Perhaps every trader heard the name of Ralph Nelson Elliott, the creator of the Elliott wave trading principle. He was a professional accountant, although I jokingly call him a “financial markets’ personal psychiatrist.” You might ask why? Because his trading theory forecasts market trends by identifying extremes in investor psychology (troughs and lows in prices –market’s outbursts and its tranquil contentment). The Elliott Wave principle states that collective investor psychology moves between optimism and pessimism. These changes of mood create patterns that can be traced in the price movements of markets.
According to Elliott, a complete “bullish” market cycle consists of a 5-wave advance and a 3-wave retracement. Waves 1,3 and 5 are impulses, waves 2 and 4 – rollbacks from the peaks in the uptrend. Corrective waves (2,4) can be divided into 3 smaller waves, whereas the impulses – into 5 waves.
Motive waves (impulses) always move in the same direction as the trend of one larger degree. Wave 2 retraces from the first wave peak, but never more than 100% of the length of the first wave. The same can be said about the 4th retracement wave (it never retraces more than 100% of wave 3). The third wave is always the longest and the most powerful in the market-movement cycle. As we already know the 4th wave is corrective; it can meander sideways for an extended period of time. It usually retraces less than 38.2% from the swing of the wave 3 (we can measure it with Fibo extension tool). It is a perfect place to buy (as it can be referred as a pullback from the peak of the third wave). Wave 5 is a final leg in the dominant uptrend. Its volume is lower than in wave 3. At this moment, many indicators can lag and give us false signals (the prices may reach a new high, but the indicators may not follow them).
This article will be the first in our tutorial on the Elliott Wave principle. In the subsequent articles, we will learn more about this trading theory and discover how to recognize the Elliott waves on the technical chart correctly.