Wave analysis is nothing else but the "wave theory" of Ralph Nelson Elliott. The basic of this theory is an assumption that the psychology of social behavior may be represented in the form of models.
Elliott used stock market as an input data. He noticed that the trajectory of the price movement shows some structured picture of the balance between supply and demand. On the basis of this, Elliott founded a unique method of market analysis with the possibility of using it on the Forex currency market. He identified more than ten graphical models of the price movement which he later called "waves" hence the name "wave analysis" occurred.
The Principles of the Wave Analysis
The main principal of "wave analysis" says that the asset price movement consists of 5 waves after which the whole model is changed by another one which consists of 3 waves moving in the opposite direction.
Waves indicated by the figures were dubbed "cardinal" by Elliott and later they were called "impulse", as for the waves indicated by the characters they were dubbed corrective waves or "triples". Wave "2" is a corrective wave to the impulse wave "1", accordingly wave "4" is a correction to the wave "3". a-b-c is a correction to the whole sequence of the model 1-2-3-4-5. On the bigger time interval the whole sequence 1-2-3-4-5 forms one wave of the interval and creates impulse waves "1","3" or "5". Accordingly, the sequence a-b-c forms the corrective waves "2" and "4" of the bigger time interval.
The Rules of the Wave Analysis
- The amplitude of the wave "2" can not be more than the one of the first waves and it can not break its start point;
- The wave "3" can not be the smallest in the amplitude but it can be not the longest one;
- The wave "4" can not break the top of the first wave.
The price movement against the current direction is called correction. In the wave analysis these are "corrective waves". Elliott formulated the main rule for such movements which says that corrective waves can not be five wave models unlike to the impulsive waves. Therefore, five-wave price movement against the wave of the bigger time interval can not be completed correction, but only the part of it.
Corrective models of the price movement may look differently. It can be both sharp jerk against the existing trend and a long time, stretched price movement.
All other models of the price behavior and also their rotation and the place of their appearance derive from the Elliott's basic model and include a lot of various combinations.
Wave analysis is quite powerful instrument which helps to make good profit by working on the financial markets such as Forex. But it is not so easy. The main disadvantage of the theory is that you need to spend a lot of time getting invaluable experience and adjusting the common trading strategy for yourself in order to apply it in real trading successfully and to make a decent profit.
This method of analyzing the price movement is usually the hardest to learn by the newbies. That's why if you want to use wave theory as the basics for your trading strategy be ready to work hard for a long period of time. As a result you will get a comprehensive understanding of the current situation on the market, you will begin to understand the logic of the price movement and will constantly increase your deposit with the passage of time.