The Elliott Wave Principle: Timing Forex Market Movements – Elliott Wave Theory (EWT) developed by Ralph Nelson, is a technical analysis approach also popularly known as the Elliot Wave Principle (EWP). He believed that everything moves in waves, including price charts. And he developed his theory in 1930.
Ralph Nelson developed this theory by studying the Dow Jones Index (DJI). It is probably incorrect to say that Elliott Wave Theory (EWT) is an evolved version of Dow Theory because there are too many similarities.
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Since his death, the EWP has evolved. Since then, many professionals have provided this theory, making it one of the most popular techniques.
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I don’t think we need to memorize the names of these developers or study their biographies. So I will not explain who they are.
Mr. Elliott stated that the market price is moving like waves. And these waves are structures, also known as chart patterns, and the timeframes of these waves are different (will be explained).
If the price of a financial asset moves up or down in waves, the main wave (the biggest wave) that moves with direction should have at least five smaller waves. And waves (larger degree waves) that move against the direction should have at least three smaller waves.
Each wave has many smaller waves in it. For example, a wave that appears on the daily chart has many smaller waves on the hourly chart, 5-minute chart, etc. The principle is the same for all timelines.
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A price movement starts with a five-wave pattern. This five wave pattern consists of three directional waves and two counter or consolidating waves.
In bullish trends, waves 1, 3, and 5 are moving in the main direction. On the other hand, wave 2 and 4 go against the direction, or we can say that they correct the market price.
A five wave pattern is actually just one wave in a larger time frame. For example, a five wave pattern in the hourly chart may only be one wave pattern in the daily chart. (You read about wave degrees later)
And each wave in a five-wave pattern is made up of many smaller waves in shorter time frames (degrees). For example, wave 2 consists of a three-wave pattern (A, B, and C waves).
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The three-wave pattern developed against the main direction acts as an interruption. Analysts mark them with letters. (A, B, and C).
Each three-wave pattern is a single correction wave in a larger time frame. And several smaller peaks and corrections exist inside a wave interruption to a greater degree. (You read about wave degrees later)
For example, the three-wave pattern in the daily chart is just one corrective wave in the weekly chart, and many waves in the hourly chart, 4-hour chart, 15-minute chart, etc.
You can name it however you want. Name what you like. To understand more easily and not to be confused, it is better to label a degree always the same.
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Many determinants affect the price of a financial asset, such as financial reports, news, a rumor, and even a tweet by a public figure.
A price determinant creates hope and fear, which spreads among investors and traders, moving the price up or down.
Some of the determinants have a large impact, which is the reason behind large waves, while others may have a small influence that causes smaller waves to form.
An investor will never know all the determinants that influence market prices. That is why we need to learn technical analysis. If someone understands every price determinant, he will make billions of millions in months.
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Although we do not know all factors, behavioral theory explains the formation of waves. So it will be useful to consider these characteristics as waves develop.
Each of the five-wave that is one wave to a greater degree, I will elaborate one by one. I will start from the first wave of the five wave optimism.
At the beginning of wave (1), the news is mostly bad, basically not looking good, and the economic indicators do not show satisfactory movement.
Because wave (1) starts during a downside, some investors believe that wave (1) is a correction pattern in the downside. So the volume increases subtly (not much) and moves upwards a little more slowly.
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Because wave (1) begins during disbelief, wave (2) retraces (pulls back) significantly but does not extend beyond the beginning of wave (1).
During wave (2), news and fundamentals are still unfavorable. Generally, wave (2) takes a long time to finish, accompanied by low volume and volatility.
During the development of wave (3), high volume, gaps in the stock market occur frequently, the fundamentals become compelling, and investors’ confidence increases.
In wave 4, probably further growth has ended. Generally, wave 4 has a low slope or goes sideways as the confidence created in wave (3) is still there.
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In wave (5), the news is still positive, and investors are confident. The volume in this phase is lower than wave (3).
Usually, but not always, wave (5) has a smaller slope compared to wave (3) because some investors take profits and unpleasant news slowly emerges.
The three waves are often named alphabetically (A), (B), and (C). Waves (A) and (C) are impulses in the opposite of the main trend, and wave (B) is corrective.
Generally, during wave (A), investors believe that this reaction is just a pullback from the main trend. So the slope of the trend is relatively low. And some investors still buy.
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Wave (A) can have a five-wave structure or a three-wave structure. If it had five wave structures, it is more likely that the pattern is a zigzag (traditionally known as the ABCD pattern). On the other hand, if it was a three-wave structure, one of the triangle patterns is more likely.
Some stocks in the stock market do well, and some don’t. There is not enough momentum, and market width (the difference between winning stocks and losing stocks) is narrow.
Wave (C) mostly moves faster. Investors mostly believe that this wave is moving in the main direction. Volume and volatility are high.
So there are some conditions to be recognized as a motive wave. If one of these conditions is not met, the wave will be a corrective wave.
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A market can be an upside or downside. To illustrate, I explain the conditions of an optimistic market. After reading these terms, you understand they are in a bear market too.
I mention once again that if one of the above conditions is not met, it is not a motive wave, even if it has five waves.
Impulses are a structure of five waves that are attached to the main conditions of a motive wave plus these three conditions.
Truncation is a characteristic of an impulse wave where the 5th does not reach beyond the end of wave (3), although it has five waves. So it happens only in wave (5). Truncation is a sign of a sharp opposite trend.
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These waves conform to the conditions of impulse waves. However, diagonally, the end of wave (4) may overlap the end of wave (1).
Diagonals are different from triangles because diagonals are motifs in patterns and triangles are corrective patterns. In addition, in diagonals, both support and resistance tend to go up or down, while in a triangle, at least one of them goes sideways.
In traditional technical analysis, diagonals look like wedge patterns: Wedge Pattern: rising and falling, more examples.
The leading diagonal develops as a motive wave at the beginning of a new trend. It can appear as wave (1) wave five-wave motif in structure or as wave A in a corrective pattern.
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A leading diagonal can be convergent or divergent. Converging means that the structure becomes narrower as the pattern develops. It is like a corner model.
As the name implies, the end of the diagonal occurs as the 5th wave of five waves in the motive structure or wave (C) in the corrective structure.
Zigzags are the most common corrective pattern in Elliott Wave Theory. They appear as a three-wave pattern and are labeled with the letters (A), (B), and (C). Traditionally, a zigzag is known as an ABCD pattern.
In a zigzag pattern, wave (B) will never go beyond the beginning of wave (A), and wave (C) will go beyond the end of wave (A).
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In a zigzag, wave (A) is a five-wave pattern (also called impulse) in a structure that can be either an impulse or a leading diagonal pattern. Wave (B) functions as a corrective to the new direction, which consists of three waves. And finally, wave (C) is again a motive wave in a five-wave pattern that can be an impulse or a finished diagonal. A zigzag is also known as a 5-3-5s pattern.
Flats are corrective patterns that go sideways. They are three wave patterns and are named alphabetically (A), (B), and (C). Waves (A) and (B) are three-wave patterns, and wave (C) is a five-wave pattern. Flats are also known as a 3-3-5s wave pattern.
Unlike zigzag, in a flat structure, wave (A) cannot form a five-wave pattern. It is a three-wave pattern. Flat also does not retrace as much as zigzag does.
A regular flat structure looks like a dish. This means that the support and resistance lines in the pattern are parallel to each other.
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Traditionally, this model is known as a rectangle, and here is an article that explains
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