An Introduction to Wave Analysis

[Samirofi]

The currency markets have a reputation for being unpredictable, and as such, they can easily confuse retail novice traders, price pairs fluctuate up and down, have unexpected violent spikes, and market trends can reverse for what appears to be absolutely no reason. Traders often wonder how such movements occur and how they can identify the factors that drive them. More importantly, they wonder how they can make a consistent profit when trading in such conditions. I believe wave analysis is one of the most effective trading strategies which can answer these questions. In this article, I’ll explain the premise of wave analysis, its history and ties to technical analysis. So what is wave analysis?

Before I provide an explanation of what wave analysis actually is, it’s important to identify what causes the price of a currency pair to change. Price is influenced by a country’s long-term macro-economic data and its political environment. These factors can affect the culmulative psychology of all the participants in the currency markets. It’s important to note that one trader alone will never be able to influence the price of the market - it’s the collective average psychology which makes price action bearish, bullish or choppy. Wave analysis, also known as Elliot Wave analysis, is a trading method which allows traders to recognise and identify culmulative market psychology. The methodology is named after Ralph Nelson Elliott, who discovered that upward and downward trends of mass psychology occur in repetitive waves. History has proven this to be true, that’s why I believe wave analysis is one of the most effective trading strategies a Forex trader can master. The Elliot Wave principle

The Elliot Wave principle is the theory behind the wave analysis methodology. The wave principle suggests that market prices behave in specific patterns - known as wave patterns - which are influenced by the forecast of supply and demand.. Put simply, the sum moods of investors form a collective investor psychology or crowd psychology, which influences price movement and the patterns they repeatedly make. Traders can then use the Elliot Wave principle to analyse financial market cycles and forecast market trends, simply by identifying extremes in investor psychology along with highs and lows in prices. It’s important to recognise that wave analysis should actually be considered as a branch of technical analysis, whereby the analysis uses visual tools on price charts.

[Samirofi]

Corrective v Impulsive Waves

With the concept’s definition explained, it is time to dive into specifics of wave analysis. It comprises two types of patterns: impulse waves and corrective waves. Simply put, all price action must either be impulsive or corrective. Generally speaking, impulsive waves describe a strong move in a currency’s price, matching the overall direction of the underlying trend. This can also be true for strong downward movements in a downtrend. Corrective waves are the opposite of impulsive waves - they are currency price moves against the underlying trend. Together these waves form certain patterns, which form the basis of the Elliot Wave theory. So how can a trader use a combination of these waves to make market predictions? Well much of Ralph Nelson Elliott’s work helps us here, as certain constants have been proven to be true in the financial markets. One of the most widely accepted constants within the financial markets is that every action is followed by an equal or opposite reaction. This is an important point that traders need to keep at the forefront of their minds. When looking at the price of a currency and using wave analysis, traders can expect five impulsive waves which move in the direction of the main trend, followed by three corrective waves which are opposite to the trend. This is known as a 5 - 3 move and completes one cycle. When using wave analysis, a traders job is to connect the dots and spot these cycles in order to anticipate the next moves and identify the likelihood of the next impulse or correction unfolding. Many Forex traders are hesitant to learn wave analysis due to its seemingly complex attributes. However, as with any other aspect of life, learning a new skill takes a fair amount of dedication to apply successfully and wave analysis is no exception. The truth is that wave analysis is actually easier to implement than most traders realise - it can be likened to finding and fitting a piece to a jigsaw puzzle.

[Samirofi]

Elliott Wave Analysis: Putting the Theory into Practice

An overview of the basics

Before I proceed with that, it makes sense to briefly summarise the key points of Elliott Wave analysis, which is more commonly known as wave analysis. The strategy is technical in nature (which means traders are required to analyse price charts) and allows traders to identify cumulative market psychology in order to predict upward or downward trends in price. Wave analysis works because historical data shows that these upward and downward trends tend to occur in repetitive patterns.

These patterns come in two distinct categories on price charts: corrective waves and impulsive waves. Generally speaking, impulsive waves can be described as a strong move in a currency’s price (both increases and decreases in price) which match the recent trend direction. Corrective waves are the reverse of this; they represent distinct moves in a currency’s price which are against the underlying trend direction.

The great thing about wave analysis is that it tells us the order in which we can expect impulsive waves and corrective waves to occur. For any particular currency’s price, traders should expect five impulsive waves, followed by three corrective waves. It’s known as a 5 - 3 move and counts as one complete cycle in wave analysis. It’s also important to note that these cycles can be found at higher and lower degrees of a currency’s price movements, as the above diagram illustrates.

The job of a trader is to identify where a currency’s current price actually is within this 5 - 3 cycle at a particular degree. They can then predict the next category of wave and changes in price direction, before taking appropriate action.


Wave analysis in action

Many forex traders are hesitant to learn wave analysis due to its seemingly complex attributes. However, as with any other aspect of life, learning a new skill takes a considerable amount of time to perfect. So persistence is needed with this methodology, but it’s actually easier than most traders realise. Simply put, a trader’s goal is to identify past impulses and corrections, then based on those past combinations, judge the likelihood of the next impulse or correction unfolding.

First of all, traders need to understand the definitions of bullish, bearish, impulsive and corrective when looking at their prices charts. This is vital to the analysis.

Secondly, traders must then dissect the price action on their chart into separate price action legs, which is where the characteristics of each leg - which can be thought of as waves - can be identified. Chart A is an example of how price action is split into legs. Each ring of the same colour represents the start and end of a particular leg.

[Samirofi]

Once this is done, traders should look at the previous five to 15 legs across a time frame of their choice. The next task is to label these legs, or waves, according to their characteristics. Each leg will be labeled as one of the following: bearish impulse, bullish impulse, bearish correction, or bullish correction.

This labelling is usually done with numbers and letters, along with colour coding to keep analysis of different waves and degrees easy to follow. Corrective price action receives the letters ABC or WXY, while impulsive price action receives the numbers 12345.

In Chart B is an example of the USD/JPY, where five wave sequences are part of a higher degree five wave sequence (notice they are in different colours). Here, I was expecting a correction of price at that time back to 38.2%, or 50% for wave 4 (coloured blue), which indeed occurred as seen in Chart C.





Logically speaking, the main focus of wave analysis is labeling each leg correctly and fitting them into the cycle of wave analysis, in order to predict the next move. However, traders may notice that at any point in time, multiple wave counts could be valid and meet the requirements according to wave analysis theory. At certain times, the wave count is more distinct than others. It’s simply a case of practicing reading charts and spotting trends. Conclusion

Wave analysis provides great benefits to traders and is easier to learn than most realise. The advantages of knowing the methodology are widespread. By learning wave analysis, a trader will be to understand the market as whole, while recognising price movements more efficiently. In addition, traders will be able to identify higher probability trading opportunities, while filtering out weak trade setups.

[cochy17]

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[Noin1976]

There are two types of waves: impulse and corrective. Impulse waves move in the direction of the larger degree wave. When the larger degree wave is up, advancing waves are impulsive and declining waves are corrective. When the larger degree wave is down, impulse waves are down and corrective waves are up. Impulse waves, also called motive waves, move with the bigger trend or larger degree wave. Corrective waves move against the larger degree wave.

[Zachary Davis]

There are two types of waves: impulse and corrective. Impulse waves move in the direction of the larger degree wave. When the larger degree wave is up, advancing waves are impulsive and declining waves are corrective. When the larger degree wave is down, impulse waves are down and corrective waves are up. Impulse waves, also called motive waves, move with the bigger trend or larger degree wave. Corrective waves move against the larger degree wave.

Hello Noin; how corrective wave can go against the impulse wave? Because I see; corrective moves are like horizontal channel; never seen any against move according to the previous impulse channel! By the way, I want to learn more according to your description; so please answer me!

[FXOpen Trader]

Hello Noin; how corrective wave can go against the impulse wave? Because I see; corrective moves are like horizontal channel; never seen any against move according to the previous impulse channel! By the way, I want to learn more according to your description; so please answer me!

We can actually make use of the Wave analysis patterns in doing our trades so that the income we are going to get can be increased.

[FXOpen Trader]

We can actually make use of the Wave analysis patterns in doing our trades so that the income we are going to get can be increased.

We must be able to understand about the Chart patterns and their benefits.