The talk of the markets this week has been heavily focused on crude oil prices that had fallen under zero. You might wonder how something can have a negative price, but as expected it means literally nothing else than that the producer would even pay for you to take it because storing it is too expensive. The shock of seeing one of the most important assets of our century (everything that is produced somehow needs oil, right) trade below zero had a deep impact on investor’s psyche and consequently on other leading indices like the S&P or the Dow Jones. All of them experienced a drop.
Some have tied this movement in the traditional markets to a price drop in cryptocurrency markets while some say those two were not that related. Whichever stance you take, one thing is for sure: investors’ psychology has a huge impact on the prices — sometimes it could even be all that matters.
And while markets seem to behave in random patterns, certain trends repeat over and over again. Ralph Nelson Elliot recognized these trends and deduced that these are triggered by either investor’s psychology or by outside influences. Whenever these trends happen, they would show up in waves on the price charts according to Elliot.
And the Elliot -Wave Theory was born.
Once Elliot identified the fractal nature of stock markets, he realized that prices move similarly to fractals in nature with patterns indefinitely repeating themselves at an ever-smaller scale. He then went on to identify these patterns and to use them to predict trends, which in return could help improve trading decisions.
Elliot differentiated between two types of waves:
- Impuls waves: waves that are travelling in the direction of an overall trend
- Corrective waves: waves that travel in the opposite direction to the overall trend
Each impulse wave consists of 5 smaller waves that follow a certain pattern again. And within these waves, the wave pattern continues to repeat on a smaller scale.
As old trading wisdom goes “What goes up must come down again”, hence after the impulse wave we usually see a corrective wave consisting of 3 distinct price movements.
It’s worth noticing that waves don’t always travel net upwards or downwards but in accordance with the overall trend. If the overall trend is decreasing prices, then the impulse wave will travel in the downward direction as well with the corrective wave moving in the opposite direction.
Overall, Elliot has defined 9 degrees of waves from largest to smallest:
- Grand supercycle: multi-century
- Supercycle: multi-decade (about 40 to 70 years)
- Cycle: one year to several years
- Primary: a few months to a couple of years
- Intermediate: weeks to months
- Minor: weeks
- Minute: days
- Minuette: hours
- Sub-minuette: minutes
Theoretically, you could spin this even further since all these patterns repeat themselves again and again -but we’d then never finish.
More importantly though is, how you can use these waves for your trading decisions. According to a tutorial from the institute that is now most famously applying the Elliot Wave Theory, the EWI “At any time, the market may be identified as being somewhere in the basic five-wave pattern at the largest degree of a trend”. When you can identify where in a wave the price is currently moving, it can support your decisions on when to enter a long position and when to sell or short an asset. Elliot has defined 3 rules that can help you identify waves in a price chart.
- Wave 2 can never fully eliminate the price increase of wave 1
- Wave 3 can’t be the shortest by price compared with 1 and 5 and often represents the strongest market movement
- Wave 4 doesn’t interfere with the price territory of wave 1.
On top of that, most trend changes happen at either major support or resistance levels, therefore it makes sense to start counting at a major resistance or support level. At the end of the day, Elliot Wave principle adds more clarity to the science of trend recognition but is also not the always right indicator. Used in conjunction with the Fibonacci retracement to identify the end of corrective waves and other indicators like volume the Elliot Wave Principle is a useful tool for any trader.
To draw in the Elliot Impuls or corrective wave, simply go to the left of the price chart and click on the icon below the “T”. Going down the different indicators, you’ll soon find the Elliot-Wave Impuls wave and others. Happy identifying waves 🌊
