Developed in the 1930s by Ralph Nelson Elliot, the Elliot Wave Theory is a based on the concept of repetitive patterns influenced by investors’ psychology. Ralph Nelson Elliot was a US based analyst and after spending years analyzing stock market data, he wrote the book “The Wave Principle” in which he described his theory. It has found wide acceptance in traditional trading and is now a common indicator used in crypto trading.
The Elliot Wave indicator looks at the swings in price action influenced by the collective psychology of traders. These swings are often come in repetitive patterns, or waves, and by identifying the early stages, crypto traders can make predictions about where the price will go next as the waves continue along the pattern.
Breaking down the Elliot Wave trading pattern
There are two different types of waves identified by the Elliot Wave indicator: impulsive and corrective. An impulsivewave goes in the same direction as the overall trend and is comprised of five waves. The rhythm of these waves is described as in the image below: waves 1 – 3 – 5 are trend-supporting, while 2 and 4 are corrections within this particular trend.
The explanation of these five waves can be seen as follows:
- Wave 1 – A modest number of investors decides to buy BTC, for example, since they believe the asset is undervalued.
- Wave 2 – Investors, not necessarily all of them, are taking profits, which causes Bitcoin to correct lower.
- Wave 3 – Due to wave 1, a larger group of people see this as an uptrend and decide to use wave 2 (a correction) to hop on the trend and buy Bitcoin. Wave 3 is usually the strongest wave.
- Wave 4 – After a strong push in the direction of the overall trend, many investors are happy to collect their profits, causing the price to correct once again.
- Wave 5 – The final move in the direction of the overall trend usually happens due to masses joining the party who can’t resist the FOMO any longer. This is also the key factor which causes the ABC pattern to kick in.
Elliot Wave: the ABC pattern
The ABC pattern, also known as the correctivewave, comes as a correction of the 5-wave pattern. It is structured as a 3-wave counter trend pattern.
In his book, Elliott outlined 21 different corrective ABC patterns. However, crypto traders tend to focus on the most occurring and simplest ABC patterns, such as Zig-zag, the flat formation or the triangle formation.
All in all, impulsive and corrective waves together form the so-called “5-3 move”, which can occur on all time frames from 1 minute to a yearly period.
Trading Elliott Wave Pattern in crypto markets
Trading with the Elliot Wave pattern, you must keep the following golden rules in mind:
Golden rule 1: Wave 3 can never be the shortest impulse wave
Golden rule 2: Wave 2 can never go beyond the start of Wave 1
Golden rule 3: Wave 4 can never cross in the same price area as Wave 1
If any of the three rules above are broken, the entire pattern is invalidated. In addition, there is a list of additional rules to abide to, however, those rules are less important and they can be broken.
As seen in the BTC price chart below, we have identified the 5-3 move on BTC/USD. The price created a short-term bottom (the start of the wave 1) before continuing higher. Once wave 5 is completed, the price action starts correcting lower, within the ABC pattern.
The example here follows all three conditions of the three golden. The main catch when it comes to the Elliott Wave Pattern is wave counting. This is especially important when it comes to identifying waves 3 and 5. For this reason, crypto traders use the Fibonacci retracement to identify where waves 2 and 4 (corrections) may finish.
For this reason, below you see the same chart but this we’re including Fibonacci retracement levels. Wave 2 finishes close to 78.6% Fibonacci retracement level. With that information, and knowing that Wave 2 can’t go below wave 1, we can use the start of wave 1 to set a stop loss just underneath the swing low.
Elliott Wave Pattern on BTC/USD including Fibonacci retracement levels
Crypto traders generally use 38.2% to 78.6% Fibonacci levels to predict the end of wave 2 and the start of wave 3. In this case, our prediction is right as the price action moves impulsively higher without correction below the start of wave 1. That’s how crypto traders catch the waves of the markets and ride them out to make the best moves. But remember, the price action must fulfill the 3 golden rules. If they don’t, the Elliot Wave pattern doesn’t apply and you’d be better off using different technical indicators like Stochastic or Exponential Moving Averages