Elliott Wave Theory and Harmonic Price Patterns – 1

Introduction to Elliott Wave Theory

Elliott Wave Theory was developed by Ralph Nelson Elliott — a professional accountant who went to work trying to figure out the stock market back in his time (1920s-1930s). He reviewed approximately 75 years’ worth of market data that was available to him at the time.

After all of that study, he came up with a theory that the market wasn’t nearly as chaotic as it appeared on the surface. He finally shared his thoughts on this when he was 66 years old. He explained that the upward and downward trends in markets had to do with the underlying emotions of the traders operating in those markets.

He proposed that those emotions often were influenced by factors that had nothing to do with the underlying value of the stocks that were being traded. He called the upward and downward movement of stocks “waves”, and he believed that if one could figure out what the trends were in those waves, one could trade them effectively and profit enormously.

What are Fractals in Elliot Wave Theory?

It is important to understand that fractals are a part of the Elliott Wave theory. This is because the Elliott Wave theory is so large that it is best broken into smaller parts that are all similar to the whole. In other words, the macro waves are made up of smaller iterations of Elliot waves like the below:

Breaking it down into easier-to-understand parts makes the theory much more digestible to many people who might otherwise get lost in the finer details of this theory.

Fortunately, it can be broken down like this, and there is room for people to better understand what they are getting with the Elliott Wave theory when they can view it in these smaller bite-sized portions. Overall, people love the concept because they love the idea that it is possible for them to make money on the market by predicting the tops and bottoms of the market. It takes time to study this theory and learn it completely, but it can prove quite effective for traders.

What are Impulse Waves?

Trending markets often move in what is known as a 5-3 wave pattern.

The 5 waves are known as impulse waves, and the 3 waves are known as corrective waves in Elliott Wave Theory.

Wave 1, 3, and 5 are the waves that you will anticipate are going to move along with the overall trend in that market.

Meanwhile, waves 2 and 4 are corrective and may move in the opposite direction from the market. Take a look at this chart to see how the different impulse waves may look on a given chart, according to Elliott Wave Theory:

Wave 1

The currency makes it move upward. This first wave is generated by a small number of traders who are true believers that the value of the pair ought to be higher than it is currently trading.

Wave 2

There are enough people who owned the pair before the first wave who want to jump ship and take some profits. Their profit-taking leads to the second wave and a small push downward.

Wave 3

This wave tends to be the strongest in the entire move. The public as a whole has seen the value to be had in the pair, and they all jump in at nearly the same time as the second wave is losing steam. This pushes the pair even higher than it was when the first wave lets up.

Wave 4

Traders once again take some profits off the table as they are simply excited and happy to have caught the big move in Wave 3. They are going to peel away some of the risks that they have taken so that they can live to trade again.

Wave 5

This is the part of the wave that is driven by FOMO or mass hysteria. Basically, everyone who didn’t catch the moves before is now looking for a way to get in on a movement that may not even have that much steam left in the tank at this point.

It can be very dangerous to try to get involved with a pair at this point, but that doesn’t stop some people from giving it a try anyway.

 Extended Impulse Waves

It is important to remember that one of waves 1, 3, and 5 should be extended. This is to say that one of these three waves will be longer than the others as more traders get involved.

It tends to be wave 3, but that is not always the case. Sometimes, the most extended and prolonged move is at the very end when people pile on as they try to catch the last remaining bit of a big move. Whatever the case, it is important to remember that one wave will be lengthier than the others.