Principles of Elliott Wave Analysis

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Elliott Wave theory is more than 70 years old but it is still used widely by the Forex traders. Successful application of the Elliott Wave (EW) principles is considered to be potentially profitable. The main problem is usually seen in the way to detect the correct wave count and to map the waves on the current chart.

Guest post by Andriy Moraru

EW principle is based on the collective social psychology of the market participants, which moves constantly between excess pessimism and reckless optimism. Such emotional traits result in certain patterns for the prices to move. These patterns were first described by Ralph Nelson Elliott.

The two main concepts of the Elliott Wave analysis are the dominant trend and the corrective trend. The former is bullish in a rising EW pattern and bearish in a declining EW pattern, vice versa is true for the latter. The dominant trend is created by 5 waves, while the corrective trend is formed by 3 waves.

The waves of the dominant trend are usually marked with the numbers from 1 to 5:

  1. The first wave (1) should be following a rather strong bearish trend. Volume may rise during this wave, but it shouldn’t be too different from the average level. Fundamental conditions should still point at the bearish trend.
  2. The second wave (2) is a retracement from the wave 1, but doesn’t go below its starting level; it usually stops near 0.618 Fibo level of the wave 1. On a closer look, wave 2 should consist of 3 smaller waves, forming a downtrend. Volume should be lower than in wave 1. Fundamental background is still rather weak.
  3. The third wave (3) is a continuation of a main bullish trend of the pattern. It can exceed 1.618 Fibo level plotted from the end of wave 1 and generally is the longest wave in the whole pattern. The volume grows considerably during this wave. Fundamental factors are usually still weak at the wave’s beginning and are improving as it unfolds.
  4. The fourth wave (4) is a second correction. It doesn’t go beyond 0.382 Fibo retracement of the wave 3.
  5. The fifth wave (5) is the final wave of the dominant trend. Volume is lower than during the wave 3. The fundamental factors are very good during this wave. It rarely exceeds the size of the wave 3.

The waves of the corrective trend are usually marked with the letters from A to C:

  1. The wave A may be rather tricky to detect. It is often marked with a rising volume after a declining volume of the wave 5. The fundamental background is usually still positive.
  2. The wave B pushes the rates up, giving a false hope that the main trend should be still alive. The volume is dropping compared to wave A. The wave B targets a level near the end of wave 3 of the dominant trend. Fundamental factors are now neutral.
  3. The wave C is the main part of the corrective trend. Its length is usually between 1 and 1.618 of the wave A. The volume is growing. Fundamentals show the worst signals.

If a trader knows which wave the market is currently trading in, they can predict the direction of the next wave with a high degree of probability, resulting in a potential profit. If you find it difficult to analyze the charts for the Elliott Wave patterns yourself, you can watch the daily Elliott Wave analysis videos provided by EarnForex.com.. Five currency pairs are reviewed in those videos in accordance with the EW principles every day: EUR/USD, GBP/USD, USD/CHF, AUD/USD and EUR/JPY.

Get the 5 most predictable currency pairs

About Author

Yohay Elam – Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I’ve accumulated. After taking a short course about forex. Like many forex traders, I’ve earned the significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I’ve worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.

5 Comments

  1. mark johnson on

    Quote,”2.The second wave (2) is a retracement from the wave 1, but doesn’t go below its starting level”

    How can a bull retrace from bearish wave #1 ever go below it’s own start level???

  2. Andriy Moraru on

    mark johnson,
    Of course, if it’s a bullish retrace from a bearish wave 1 then we are talking about not going above wave 1 starting level. But the wave descriptions in the post refer to the bullish EW pattern. Wave 1 is bullish, Wave 2 is bearish and shouldn’t go below the Wave 1 starting point.

  3. AndreYoung on

    Hi,
    Very good article Adrniy, but you have forgot to mention one important and most crucial thing, that there are variations to the waves, and they don’t always come in the 5 waves up 3 waves down format! this waves, if studied, are fractals, objects which have the same shape at different scales! knowing this can help a day trader, but also a trader which buys the main, long trend!

    • Andriy Moraru on

      Hmmm… I’ve always thought that the 3- and 5-wave EW structures are also fractals themselves.

  4. AndreYoung on

    they are indeed, no one said otherwise, i just said that there are variations from the classic 3-5 wave 🙂