Haven’t we all tried reading charts as amateurs? Trying to decipher a pattern and noticing that unmistakable wave of sorts when an asset rises, or even when it falls? Whether we understand technical analysis or not, if we’ve tried our hand at trading any asset – whether conventional or crypto – we’re most likely familiar with the Elliott Wave Theory. It is this theory our subconscious mind has unwittingly often put to use.
The Elliott Wave Theory is a popular technical analysis tool developed by Ralph Nelson Elliott in the 1930s. Elliott was an American accountant and author who was also a stock market trader. In his book The Wave Principle, Elliott shared his observation that a common pattern emerges as a result of trader psychology & human behavior and that a lot of trading is based on a cyclical nature. Elliott noticed that the market tends to behave like ‘fractals’ i.e., mathematical structures that tend to repeat themselves infinitely (even on the smallest scale). Interestingly, the term fractal was coined much later.
In the book, he states, “Because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable.” He must have been right because here we are, almost a century later, still using the same indicator!
How does the Elliott Wave Theory Work?
As has been seen plenty of times in the markets, the price of any asset inevitably moves up and down in a wave-like motion. The Elliott Wave Theory divides that price action into trends and corrections. An upward or downward price action showcases the direction of a trend, while corrections will always move against the trend.
The trend is called an impulse/motive wave, and the correction is called a corrective wave. The main pattern Elliott brought to our attention was that the impulse wave tends to respond in 5 waves, which means that the market progresses in the form of 5 repeating waves. This impulse moves in one direction, followed by a larger corrective move in three consecutive waves. It is essentially a 5-3 wave pattern.
On the chart, impulse waves are numbered from 1-5, and the three corrective waves are lettered A, B, and C. Three of the impulse waves (1, 3, and 5) affect the directional movement. For example, if your crypto asset is moving upwards, these three waves will help us go up as well. The other two waves (2 and 4) are counter-trend waves. So if the market is moving upwards, these will go downwards and retract the price a bit.
What makes identifying the waves difficult for new traders is that the Elliott Waves can actually be present on several different time frames. You may see a pattern on the one-hour chart that might fit into a larger version of the Elliott Wave on the one-day chart, for example. From a bird’s eye view, you’ll notice that each unfolding wave pattern is part of a bigger wave pattern unfolded in the higher chart.
To help you out, there are three critical rules that apply here.
- Wave 2 never moves beyond the start of wave 1.
Remember that wave 1 is actionary, while wave 2 is reactionary. This means that the move upward is never retraced.
- Wave 3 is never the shortest wave.
We have three waves that move with the trend (1,3, and 5). When measuring the length of these waves, wave 3 is never the shortest. It is, in fact, often the most powerful wave.
- Wave 4 never enters the price territory of wave 1.
Wave 4 is one of the reactionary waves, i.e. one that moves against the trend.
A common strategy you’re going to see with impulse waves, and something that you can use in your trades is that you have impulse wave 3 as the longest wave, and that impulse wave 5 will be the same length as wave 1.
For example, here’s an Elliot Wave analysis from 2019 for Bitcoin since its inception. In this analysis, the trader predicts prices upwards of $27,000 for Bitcoin by the end of 2020. For those trading Bitcoin, Bitcoin futures, or really any cryptocurrency derivatives, these analyses can be useful.
What are the best entries and exits?
The start of wave 1 is the ideal entry point. However, this can be hard to spot as it comes after a sudden market dip or a consolidation period that could last days or even weeks.
Easier spots to trade are the bottom of wave 2 or wave 4, and these are popular spots among traders. The top of wave 3 or wave 5 is best avoided.
As far as exits are concerned, the end of wave C is your best option. Again, this can be hard to time since these final waves can retrace to 100% of the initial 5-Wave Elliott pattern. A safer alternative is a consolidation that breaks outside of the final corrective wave trend line.
While it’s one of the greatest tools discovered to predict investor sentiment and have an edge as a trader on a crypto exchange, it’s imperative to remember that the fractal-pattern behavior of the market does not necessarily make it 100% predictable.
Buying and selling into the market have always required your own research, and it always will. Period.
What you can use the Elliott Wave Principle for, though is to make an informed buying decision, depending on which of the two phases (motive or corrective) the market is currently in. You can also use the principle in conjunction with other trading strategies, such as the Fibonacci Retracement.
When you decide to get started though, head over to the Delta Exchange 🙂