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Ever since the creation of stock exchanges, there has been an irrepressible desire among market participants to discover stock exchange laws for price forecasting. As always, it is the quest for the holy grail to get rich. With the Elliott Wave Theory there is unfortunately no Grail, but at least a “shot glass” of it. The inventor’s name was Ralph Nelsen Elliott, and he revolutionized course analysis with his wave counting.
Elliott Theory: Too much perfection?
Every course movement can be explained by Elliott waves. It is apparently perfect as an instrument of stock market analysis. However, because stock market prices have a random component, there is a contradiction, because there can be no “regularity” in the consequence. Thus, in most stock market situations, several valid wave counts arise. Even among the most zealous Elliottwavers there is no uniform opinion.
To help you appreciate this article, I would like to point out that I am not a strict adherent of the Elliott wave theory. Nevertheless I use the Elliott systematics under certain conditions. You could say that I pick the “raisins” to give myself an advantage.
The basics of the Elliott waves
Elliott waves are inseparable from the existence of cycles and Fibonacci relations. This means that everyone who works with Elliott waves believes in the recurring market movements through cycles. In addition, all Elliott Wave followers believe that Elliott waves fit into Fibonacci’s biological number series. For the followers of wave theory, it is the analytical tool par excellence.
All price movements are divided into 5-part impulse waves (black line) and 3-part correction waves (red line). Each individual wave (wave 1 in the upper picture) is further divided into smaller sub-waves. Elliottwaver speak thereby of “fractals”. This sounds complicated, but it is not. It is just a nesting of a pattern in another pattern. In picture 1, wave 1 is shown magnified again. In detail there is a 5-part impulse wave and a 3-part correction wave. It is the same basic pattern. Elliott waves can be divided into any number of small sub-waves. However, it does not make sense to continue this to infinity. Basically, Elliott waves should be counted in the personal time unit in which you are trading. Only in case of uncertainty a breakdown into smaller time units makes sense.
Small reading tip:
It would go beyond the scope of this article to write a full paper on Elliott wave analysis. If you want to deal with the topic in more detail, I recommend the book by Werner H. Heussinger “Elliott Wave Financial Market Analysis”. It is only a small book with about 170 pages. The advantages are the compact and complete presentation of the theory.
My own rules about Elliott-Wave
In order to benefit from the Elliott waves, basic assumptions are required:
- If all course waves can be divided into impulse waves and correction waves, then the goal must be to catch a 5-part wave and surf it until there is a clear end.
- A trend can only emerge if impulse waves drive the market to it. Consequently, there must be more impulse waves in the trend direction than vice versa. Therefore, a clear advantage arises if one positions oneself preferably in trend direction.
- In order to catch a pulse wave, one must concentrate on correction patterns. Because a correction pattern is always the precursor of the impulse wave.
- An Elliott wave pattern is only valid if it is clearly visible. There are many Elliottwavers worldwide with subjective perception. Only the clear Elliott patterns can have a powerful effect.
The practical approach to making a profit
If you think as a trader in wave structures, the goal must be to catch a 5-part impulse wave. However, the trader can only guess at this if he has previously analyzed the wave structure. Accordingly, the trader must concentrate on the correction waves. There are two correction patterns that would be particularly promising before a long trade. It is the flat and the triangle. The downward zigzag is the ideal pattern for a bear market. Every stock market crash in the past has been part of a zigzag pattern. This makes it clear that as a trader, you should rather not oppose a zigzag pattern.
The flatrack and the triangle are relatively easy to recognize. If one of these patterns occurs in an upward trend, then one can assume a strong long signal after completion of the patterns. The wave a and b consist of three parts. While the wave c has five parts. The triangle consists of five small waves. Each of these individual waves contains three parts.
Elliott waves and the complexity
The big problem of Elliott wave theory is the formation of complex correction patterns. This leads, for example, to the fact that after a long impulse wave and a subsequent flat, an upward movement does not necessarily have to follow. The transition can be another correction pattern. For example, an a-b-c correction pattern can consist of a flat + zigzag + triangle. Elliottwavers refer to such a pattern as “Double Three”. And there are several other complex patterns. I recommend not to deal with these complex patterns in trading practice. The stringing together of correction patterns is typical of long-running sideways markets. It takes time and energy to break down the complex patterns, and there is little to be gained from doing so. Experienced traders prefer to focus on other trading objects with simple wave patterns.
Concentration on the flat and the triangle
Flat and Triangle are easy to recognize. The two patterns also harmonize with the traditional chart technique. Therefore the patterns have a strong effect on all followers of technical analysis.
Grey-marked is a classic flat. It consists of the wave a (3-part), wave b (3-part) and wave C (5-part).
A good entry point for a long trade is to work with the channeling technique. For this purpose, a trend line is placed on the low points of wave a and wave c. The trend line above this is created as a parallel line. The support point is the high of wave b. The result is always a channel. As long as the price does not penetrate the upper trend line, the long signal is not yet complete.
Gray-marked is a bearish triangle. It is composed of 5 small sub-waves. With a triangle there is usually a subsequent dynamic movement. In this picture it is downwards in line with the trend.
The advantage of the Elliott waves
You can’t predict the future with Elliott waves. However, unlike most lagging indicators, Elliott waves are geared towards future price movements. One goal of wave counting should be to create different scenarios that allow you to react to the randomness of movements. In the examples above, there are good applications without having to go deeper into Elliott theory.