Elliott waves are a notoriously difficult indicator to use but is very precise and effective. In this guide, we’ll give an overview of how to use Elliott waves to trade cryptocurrency.
Why Should I Learn About Elliot Waves?
The main reason why you will want to learn how to use Elliott waves is that it is the best indicator of where you are in the market’s movement from up to down and back up again.
As an analysis of the market’s underlying structure, the Elliott wave is related to the fractal. Any movements between two consecutive fractals in opposite directions is considered an Elliott wave.
Elliott waves are named after Ralph Nelson Elliott, who searched for repeating patterns that would allow him to identify tops and bottoms.
Elliott found that the market usually moves in a sequence and displays a basic rhythm of five waves, which are then corrected by a three wave movement in the opposite direction. The five waves are termed impulse waves, while the following three wave movement are known as corrective waves.
The five wave pattern are known as impulse waves, and each wave has particular characteristics, which we detail below:
1. Wave 1 is a change-in-trend movement. To identify wave 1, look for the internal wave count, as Elliott waves are fractal in nature, where wave 1 will comprise 5 smaller waves. To identify the end of a wave, we can look for a fractal to form and a squat in the Market Facilitation Index (which means volume is rising but price moves are shrinking, suggesting either buyers or sellers will soon triumph).
2. Once the first wave has finished, we expect a second wave in the opposite direction, created by new buying (or selling). Wave 2 targets can be generated by Fibonacci levels and internal wave counts. Most wave 2 counts end between the 38 percent and 62 percent retracement levels of wave 1. It is important to target the end of wave 2 accurately, as the greatest potential for profits are produced by wave 3, which moves the fastest out of the five waves and generally moves the largest distance.
3. As mentioned above, wave 2 gives the greatest profit opportunities. One way to identify wave 3 is to look at its slope, since wave 3’s are steeper than a wave 1 (sometimes they are near-vertical). Wave 3 is also accompanied by heavy volume. The best targets for the length of wave 3 are between 1 and 1.62 times the length of wave 1. It is very rare for wave 3 to be shorter than wave 1, and sometimes it may be more than 1.62 times the length of wave 1.
4. Wave 4 is driven by profit taking rather than new buying/selling (unlike wave 2). As a result, the retracement percentages for wave 4 are quite different to wave 2. Wave 4 corrections tend to last longer but do not retrace as much as compared to wave 2. In wave 4, you should observe a drop in volume, volatility, and momentum indicators. The most likely target is between 38 percent and 50 percent of wave 3. One hard rule is that wave 4 never goes below the top of wave 1. We can also use the internal wave count to figure out when wave 4 is starting or ending.
5. Wave 5 represents the last struggle of traders to create a new high (or low). It is not as enthusiastic or euphoric as wave 3 and as a result, the slope of wave 5 is not as steep. One way to estimate the end of wave 5 is to measure the difference in price between the start of wave 1 and end of wave 3. Add this measurement to the bottom of wave 4. Also, take 62 percent of the length of the difference between the start of wave 1 and end of wave 3 and add that to the bottom of wave 4 as well. Most of the time, wave 5 will end between these two values. However, it can occur that wave 5 never breaks the high (or low) of wave 3.
The diagram below shows a generalised version of the five-wave pattern. Each wave can be broken down into internal waves, as shown be the 5-3-5-3-5 pattern, and broken down further into even smaller waves (as the 21-13-21-13-21 pattern). The wave patterns shown below start with an uptrend, but they can also start with a downward movement.
The three cardinal rules of impulse waves are as follows:
- Wave 3 can never be the shortest impulse wave
- Wave 2 can never go beyond the start of wave 1
- Wave 4 will never cross the price area of wave 1
If any of these rules are broken, you will have to re-assess your wave counts.
A 3-wave corrective pattern follows a 5-wave pattern. These corrective patterns can be classified as simple or complex, where simple refers to zig-zag patterns and complex refers to everything else. The 3-wave corrective pattern is known as the a-b-c wave.
The b wave always contains 3 waves, while the c wave always contains 5 waves. The a wave may contain either 3 or 5 waves. It the a wave contains 5 waves then the correction will be of the zig-zag type. If the a-wave contains just 3 waves, it is more likely to be flat, irregular or a triangle correction.
In a simple correction, the b wave correction does not usually retrace more than 62 percent of wave a. If wave b ends between 50 and 62 percent of wave a, look for a fractal and a squat to establish an entry for trading wave c.
For complex corrections, there are three types: flat correction, irregular correction an triangle correction. A flat correction is where each wave is almost identical whereas an irregular correction is where wave b exceeds the high of the last impulse wave. Triangle corrections are five-wave patterns labelled a-b-c-d-e and usually occur in wave 4 or wave b. When triangles occur with wave b, the price tends to break out in the opposite direction to wave a.
Trading with Elliott Waves
An example of how to use Elliott Waves to trade BTC-USD is shown below. We’ve added fractals and the MFIndex_LB custom indicator on TradingView (which is the Market Facilitation Index created by ‘LazyBear’) to help identify impulse waves.
Notice at the beginning of the chart, bitcoin is in a downtrend. As mentioned above, the first wave of a 5-wave movement is a change-in trend movement, and we see bitcoin bouncing from lows to reach higher highs after a down fractal has formed.
Remember, any movement between two fractals in opposite directions is an Elliott wave, which is the case for wave 1 below. Since we are using a 4-hour chart, we could look at lower timeframes to identify the 5-wave structure within wave 1.
Once the down and up fractals have been observed, we know that wave 1 has been completed and we can draw a Fibonacci retracement on this wave to find an entry for wave 2.
As mentioned above, wave 2 normally start between 38 and 62 percent retracement of wave 1. As the chart below shows, the wave 2 retraced more than expected, but we would have got our buy orders filled if we had set limit orders at the 38 and 62 percent retracement levels at $7,452.41 and $7,415.59. The wave 2 ended up bouncing off the 76.4 percent retracement at $7,392.82.
We also see that the end of wave 2 also produced a squat using the Market Facilitation Index (MFI), telling us the market is getting ready to jump and establish a trend. Notice that at the end of wave 2, the MFI is pink (the dot below the candle).
Now we would have been in a long position as wave 3 unravelled. The wave 3 however exceeded all targets as we would expect wave 3 to end around the 1.618 or 2.618 Fibonacci extension levels at $7,608.41 and $7,764.41 above. The price continued to rise and we could have switched to a lower timeframe (e.g., the hourly chart) to try and count the internal waves of this wave 3. Also, we could look for a fractal to form and a squat from the MFI to determine when wave 3 ends.
As shown below, the hourly chart shows a fractal resistance formed at the top and there is a squat in the MFI, as indicated by the pink dot under the last candle of wave 3. Generally, we should look for a squat in one of the three topmost bars (or bottom bars in a downward move).
Once wave 3 is over, we should have exited the long position and/or entered a short position. Wave 4 is driven by profit taking and usually targets the 38 and 50 percent Fibonacci retracement levels. As shown below, wave 4 did indeed end near the 50% retracement level at $8,871.57. We also obtained a squat from the MFI suggesting that wave 4 is coming to an end.
Notice that the slope of wave 5 is considerably smaller than the slope of wave 3. We would expect the end of wave 5 to be anywhere between $10,750 and $11,888, since the start of wave 1 to the end of wave 3 is 2,994 and added to the bottom of wave 4 gives $11,888 while 62 percent of 2,994 added to the bottom of wave 4 gives $10,750.
However, the price only managed to reach $9,950 before being cut short. As mentioned previously, wave 5 may not break the high of wave 3.
After the 5 impulsive waves, we see three corrective waves clearly on the chart (a, b, and c). Once the price changes direction and enters wave a, we can draw the Fibonacci retracement levels over wave a to find an entry for wave b.
As previously mentioned, the corrective wave b will not retrace more than 62 percent of wave a. As the chart above illustrates, wave b retraced to the 50% Fibonacci level at $9,563.92 and provided an entry signal to go short. Moreover, the high point of wave b was also a squat, providing further confirmation that wave b has ended. Therefore, we would enter a short around $9,563.92 and should have had limit sell orders ready at $9,655 as well. These sell orders should target the end of wave c, which should be as long as wave a or head towards the 1.618 extension level.
As shown above wave c does extend beyond wave a but does not reach the 1.618 extension level. We could have used the 100% retracement level at $9,177.84 as an initial target with $8,700.65 serving as another target. As wave c unfolds, we could also switch to a lower timeframe to try and count the internal waves. Once we observe the fifth internal wave of wave c, we should get ready to exit the short position as the trend is likely to be corrected.
As the example above shows, Elliott waves can be quite subjective and there are only a few hard rules that allow you to identify what wave the market is currently in.
A useful technique is to look for Elliott waves using price movements where there are two, opposite fractals. You can then use the characteristics of each wave described above to try and identify what stage the market is at.
Also, using Fibonacci retracement tools are also helpful in identifying Elliott waves, since particular waves tend to display certain characteristics, e.g., the wave 3 generally extends to the 1.618 or 2.618 Fibonacci extension levels of wave 1 and wave 2 will generally bounce off of a Fibonacci level of wave 1. Identifying wave 3 is the most important goal with Elliott waves, as wave 3 is the fastest and most profitable move.
While Elliott waves can be very accurate, they also require a lot of patience, as signals may not be given that often or the wave the market is currently in may be ambiguous.