The concept of trend is central to trading in financial markets. Ralph Nelson Elliott found that in any trend, price tends to move in a five-wave pattern. Borrowing from the Dow Theory, the Elliott wave theory proposes the five wave structure of the trend with three waves in the direction of the trend. Waves in the direction of the trend are called the impulse waves, and the other two waves – the motive waves. The Elliott waves adhere to some strict rules of retracement. Thus, it is safe to say that Elliott waves also depend on the Fibonacci retracement levels.
From a trading perspective, Elliott waves help chart technicians to pick turning points in a trend. We already know that within the five-wave pattern, the impulsive waves move in the direction of the trend. Among the three impulsive waves, the third wave is potentially the strongest of the three. The third wave does not just stand out visibly but it is also the longest of the three.
Most of the trading activity occurs during the third wave. The third wave is when there is a lot of market euphoria. In most cases, traders tend to identify the third wave when it has already been established. The third impulse wave of the Elliott wave theory is the most visually standing out impulse wave. Following the consolidation of the second wave, the third wave breaks out. Because the third wave is also the impulse wave, this is always in the direction of the underlying trend. While the third wave is easily identified (in hindsight), trading the third wave as it evolves can be somewhat difficult.
Elliott suggested that the number and formation of waves are directly related to the psychology of traders. Let us discuss how it can be explained with the example of a long trading position:
- The first wave is formed after the flat. At that time big players open long positions on the analysis or insider information. The market begins to move up and keeps going until some traders take profit.
- The second wave is usually short. It is a small correction caused by the “sharks”: they support their positions.
- The third wave resembles the first. New big traders join the trading..
- The fourth wave is a correction. It is usually longer than the second.
- The fifth wave consists of latecomers. Players who missed the opportunity finally come into play. This wave is considered the weakest and is often truncated.
After 5 waves, the new trend is formed in the opposite direction. Elliott suggested that in the final stage, the downward trend consists of three waves.
How to use Eliott’s theory in binary options trading?
Based on Eliott’s theory, the most profitable for trading is the third wave because the market moves under the pressure of most players and last the longest. The third wave appears right after wave 2. It can somewhat easy to wait for the start of the third wave. However, a wrong move by price action could quickly invalidate the whole wave count. This would mean that the trader will have to start from the beginning and count waves to adjust to the evolving price action.
This is one of the reasons why, despite the third wave being the strongest and visually standing out, it can be daunting. The third wave (and the entire Elliott wave itself) can form across multiple time frames. Ralph Elliott called these the degrees of waves. The degrees of waves are nothing but a pattern. To identify the 3rd wave, the second wave has to complete and fall within the general rules of Elliott waves. While there are many explanations on the nature of the second wave, the one hard and fast rule is that the second wave should never overlap the first wave. Also, the second wave should never retrace more than wave one. Therefore, in order to successfully trade the third wave of the Elliott wave, traders need to keep a close watch on the second wave.
After you identify a turning point, the wave three begins. The next step is to wait for the 3rd wave to break the previous high or low of wave two. Trading the third wave can be even more successful when analysing the candlestick patterns a well.
How do traders determine when the market exits the flat and starts the trend? In the following section, we illustrate how you can trade the third wave based on the above simple rules.
To confirm it, we will use two exponential moving averages of 14 and 21 periods. You can find Elliot’s waves tool in the Olymp Trade terminal and activate it. The signal of the uptrend will be the moving averages in the upper direction. The signal of the downtrend will be moving averages downwards.
The second wave is the correction: it stalls the upward movement. To determine when to stop, draw a resistance line if the correction is downward or a support line, if the correction is upward. if vice versa.
The third wave begins when one of the averages breaks out. Consider the following steps:
- The CALL contract is acquired after breaking the resistance line.
- The PUT contract is acquired after breaking the support line.
Period expiration should be at least the time of formation of three candles. You can use any timeframe starting from 15 minutes.
Elliott wave theory can get a bit overwhelming. A wrong counting of the waves can leave the analysis invalid. Moreover, Elliott waves can be quite subjective leading to devastating trade entries.
To avoid all of this, traders can simply focus on the third wave of the Elliott wave theory. By starting with identifying the trend and trading the third wave, traders can enter this potentially powerful wave with ease.
The third wave of the Elliott wave method is compatible with other technical indicators. However, traders need to apply caution as using too many indicators alongside an existing method can lead to analysis paralysis.