The Elliott Wave Phenomenon: Fundamentals of Theory

No one will deny that human activity is behind the behavior of markets, including financial markets. Any processes taking place in the universe, nature and social environment are subject to certain laws described by the corresponding sections of theoretical and applied sciences. In our case the process of trading is directly connected with the laws of market and social environment, which undoubtedly appear in the window of traders' terminals day in day out. In order to be successful in any activity one should have an idea about the identified laws and use them to one's advantage.

A bit of history

The pioneer and creator of the foundations wave theory is Ralph Nelson Elliott (1871-1948). He discovered that the same regularities are steadily manifested at different time intervals, which served as a discovery of a new understanding of the behavior of markets. In 1938, Ralph Nelson published a book entitled Law of Waves in which he stated the basic principles he had discovered. This was followed by The Law of Nature - the Secret of the Universe, published in 1946, which introduced refinements and additions to the theory, as well as the basic laws of working with Fibonacci levels.

Basic regularities and principles of trade

Although Elliott did not create a mechanical system that allows trading based on wave patterns, many traders successfully use this approach to the market, combining it with their own trading systems and indicators. Some basic principles of trading "on waves" we will look at in this article.

Fig. 1. Working breakdown of the EURUSD chart.
Fig. 1. Working breakdown of the EURUSD chart.

Elliott's basic rule is that the markets develop according to a clearly established law: 5 waves of momentum and 3 waves of correction. And an impulse always has a five-wave structure, and a correction is always a three. This position is a complete price cycle.

Let's go back to the graph. Since the beginning of 2008, we have seen a steady upward movementwhich can be easily fit into the framework of the wave theory. Based on the position that an impulse always consists of five waves, we find confirmation of this on the chart. So we have 1, 2, 3, 4, 5. Another logically resulting rule states: a higher-order pulse always consists of five lower-order wavesAs can be seen by looking closely at the internal structure of these waves.

The impulse is always followed by a correction, being three-wave in nature, it usually rolls back in price terms to about the level of wave 4 of the previous movement. The figure clearly shows that the correction marked W-X-Y reached these levels and went a little deeper, again to the wave [iv] of the impulse of a shallower order. Thus, we can confidently state that the market, so far, has been passed full Elliott price cycle. As a result, given the peculiarities of the markup, we can argue about the further strengthening of the euro against the dollar.

Fig. 2. Current situation on EURGBP.
Fig. 2. Current situation on EURGBP.

Here is another example of a complete Elliott price cycle on the EURGBP chart.

As you can see from the markup, there was an impulse marked as (1), (2), (3), (4), (5), followed by a correction (a), (b), (c), (d), (e), which is a completed cycle. Interesting properties of this correction are that it consists not of three, but of five successively diminishing in price waves with a slope towards the dominant trend. In the circles of traders it is more known as a sloping triangle. Another important feature of this type of correction is manifested in its position relative to the entire wave structure. The triangle is always the penultimate wave (in our case, the impulse), after which the continuation of the growth of the pair should be expected.

But on this interesting features wave markup are far from being exhaustive. Considering the same five-wave wave, it is easy to see that wave (1) is significantly inferior in size to wave (3) and (5), and the two latter are easily decomposed into similar impulse structures; in wave analysis, this phenomenon is called lengthening.

Here it is necessary to mention at once about necessary and sufficient proportions of wavesThe third wave is never the shortest in an impulse, and the bases of the impulses never cross. Namely: the third wave is never the shortest in an impulse; the bases of impulses never cross. Based on this rule, the lengthening can be observed simultaneously in the first and third waves, in the third and fifth waves, but never in the first and fifth waves, as this would violate one of the rules of alternation. So, the future prospects of the pair also seem to be quite positive.

Fig. 3. Current situation on EURJPY.
Fig. 3. Current situation on EURJPY.

Here everything looks much more complicated. Not only the major major upward waves are not marked with numbers, but they also contain "inside" the completed Elliott price cycles. The thing is that the real ascending section of the weekly chart is itself a correction in relation to the dominating trend. For example, wave A is decomposed into a five-wave impulse, which is typical of corrections of a zigzag type. Since a correction is always a three-wave correction, and we see completed waves A and B, we just need a third wave C to complete this very zigzag, which we should expect in the near term. Again we should pay attention to the fact that the correction [a][b][c] rolled back exactly to the price level of wave [iv] of the previous impulse, which once again confirms one of the basic rules and proves the correctness of the markup.

So we have a strong euro for the next second half of 2008, after which it is likely to start a new phase of markets and decline euro against the currencies considered.

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