How to trade Elliott Wave in crypto markets
Elliott Wave Theory was developed in the 1930s by Ralph Nelson Elliott, a US-based accountant and analyst. After spending years analysing stock market data, he wrote a book titled “The Wave Principle”, in which he describes the concept of stock market trading in repetitive patterns. The same principles seen in stock market, largely apply to crypto trading as well.
The patterns Elliot Wave noticed were primarily influenced by investors' psychology. More specifically, swings in price action are impacted by the collective psychology and as a result, they are translated in the same repetitive patterns, titled waves. So, by correctly identifying prior waves, a crypto trader can predict where the price will go (or not go) next.
Structure of Elliot Wave
Elliott identifies two different types of waves: Impulsive and corrective. An impulsive wave goes in the same direction as the overall trend and is comprised of five waves. As seen in the image below, waves 1 - 3 - 5 are trend-supporting, while 2 and 4 are corrections within this particular trend.
The psychologically-related 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 us 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. 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 corrective wave, 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 i.e. from 1-minute to a yearly chart.
Trading Elliott Wave Pattern in crypto markets
Before we show a specific example to demonstrate how to incorporate the Elliott Wave formation in your daily crypto trading plan, we must outline the three golden rules of this pattern.
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 of lesser importance and they can be broken.
As seen in the 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.
Our example fulfils all three conditions of the three golden rules guidelines. 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, traders and analysts use the Fibonacci retracement to identify where waves 2 and 4 (corrections) may finish to allow the next move higher to start.
For this reason, below you see the same chart but this time with Fibonacci retracement levels included. The wave 2 is finished, closed to 78.6% Fibonacci retracement level. Since wave 2 can never go, in this case, below wave 1, we may use the start of wave 1 to set a stop loss just underneath the swing low.
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.
Summary of trading Elliot Wave
- Elliott Wave Theory believes that swings in price action are impacted by the collective psychology and as a result, the price moves in the same repetitive patterns, titled waves.
- An impulsive wave goes in the same direction as the overall trend and is constructed by five waves.
- A corrective wave, also known as the ABC pattern, comes as a correction of the 5-wave pattern. It is structured as a 3-wave counter trend pattern.
- Together, these two create a 5-3 pattern
- The three golden rules of the Elliott Wave pattern must be valid at all times.