There are thousands of trading strategies in the financial market. Some of the most common trading strategies are: hedging, scalping, support and resistance, moving averages, Fibonacci retracement, and horizontal levels trading strategy among others. As a trader, your goal is to understand 2 or 3 strategies and use them for your daily trading. In addition, you can always define your trading strategy that suits your trading patterns.
The Elliot’s trading system was accidentally established by Ralph Elliot who decided to study market behaviour in his later stages in life. After spending time learning and analysing the markets, Elliot came up with the book, ‘The Wave Principle’ where he published his opinions. As an accountant, Elliot believed he had a role to play in the financial market but he did not discover it after retiring at age 58. Today, his theorem is one of the most commonly used trading strategies. In most cases, traders combine the strategy with many other strategies such as moving averages, Fibonacci, stochastic, and support and resistance among others.
In his analysis, Elliot analysed stock prices of more than 70 years and discovered that the market moved as a result of psychology. For a large extent, the market moved as a result of fear and greed among the participants. In addition, Elliot noted that the market did not move in a chaotic manner but in an iterative manner. He also noted that group psychology moves back and forth from optimism to pessimism at diverse levels. As a result, during times when the market is in a strong uptrend, there are times when the mood changes and traders begin to sell. On the other hand, when the market is in a strong downward trend, a time reaches when the traders moods changes and exits the trade.
In the Elliot Wave Strategy (EWS), the key idea is to understand the market psychology which indicates the swing between optimistic and pessimistic modes. At times, the market instruments will be bullish and at times, they will be bearish. When the market is in a bullish state, the traders and investors will have an appetite for making more money and go long. After some time, the buyer’s remorse sets in and the traders dump some of their holdings. At this time, the market is in a correction phase. The motive phase according to the EWS takes 5 steps which are shown in the chart below.
In this chart, a number of things can be seen. At the beginning of the wave, the longs have an appetite for taking more risks which leads to a price hike. In the second wave (2), emotion sets in and traders dump some assets which reduces the price of the pair. This is a phase where correction happens which results from human emotion. In the 3rd phase, the traders decide to continue the Bull Run which sends the prices higher. In the next phase, the second correction happens and aims to retrace the wave. Traders sell the instrument. In the fifth wave, the price finally settles up near the highest point of the pattern. However, this is usually not the end of the wave. By expanding the chart, the following pattern will be seen.
In addition, the Eliot wave is not only limited to a bullish chart. The correction will also happen in a strongly bearish market where investors are selling certain instruments.
As stated above, the key to understand a trend is to identify the trend. As a result, trend analysis is very important when using EWS because at times, naked eyes can reveal a false trend. A number of tools are used to identify the trend. The moving averages is the most common method of identifying an up or downtrend. Other indicators which can be used very well using the strategy are: Fibonacci retracement, support and resistance, and stochastic indicators. Therefore, it is important to first understand these indicators before using the EWS strategy.
In conclusion, it is very important to note that using this strategy is not as simple as explained above. The fact is that it takes a lot of work, patience, and time to learn the strategy. If the strategy does not fit you, the best thing is to find another strategy that is simple and easy to understand for you.