The underlying theory behind the Elliott wave principle is based around how price moves, which typically is not in a straight line, but in a series of waves. A great analogy would be one that compares an ocean tide coming in as the water rises, and flowing out as the water recedes into the sand below.
Within any financial market (including cryptocurrency), every action creates an equal and opposite reaction. When price movement moves up, a contrary downward movement must follow.
Price action within any financial marketplace is often divided into trends and corrections (sideways movement). Upward or downward price action will showcase the direction of a trend, while corrections will always move against the trend. These repeating patterns have been shown to occur within all financial marketplaces since the dawn of time.
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A man by the name of Ralph Nelson Elliott, first discovered these repeating patterns, known as impulsive and corrective waves. He noticed that these impulsive waves, which always coincide with the main trend, tend to respond in 5 waves.
Even on a smaller scale, each of these impulsive waves can be found and continue to repeat themselves inside the larger Elliott wave patterns. These “waves within waves” are labeled as “wave degrees” within the Elliott Wave Principle.
We’ll cover more about wave degrees below, but first a quick history lesson….
The History Behind the Elliot Wave Principle
Ralph Nelson Elliott developed the Elliott Wave Theory back in the late 1920s. Elliott proved that the stock market does not behave in a chaotic manner but more so in a repetitive cycle. He proposed that these market cycles were the result of investor reactions to outside influences and the predominant psychology of the masses.
His studies concluded that the upward and downward waves of these mass psychological signals continued to show up in the same repetitive patterns throughout time. His theory is also based on the Dow Theory that also states that stock prices move in waves.
Elliot also noticed that the market tends to behave in a “fractal” like nature. Fractals are mathematical structures that tend to repeat themselves infinitely, even on the smallest scale.
Enough of the history lesson. Let’s get to what you really want to know about…
How Exactly Do Elliot Waves Work?
Human social nature can be found within these repetitive patterns due to the predictive manner of human psychology in which the powers of greed, FOMO, and “weak hands” rule. You can call it another “self-fulfilling prophecy” all you want, however these patterns show up within all financial markets due to these reactive and basic human emotions.
As discussed above, Elliot waves come in 2 different phases: motive (the trend) and corrective phases. The motive phase forms 3 advancing waves of 1, 3, and 5. The counter waves (downward) are comprised of 2 and 4.
During the corrective phase, you’ll typically find 2 receding ways labeled A and C, with a counter wave (upward) labeled B.
This is best illustrated on the chart below…
The rules behind the motive waves are as follows:
Wave 2 never moves below the beginning of wave 1.
Wave 3 is never the shortest wave.
Wave 2 and 4 can sometimes alternate in form, for example, Wave 2 can show up as a zigzag wave while Wave 4 will be flat.
At least one of the waves (1, 3, or 5) will be much longer than the other two. Most of the time, the third wave is the longest of the three, but that is not always the case in crypto.
Rules for the corrective phase are as follows:
Wave B terminates at or below the start of Wave A
Wave C typically terminates below Wave A.
In the cryptocurrency market, corrective waves typically claim more than 60% of the all-time high price (top of 5th wave). Some would argue that the norm is 75 to 80% and 100 to 120% retracements can be found if correlated with bad news.
Ok, enough about rules. Just remember that if you get confusing results from your chart, it’s most likely that you’ve miscalculated and dismissed some of the rules mentioned above. Don’t worry though; you’ll most likely miscount these waves the first several times you try.
In order to combat this miscounting issue, here’s a trick I use to help spot these waves.
Go to the top bar where you can change the candlestick display on TradingView and choose the Heikin Ashi candlestick. This type of candlestick helps you better view red or green candles that correspond with a particular trend.
The Heikin Ashi displays the average pace of prices, which is great at identifying trending periods. This is what Elliott waves are all about. It will greatly reduce the confusion on whether candlestick patterns are showing bearish or bullish patterns. Trust me, these help immensely.
Tip: I use the Heikin Ashi for all my trades and not just recognizing Elliot Waves. It can be used all by itself without any indicators or charting patterns in order to spot various trends. Pairing charting patterns like Elliott waves with the Heikin Ashi will arm you with an extremely accurate and powerful predictive toolset.
As you can see from the image above, it’s much easier to count waves using the Heikin Ashi candlesticks over standard candlesticks.
Wave Degrees : The Waves Within Waves
Each wave of the 5 Wave Elliott Principle consists of one wave of a larger timeframe. Each wave can consist of much larger market cycles that last decades.
The degrees of each wave pattern have different names as labeled below.
Intermediate: weeks to months
Primary: several months to a few years
Cycle: one to several years
Supercycle: multiple decades (40-70 years)
Grand Supercycle: multiple centuries
What are the Best Entries and Exits?
The very best entry point would ideally be at the start of the first wave, however these can be hard to spot as they come after a period of consolidation (these can sometimes last days or weeks) or after a sudden dip.
Most traders who trade this pattern start at the bottom of the second or fourth wave. These are much easier to spot. Whatever you do, do not ever buy near the top of the third or fifth wave.
The best exits would be at the end of the third corrective wave, however these can be hard to time as well due to the fact that these final waves can retrace to 100% of the initial 5 Wave Elliott pattern.
For a safer exit position, look for a consolidation that breaks outside of the final corrective wave trend line.
The Elliott Wave Principle is another highly useful chart pattern that many veteran traders use to recognize the beginning and end of a trend.
Never buy into the news or hype alone. These systems are used to fool people into buying the tops or bottoms of the market, which is a sure-fire way of getting REKT.
Do your own research before buying and selling into the market. Know what phase the market is currently in (motive or correction) and make an informed buying decision utilizing the Elliot Wave Principle.
For more “beginner friendly” trading tutorials, visit our trading section, located here.
As always, if you have any questions, please comment below.
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