Description
Elliott Waves are a chart analysis method that was developed by Ralph Elliott in the 1930s. Elliott Waves are not a technical indicator (as the MACD is), nor a type of chart (as Heikin Ashi is), but are a way of analysing candlestick and bar charts to determine the expected direction of a market.
Elliott Waves are based upon the theory that markets move in waves (alternating between bullish and bearish), and that these waves can be predicted (somewhat). Specifically, Elliott Waves propose that markets move with five waves in the primary direction (i.e. long in a bullish market, and short in a bearish market) and three waves in the secondary direction (i.e. the opposite direction). In addition, Elliott Waves propose that the same pattern (five waves and then three waves) is repeated in every time frame (e.g. minutes, hours, days, weeks, etc.), and are therefore considered to be a form of fractal (i.e. exhibiting self similar properties at every level).
Elliott Waves are also related to the Fibonacci numbers, in that the five and three waves are both part of the Fibonacci sequence, and that full primary and secondary waves include eighty-nine and fifty-five smaller waves respectively, which are also both part of the Fibonacci sequence. Ralph Elliott claimed that this relationship was only discovered after Elliott Waves had been designed (i.e. Elliott Waves were not purposely designed to have a relationship with the Fibonacci numbers).
In the example chart, the primary and secondary Elliott Waves are shown on a bar chart by the yellow and blue lines respectively.
Calculation
- Description: Elliott Waves are not calculated at all (in the usual indicator sense), but are analysed according to specific criteria that define the location of each wave in relation to the previous and following waves. The analysis criteria can include the order of the waves, the distances that each wave moves, and the volume of each wave. A complete description of the analysis criteria is available in my Elliott Wave analysis discussion.
Trading Use
Elliott Waves are used to determine the direction and distance that a market is expected to move. The theory being that once the current wave has been identified, the wave pattern can be followed and trades made accordingly. For example, an Elliott Wave trader that determines that a market is currently completing the fifth wave in a bullish market, might prepare to make a short trade and expect to hold their short trade for three waves. The difficulty with Elliott Wave based trading is knowing which wave the market is currently making (if any), and two different Elliott Wave analysts can easily interpret the same chart differently, with different resulting trades.
In the example chart, an Elliott Wave trader that trades with the primary wave might enter a trade on the third and/or fifth waves of the yellow line, while an Elliott Wave trader that trades with the secondary wave might enter a trade on the third wave of the blue line.
