How to apply Elliott Waves in Forex

Good afternoon, fellow forex traders! Today, by your request, we’ll talk about Elliott Waves.

A long time ago in a distant America lived a man called Ralph Elliott. Analyzing the market on long winter evenings, he developed the concept of the fractal nature of the market. Several generations of traders have changed, but his theory still finds its application in the analysis of the market. It should be noted that the theory is exclusively trendy and absolutely not suitable for flats. It should also be noted that over the past 100 years, the market has changed very much, and Elliott’s theory no longer finds such strong confirmation as before, but it can still be used in the arsenal of every trader to this day. There are traders who have completely built their trading strategy based on the Waves.

Today, we will consider the basic postulates of the Wave Theory, on what they are based, and how to apply the theory in Forex trading.

Ralph Nelson Elliott

Overcoming the consequences of a serious illness, Elliott found a distraction in studying the behavior of the stock market. Concentrating on the study of charts of different time periods, he tried to find some universal principle in the behavior of prices, which would allow predicting the direction of the movement of market quotations with high accuracy.

By the end of the 1920s, a working version of the theory was ready - a 5-wave pattern describing most of what is happening on the market. Elliott noted that the psychology of the masses as a whole is uniform, and is a consequence of the reaction to external factors. Thus, the sequences of increasing and decreasing oscillations can be described by some repetitive pattern - a wave. At the same time, the discovery for the author was that the market itself has a fractal nature, the same pattern is repeated at different time intervals. That is, we can split the existing wave motion into smaller ones. In other words, each movement repeats itself, but on a different scale.

Wave Levels

In the classical theory, there are 9 wave levels. Such a markup helps to estimate the scale of the underlying trend movement. Waves of the highest level are usually marked with Roman numerals of the upper register, simple numbers denote waves of the middle level and Roman numerals of the lower register indicate waves of the lowest level. In real life, you probably will not need that many levels. Marking even more than 3 wave levels are already becoming difficult and not very suitable for trading.

Basic sequence

Waves are divided into two types: impulse and corrective ones. The main direction of the pattern is determined by the impulse waves, correctional ones are directed in the opposite direction. In this case, waves 1, 3 and 5 are impulse ones, since they determine the trend. Waves 2 and 4 are corrective. This five-wave sequence forms a higher-order impulse wave.

The correction figure consists of three waves, marked by A, B, and C. In this case, the main impulse is directed downwards, therefore waves A and C are impulse ones, and wave B is corrective. At a higher wave level, the sequence becomes a single correction wave.

By combining a 5-wave sequence with a 3-wave correction figure, we get a complete eight-wave cycle. That is, the complete cycle consists of two phases: impulse and corrective. Upon completion, the cycle begins again.

In the market, we always enter at the beginning of a new cycle, that is before the beginning of the formation of the first wave. In any case, we need to wait for the formation of at least one complete eight-wave sequence. Only after the trend was formed, and the corrective wave A-B-C began, you can start looking for a moment to enter. The wave sequence has the property to rebuild as it is being formed, so it is highly recommended not to enter until the completion of the first cycle.

It is very important to understand that Elliott’s sequence is essentially a fractal. That is, each wave is divided into smaller ones while maintaining a common structure - a continuous change of momentum and correction. Specifically, each pulse wave is divided into a 5-wave sequence, and each corrective wave is divided into 3 waves.

The corrective wave sequence in the classical theory of Elliott must correspond to three characteristics:

• Wave 2 in no case can go beyond wave 1. If this happens, the sequence must be recalculated in accordance with this rule;
• Wave 3 can never be the shortest of a sequence. As a rule, it is a wave with the strongest impulse. Also, wave 3, in any case, should exceed wave 1 level. In this case, waves 1 and 5 should be approximately equal in size;
• The intersection of wave 4 with wave 1 is excluded. If this condition is not met, a sequence recalculation is also required. The final cycle of A-B-C correction usually ends just in the region of the 4th wave.

Tools

So, to start, let’s see what kind of tools we really need. First of all, if you are a beginner, and still have problems with determining the extremes on the chart, the ZigZag indicator will be very useful. However, in most cases, it will only interfere, since the result of the indicator strongly depends on the input parameters. The same applies to any automatic Elliott Wave Marking tools. Therefore, personally, I would advise you to mark out the extremes on the chart manually.

You can use any preferred oscillator, for example, RSI, to confirm the input. Also, the ATR indicator will be required to calculate the stop loss. If desired, of course, you can use any other indicator of volatility.

In general, any candlestick or bar charts and simple graphical tools are sufficient for marking waves. Many have a fairly clean candlestick chart and some candlestick patterns. Do not forget that Elliott’s wave theory is, for the most part, a creative process, the author only indicates boundaries that should not be crossed.

Under these requirements, any version of Metatrader and the TradingView Service are suitable. In MetaTrader 5, for example, there is a special semi-automatic tool for marking the pulse and corrective Elliott wave. But, in general, the same result can be achieved with a conventional text label.

Examples on a Chart

So, we start the markup with a 5-wave sequence. For the starting point take the time of the reversal of the current trend. The main thing here is to observe the three basic rules for building Elliott waves, which we discussed earlier:

• The second wave cannot be below the minimum of the first wave;
• The third wave is almost always the longest of the sequence, but in no case can it be the shortest;
• The fourth wave does not cross the maximum of the first one.

Together with this, we get the first (impulse) wave of a higher level. This is important since the simultaneous marking of several wave levels strongly helps in determining the entry point. The safest entry point is after the completion of the full cycle, that is, after the completion of the correction wave formation, before forming the first wave. If we talk about waves of a higher order, marked on the chart in red, then you can enter the market after the second and fourth waves.

You can most easily determine the completion of the corrective wave by going down to the timeframe below. Correction movement along the structure is almost identical to the harmonic ABCD pattern, so when marking you can use the same construction rules.

The harmonic pattern is in most cases symmetrical and ends either at 127.2% or at 161.8% of the Fibonacci expansion. In this case, the correction turned out to be more stretched, so we stretch the grid from wave B, and wait for the price to reach 161.8%.

In this place, you can enter the purchase. The stop loss will be equal to the triple ATR value. Since a third wave is just starting to form on a higher wave level, the take-profit should be quite large. Alternatively, you can set the take-profit 3 times more from the stop. Also, we can use a trailing stop.

Thus, to determine the potential entry point, we need to first measure the distance to point 5 by stretching the corrective wave a-b grid. So we found out the level of correction necessary for us - 161.8%. The same principle works at any wave level.

Calculating the entry point is now a matter of technique - point C will be at a distance of 161.8% of the corrective wave A-B.

Of course, one of the most important stages is determining the right place to set a stop-loss. A fairly universal solution is the triple value of the ATR indicator. However, in most cases, we just need to find the point at which the current markup will lose its relevance. It is the point to put a stop-loss.

It is best to close the position in parts. In this case, having opened for purchase, we are waiting for the formation of the next corrective wave. Once we identify it, you can close half of the position. Even if the forecast is wrong, we will still get a good profit. For the rest of the position, set the trailing stop.

The self-similarity of the wave sequence allows us to make a fairly accurate forecast of the price movement, based only on the data of the lower time periods. Therefore, when marking, try to use at least two wave levels, for a better effect - 3.

To sharpen the marking skill, limit first to one wave level. It is convenient to train on the hourly chart. If you are going to trade in the real market, you need to switch to day time.

The main thing is to learn how to determine a continuous wave sequence on the chart, when the end of one complete cycle determines the beginning of a new one. First, we find the last major extremum. Roughly speaking, the maximum or minimum of the whole chart.

Then determine the first wave. To define it, simply find the first local maximum lower than the previous one. The third wave cannot be less than the first one. There must be a powerful directional movement. When the chart shows another maximum below the low of the second wave, a fourth wave is formed. After the fifth wave, we wait for correction of ABC, the formed correction simultaneously means the completion of wave 5.

Then, on the chart, one higher minimum and a higher maximum should be formed. Next, you need to stretch the Fibonacci grid from the wave b - 0% at the end of wave B and 100% at the beginning. We are waiting until the price reaches 161.8%. If desired, at this level, you can set a pending order for sale.

To set the stop-loss, we use the triple value of the current ATR (at the time of the Fibo grid installation). Set take-profit at 3 times bigger then stop-loss. Also, the position can be closed when the next corrective A-B-C wave appears. Thus, we trade a continuous cycle - enter the market at its beginning, and exit at the end.

Conclusion

Elliott Waves is a versatile and independent trading tool, that with the proper markup skill, allows you to get stunning results. Nevertheless, despite its age, the theory has not grown into a full-fledged trading system, and for the most part the result depends on the subjective perception of the trader. If you want to learn to understand the market better, Elliott Wave Theory will help you in training the skills necessary for this and can make up your main trading strategy.

Regards, Michael

ForexTraderPortal.com