Elliott Wave Analysis: Putting the Theory into Practice

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In the last article, we introduced the main concepts behind Elliott Wave analysis and how the methodology is an excellent trading strategy for serious forex traders. But knowing the theory is one thing. Being able to apply it in trading conditions is something entirely different. In this article, I will explain how to start applying the theory in a real trading environment.

An overview of the basics

Before I proceed with that, it makes sense to briefly summarise the key points of Elliott Wave analysis, which is more commonly known as wave analysis. The strategy is technical in nature (which means traders are required to analyse price charts) and allows traders to identify cumulative market psychology in order to predict upward or downward trends in price. Wave analysis works because historical data shows that these upward and downward trends tend to occur in repetitive patterns.

These patterns come in two distinct categories on price charts: corrective waves and impulsive waves. Generally speaking, impulsive waves can be described as a strong move in a currency’s price (both increases and decreases in price) which match the recent trend direction. Corrective waves are the reverse of this; they represent distinct moves in a currency’s price which are against the underlying trend direction.

The great thing about wave analysis is that it tells us the order in which we can expect impulsive waves and corrective waves to occur. For any particular currency’s price, traders should expect five impulsive waves, followed by three corrective waves. It’s known as a 5 - 3 move and counts as one complete cycle in wave analysis. It’s also important to note that these cycles can be found at higher and lower degrees of a currency’s price movements, as the above diagram illustrates.

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The job of a trader is to identify where a currency’s current price actually is within this 5 - 3 cycle at a particular degree. They can then predict the next category of wave and changes in price direction, before taking appropriate action.

Wave analysis in action

Many forex traders are hesitant to learn wave analysis due to its seemingly complex attributes. However, as with any other aspect of life, learning a new skill takes a considerable amount of time to perfect. So persistence is needed with this methodology, but it’s actually easier than most traders realise. Simply put, a trader’s goal is to identify past impulses and corrections, then based on those past combinations, judge the likelihood of the next impulse or correction unfolding.

First of all, traders need to understand the definitions of bullish, bearish, impulsive and corrective when looking at their prices charts. This is vital to the analysis.

Secondly, traders must then dissect the price action on their chart into separate price action legs, which is where the characteristics of each leg - which can be thought of as waves - can be identified. Chart A is an example of how price action is split into legs. Each ring of the same colour represents the start and end of a particular leg.

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Chart A