Principles of Elliott Wave Analysis

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.