Elliott wave theory developed by Bill Williams. Part 1.
Wave models. Wave properties. Signals of wave alternation. Combination of wave theory and indicators.
Dear friends! You are likely to remember that I mentioned Elliott waves in my previous article devoted to the Three Wise Men trading strategy based on Trading Chaos by Bill Williams. Today, I’m going to describe the wave theory in more detail and explain a new approach to the cryptocurrency market analysis that will help you increase your trading performance! Today, I will deal with Elliott wave theory, I will describe its major elements of an Elliott wave, its basic structure, and patterns. Next, I will give you practical examples to demonstrate how to apply this tool in cryptocurrency trading. Well, let’s get started!
Elliott Wave pattern
According to the Elliott Wave principle, every trend consists of particular basic elements (waves) that have a tendency to repeat. According to the movement mode, waves are grouped into two types:
- Impulse (motive) waves move the main trend
- Corrective waves move counter to the trend
In the Elliott Wave analysis, waves, which are elements of an impulse, are marked with numbers. The elements of corrections are marked with letters. Impulse and corrective waves form a basic pattern.
According to the Wave Principle of Ralph Nelson Elliott, there are five waves in any trend. After the fifth wave completes, the trend either reverses or corrects through three elements. Therefore, the wave model rise-fall contains eight waves in total. When the trend reverses, there form a couple of large impulse waves that consist of ten elements in total. Besides, waves can be contracted or expanded in time in separate parts of the chart, but their basic form doesn’t change.
The daily BTCUSD price chart displays a classical Elliott wave that consists of five waves of the main impulse, their tops are marked with numbers, and three corrective waves, whose tops are marked with letters. Wave 1 is corrected by wave 2, wave 3 is corrected by wave 4, and wave 5 is the peak of the bullish trend.
After the five-wave structure completes, it becomes one of the waves one degree higher. Differently put, it becomes one of the elements of a bigger wave. The movement from wave 1 to 5 form a greater wave 1, 3 or 5. Accordingly, the corrective sequence from A to C forms wave 2 or 4.
Characteristics of Elliott waves
In addition to the above-described rules, you need to know their characteristics to analyze the process of formation. This will facilitate the procedure and reduce the number of errors made.
The first wave always moves with the expected trend. To spot the inception of the wave, you can use almost any tools that identify the trend starting point. You can, for example, employ trading signals of Bill Williams’s Three Wise Men trading strategy described in the previous article, or you can refer to trading volume.
You can also use the MFI indicator as an additional tool. It monitors the current market situation, identifies the overbought and oversold zones, highs and lows that help to anticipate the trend reversal in advance. By default, the indicator analyzes a 14-bar period, the overbought and oversold zones are at levels 80 and 20 respectively. The MFI can provide the following signals:
Divergence (convergence) is when the price is moving in the opposite (the same) direction of the MFI lines. This trading signal suggests that the trend should soon reverse. I must note that divergence (convergence) can be observed for a long time. So, it should be treated as a validation of other reversal signals, rather than as a reversal signal on its own
In the above chart, divergence is marked with blue, and convergence – with green. The blue line in the price chart that connects two highs in the bullish trend is not accompanied by the high update of the indicator. The indicator doesn’t signal that the high has been broken through. The low is higher than the previous one. Therefore, two lines connecting the extreme price values are pointed at each other.
If the MFI line repeats the bullish price movements in the chart, it means that the money is still injected in the market and trading activity is high. In a bearish trend, when the indicator repeats the price movement, it signals that the traders are taking their profits and leaving the market.
Let us see the above chart as an example. There is a bearish trend in the BTCUSD price chart. The red lines highlight the points where the extremes in the indicator chart repeat the extreme points of the downtrend in the price chart, which means the down move continues.
Next, there is convergence (the blue line) accompanying another bullish try to correct the price up, which indicates the weakness of bulls, and the price is expectedly falling.
If the price extreme is confirmed by the indicator line in the overbought zone, the uptrend will soon be replaced by either a sideways trend or a downtrend. When the MFI line breaks through level 20 and there is a new local low at the same time, there should soon start a new bullish trend.
Going back to the previous chart, we also circle the points where the price goes into the overbought and oversold zone. The chart displays the local correction and the alternation of one wave with the other when the MFI indicator reaches levels 20 and 80.
While the wave is forming, we should study its structure, analyzing it in shorter timeframes. If the first wave is true, it should consist of five smaller waves of the major impulse.
Let us study the first wave from our example.
There is a bullish reversal bar at the inceptive point of the first wave in the hourly BTCUSD price chart. Remember, this bar is the so-called First Wise Man in Bill Williams’s trading strategy Three Wise Men. The bullish reversal follows the bar the lowest low, it must close in its upper half. The MFI doesn’t deliver a clear signal of the trend reversal. However, its line doesn’t break through the low, unlike the price chart, which signals convergence, a confirming signal of the trend reversal.
Now, let us look at the first wave. The assumption that the first wave of the bullish trend started is confirmed by the fact that the five-wave sequence has formed within the wave, I marked the five-wave structure with green lines.
Once the first wave reaches its peak, there is always a short movement in the opposite direction. It is created by traders staying outside the market. As most of such traders are weak holders who wrongly think that the beginning trend is just another correction, the upward movement in the ongoing bearish trend or the down move in the ongoing bullish trend is short.
The most likely target where the correction should finish is the range between the Fibonacci levels of 38% and 62% of the previous wave. Sometimes, waves may be greater than 62%, more seldom, they are less than 38%. In the latter case, it is an irregular correction.
Like impulse waves, corrective ones are also complex wave structures, which are easily discovered in shorter timeframes. They only not five-wave sequences but three-wave ones.
It is clear from the chart above that the big second wave contains a three-wave corrective sequence. As for targets, they match the Elliott Wave model. The second wave (marked with the oval zone) finishes in the range between 0.382 (olive colored line) and 0.618 (horizontal green line).
There usually appear two beneficial factors for traders in the third wave. We can determine with high accuracy the ongoing trend by the time the third wave starts. Besides, the third wave is usually the largest and most powerful wave in a trend, and so it gives a chance to make the largest profit. That is why it is so important to spot the end of wave 2.
One of the ways to recognize wave 3 is its slope. The third waves re very often steeper than the first ones and can even be almost vertical. But that is not always so, and, if in your case, wave 3 is not steep enough, it should not be seen as the mistake in the wave identification.
The second important moment is trading volume. The third waves usually feature increased volume. However, if the movement is not intensive enough it can be accompanied by normal volume. If a sharp move is accompanied by low volume, which can also occur, it is the so-called explosion or flash that can’t be long-term.
In our example, there is a not very intensive up move. So, it is natural that it is accompanied by a low volume with rare surges of trading activity.
And, finally, the third important factor is the news. The emerging of wave 3 is often accompanied by good new which matches the technical and psychological reasons for growth.
The most likely targets are in the range between 100% and 162% of the first wave size. Sometimes, the third wave could be even longer but is seldom less than wave 1.
The best way to identify the peak of wave 3 is two discover its five-wave structure in shorter timeframes and making sure that the following conditions are met.
- The bar that forms the high is in the zone between 100% and 162% of wave 1.
- The MFI indicator signals the trend reversal.
- There forms a fractal (a wrote about fractals in the previous training article) at the high or low if it is a bearish trend.
- There is a complete reversal bar.
- The MACD moving averages are converging or moving apart.
I should note that it is not necessary that all the conditions are fulfilled. But the more confirming signals are delivered in the shortest timeframes the better.
Let us see which of the above conditions are met in the six-minute chart. The peak of wave 3 is the zone between 100% and 162% of wave 1. MFI signals overbought when the price is approaching the high, which is an early reversal signal. Besides, the bar which hits the local high is a reversal bar although it is not perfect.
Now, let us have a look at MACD. The indicator is lagging as usual, but it also signals the bullish trend exhaustion in a few bars.
When wave 3 completes, experience traders start taking profits. Their actions are the main driver for the correction. The structure of wave 4 in most cases is the exact opposite of the wave 2 structure. If wave 2 was plain, wave 4 will be complex, and vice versa. For example, if wave 2 was zigzag-shaped, wave 4 will be a complex flat sideways correction, a correction in the shape of an irregular triangle or some other complex pattern of technical analysis. I will deal with types of corrections and how to distinguish them one from another in my next training lesson.
There is also interesting research, according to which, 4 out of 5 errors of perception are made at wave 4. So, if you are not sure which wave is currently developing, there is likely to be forming wave 4. If you manage to more or less accurately find out its final point, you can count on quite a good profit.
Wave 4 usually forms longer than wave 2. However, less significant targets are reached, from 38% to 50% of the third wave spread. Besides, 20% of waves may not reach level 38%, it is also a norm. I also want to remind you about an important rule, wave 4 hardly ever exceeds the peak of wave 1.
To find out the final point of wave 4, I will use the same method. I will analyze the three-wave sequence forming within the fourth wave, calculate the target profit zone, study the signals delivered by MFI and MACD, spot fractals and reversal bars.
On the BTCUSD price chart above, the extreme point of wave 4 is marked with an oval area. The low is a little higher than 50% level of wave 3 length, so, it is in the range appropriate for reversal. The MFI enters the overbought zone one bar earlier than the reversal, thereby forming early signs for the price movement reversal. There is also a fractal at the low, but there is no reversal bar though.
The MACD indicator sends a reversal signal a little later. Remember, we use the tool as an additional validation of the forecast. The main advantage of this indicator is the high accuracy of the forecasts. That is why it is a kind of last confirming signals suggesting that the forecast is relevant.
Let us see the structure of wave 4. As I already wrote, it is often the exact opposite of wave 2. Remember, in out example wave three was a plain three-wave zigzag. Wave four is a triangle-shaped formation that consists of five elements A-B-C-D-E (it is marked with red lines in the chart). The probability of such structures should be considered when you analyze wave 4, as the wrong interpretation may result in the wrong entry point.
It doesn’t feature the movement so intensive as wave 3, but it is still a good moment to make profits. That is why, if you for some reason have missed the beginning of wave 3, wave 5 will provide another opportunity to make a profit. Besides, even if you have managed to make a profit from wave 3 having opened a position on time, you can increase your profit, taking most of the finishing trend. I recommend you define the end of wave 5 using the same methods as we employed when analyzing waves 3 and 4.
To identify the target zone; I will use the method described by Tom Joseph one of Elliott’s followers. First, we need to measure the difference between the prices of wave 1 start and wave 3 peak. Next, we add 62% and 100% of the calculated value to the end of wave 4. The wave is likely to finish between these two levels. To increase the accuracy of calculations, we can divide the major wave into five waves of lower degree and make a similar calculation for the fifth wave of lower degree. In most cases, the narrower range will be within the broad one.
Let us see how Tom Joseph’s method works on our example. As you see, the target zones for the fifths wave of this degree do not coincide (blue an olive-colored). As a result, due to a narrow spread of wave 3 of a lower degree, the extreme point of wave 5 goes beyond 100%, but for waves of higher degree that we analyze, it doesn’t even reach 50%. These cases are not rare in practice, so it is not the necessary condition of finishing the way that the price should reach the target zone.
Now, let’s see what other indicators signal. MFI indicates the overbought, there is a fractal at the peak, and there is a reversal bar one bar before the peak.
MACD, typically being a few bars later, delivers a reversal signal. Therefore, there are enough signs to expect wave 5 to finish, even though some of the conditions are not fulfilled.
Well, we have studied the structure of impulse waves in the Elliott Wave theory, we have also learned how to identify the starting and the ending points of major waves. In the next educational post, I will deal with correction types, reveal the secrets of making the analysis more objective, as some traders claim the method is too subjective. In the end, I will sum it all up and describe the trading system based on the Elliott wave principle.
I wish you good luck and good profits!
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