave 3 as the longest wave, and that impulse wave 5 will be the same length as wave 1.
For example, here’s an Elliot Wave analysis from 2019 for Bitcoin since its inception. In this analysis, the trader predicts prices upwards of $27,000 for Bitcoin by the end of 2020. For those trading Bitcoin, Bitcoin futures, or really any cryptocurrency derivatives, these analyses can be useful.
WHERE TO CONTACT US:
Website : WWW.CRYPTOTRADE1.COM
Twitter: https://twitter.com/cctrade11
Telegram : https://t.me/cctrade1
Facebook : www.facebook.com/cryptotrade1
Instagram : www.instagram.com/cryptotrade1/
YouTube : www.youtube.com/cryptotrade1
Email : info.cryptotrade1@gmail.com