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What is Elliott Wave Theory and its Importance in Swing Trading?

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What is Elliott Wave Theory and its Importance in Swing Trading?

What is Elliott Wave Theory and its Importance in Swing Trading?

Umesh Sharma 15 Sep 2020

Elliott Wave Theory is one of the most renowned theories in technical analysis.this was developed by Ralph Nelson Elliot. This theory speaks about Waves (patterns). Elliot believed that mass psychology depicts the same recurring patterns in the financial markets. He discovered the underlying social principles and developed the analytical tools in the 1930s. Elliott stated that "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"

Elliott developed his market model theory before he realized that it also reflects the Fibonacci sequence. The Fibonacci sequence is also closely connected to the golden ratio of retracement and extension (1.618). Intraday and Swing Traders commonly use this ratio and related ratios in sequence as to establish support and resistance levels for market waves, ideally, it signals the price points which help define the parameters of an uptrend or downtrend.

 

The Elliott Wave theory infers that layman trader’s psychology, or herd psychology moves between optimism and pessimism which occurs in natural sequences. These mood swings or behavior can be created in the form of patterns which show as an evidence in the price movements of markets at every degree of the trend either uptrend or downtrend or multiple time scale. This theory helps a swing trader to identify longer duration trade setup with signals of resumption, termination of an uptrend, downtrend, correction and extension of the trend.

Elliott's final major work isNature's Law --The Secret of the Universe, which was published in June 1946, two years before his death.

Elliott Wave Theory was popularized in the seventies by Robert Prechter and A.J.Frost with their book " Elliott Wave Principle"

He speaks about waves in 5-3 moves, wherein five waves move in an upward direction of the main trend, known as impulse and three waves move in the corrective phase. These 3 moves are also referred to as ABC. The completed motive patterns include 89 waves, followed by a completed corrective pattern of 55 waves. This theory helps in gauging the upward trend and the corrections that are likely to happen in the future with very high probability.

The classification of the wave at any degree can vary slightly however standard order of degree or duration would be approximately:

Grand Super cycle: It can be of multi century (which historically not yet tested in swing trading as no data sets available in financial markets before 19th Century)

Super cycle: It can be of Multi Decade (again reliability cannot be justified with datasets available given the fact that for any strategy to be tested in trading we need to have backtesting datasets of at least 4 to 5 times)

Intermediate Cycle: The duration can range from a few weeks to a month which is majorly used or can be deployed by swing traders practically as the other cycles discussed before need extreme discipline and a very high degree of patience. Excuse Me!!! Markets test your patience and to work on Cycle or Super Cycle a trader himself knows how much discipline one needs to have to work on extremely long duration timeframes. Sometimes we need to be practical and realistic in approach. 

Minor Cycle: The duration cycle can be of a week 

Minute Cycle:  The duration will be of days and can be used by traders and can be deployed for a day or two

Minuette Cycle: The duration will be of an hour and can be used by an intraday trader

Subminuette: The duration will be of an hour and can be used by a scalper who wants to take trade setup for a few minutes of shorter durations.

 

 

Every wave serves one of two functions: action or reaction. Specifically, a wave may either advance the cause of the wave of one larger degree or interrupt it. The function of a wave is determined by its relative direction. An actionary or trend wave is any wave that trends in the same direction as the wave of one larger degree of which it is a part. A reactionary or countertrend wave is any wave that trends in the direction opposite to that of the wave of one larger degree of which it is part. Actionary waves are labeled with odd numbers and letters. Reactionary waves are labeled with even numbers and letters.

 

All reactionary waves develop in corrective mode. If all actionary waves developed in motive mode, then there would be no need for different terms. Indeed, most actionary waves do subdivide into five waves. However, as the following sections reveal, a few actionary waves develop in corrective mode, i.e., they subdivide into three waves or a variation thereof. Detailed knowledge of pattern construction is required before one can draw the distinction between actionary function and motive mode, which in the underlying model introduced so far are indistinct.

The following are the advantages of trading with Elliott wave theory in swing trading:

1. Wave analysis identifies the trend

2. It signal resumption of the trend

3. It identifies the termination of the trend

4. It provides a High probability risk reward ratio trade setup in swing trading

5. It provides specific exit points when the trade setup fails.

6. It identifies countertrend move within the trend

 

We also have full fledge training programme for Elliott Wave Theory click here

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