In the realm of market technical analysis, we would both agree that it is impossible to accurately “predict” the market using any available tools. Just as we could not foresee when Nvidia experienced a significant 30% surge after its last earnings report. We just cannot claim to possess clairvoyant abilities. The market, by its very nature, is unpredictable and often defies our expectations (unless, of course, one possesses substantial capital to manipulate it).

Nevertheless, despite the inherent uncertainty, traders are constantly in pursuit of methods to forecast market movements. There is an undeniable satisfaction when our predictions align with the actual market direction. While achieving a 100% prediction rate is an unattainable goal, even a success rate of 60% or 70% can establish one as a professional trader.

In the 1930s, Ralph Nelson Elliott, a renowned stock market analyst, postulated that markets possess a recurring structure. By identifying these cycles and waves, he believed it was possible to predict stock market movements. This theory, known as the Elliott Wave Theory, has stood the test of time and continues to be relevant in today’s stock market, as well as the crypto market.

The Concept Behind The Elliott Wave Theory

The concept of repetition is prevalent in various aspects of our world, as highlighted in Ray Dalio’s book, “Principles for Dealing with the Changing World Order”. The financial market, too, exhibits repeated patterns over time, which can be attributed to the psychological element of trading.

If we can identify these patterns across different assets and time frames, it is believed that we can predict price actions when they repeat in the future. This is precisely what we do at TradeDots. Through the analysis of historical price actions, we detect repeated trading patterns and provide market reversal signals before they become apparent to other traders. You can try it out for free here.

What is Elliott Wave Theory?

Elliott Wave Theory is based on three fundamental components that contribute to the formation of market trends: impulse waves, corrective waves, and wave degrees. An impulsive wave consists of five sub-waves, collectively moving in the direction of the main trend. This is followed by a corrective wave, which comprises three sub-waves moving in the opposite direction of the main trend. This 5–3 move pattern constitutes a single cycle.

The sub-waves within the impulsive wave are labeled as 1 to 5, while the corrective waves are denoted as A, B, and C. However, multiple 5–3 moves can combine to form a broader 5–3 wave. Consequently, while the concept of higher highs and higher lows typically indicates an uptrend, Elliott Wave theory emphasizes that short-term corrections within the trend can manifest as lower highs and lower lows. This does not necessarily negate the overall trend but signifies a period of retracement that is more substantial than previous corrections within the impulsive move.

The Rules in Elliott Wave Theory

To effectively apply Elliott Wave Theory, certain rules must be followed:

Rule 1: Wave 2 cannot retrace beyond the starting point of wave 1.

Rule 2: Wave 3 must be longer than both wave 1 and wave 5.

Rule 3: Wave 4 cannot exceed the end point of wave 1.

Using Fibonacci Retracement Levels in Elliot Waves

In conjunction with Elliott Wave Theory, Fibonacci retracement levels serve as a valuable tool for identifying reversal points. We have previously discussed the details of Fibonacci retracement levels in our blog, which you can find here.

After identifying the first three waves, we may start observing a fourth wave landing between the 23.6% to 50% retracement level. Additionally, correction waves A, B, and C often occur within the 50% to 61.8% range after the whole initial five impulsive waves. These Fibonacci retracement levels provide a useful reference for determining optimal market entry and exit points.

The Bottom Line

In conclusion, it is important to recognize that tools such as Elliott Wave Theory are not infallible crystal balls for market prediction. They should be regarded as references rather than sole indicators for trading decisions. However, they undoubtedly offer a valuable framework for understanding market cycles and trends, providing traders with a better grasp of how the market is evolving.

About TradeDots

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Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial advice. Trading involves risk, and it is important to conduct thorough research and seek professional guidance before making any investment decisions.

Originally Published on Medium