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When you are new to the trading market and try your hand at the grand casino of stock trading, there is a good chance that you might turn back a bit poorer, but much wiser.
Lack of success in trading for a majority of trading newbies happens due to one reason - inadequacy of basic skills. The basic trading skills are luck bearers of the trading market, that will help you turn the tables in your favor.
There are a few things one must learn before stepping into the big game.
Learning to learn
Educating yourself about the financial markets with charts and price actions is important to understand the stock market trends. The financial markets are an ever-evolving arena, where the patterns of trades substantially change every passing day. Hence it is important to learn the patterns and trends to understand the stock markets and stock price movements to trade profitably.
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Using technical analysis along with fundamental analysis
Studying technical analysis is the first and basic step in trading. Good experience in reading charts and technical analysis will give you the upper hand in price prediction in the stock market. One of the classical technical analysis theories that are being prominently practiced in the market is the Elliott wave theory.
For the neophytes, here's a brief introduction to Elliott Wave Theory and its application in the stock market.
In the 1930s, Elliott Wave Theory was developed by Ralph Nelson Elliott. Ralph Nelson Elliott disapproved of the wide belief system which stated that stock markets moved in an unpredictable and chaotic manner. Instead, by constantly observing and charting the price movements, he proved that the stock market traded in repetitive patterns.
What is Elliott Wave Theory?
Elliott wave theory is a technical analysis that keeps a keen eye on recurring long-term price patterns connected with continued changes in investor sentiment and mass psychology. Ralph Nelson Elliott noticed swings in mass psychology that resulted in the same patterns, called "waves" in financial markets.
Elliott Wave Theory, much like the Dow Theory, recognized that the stock prices moved in waves. Additionally, Elliot also identified that the markets also have a fractal nature, which helped him with market analysis in great detail.
Understanding Waves and Wave Patterns of Elliott Wave Theory
Elliott understood that detailed market predictions can be made by observing the behavior of the wave patterns. The waves are classified into two:
- Impulse waves
- Corrective waves
The wave movements in the direction of the trend are called motive waves or impulse waves, whereas the wave movements in the direction opposite to the larger trend are known as the corrective waves. A corrective wave is not as clearly identifiable as an impulse wave in the chart. Sometimes corrective patterns are identified only after the pattern is completed, unlike the easily identifiable impulse wave.
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As per the Elliott wave structure, the five impulse wave: wave 1, 2, 3, 4 and 5 - together form the motive phase, comprising of the wave 1, 2, 3, 4 and 5 impulse wave. The corrective phase comprises the corrective wave a, b and c. In the Elliott wave theory of technical analysis, the trading decisions are influenced by five consecutive waves.
The direction of the movement of impulse waves or motive waves versus corrective waves is one of the fundamental Elliott wave principles. By properly learning and understanding wave patterns of the impulse waves and corrective waves, the Elliott wave theory can increase the chances of gaining good returns from stock market investments.
The ability to combine technical analysis and fundamental news is what makes Elliott Waves popular among the traders. The underlying principle of Elliott Wave Theory is that the prices move in a certain pattern over a certain period of time.
In Elliott Wave Theory, the Elliott waves can be categorized into five waves pattern. These five waves are labeled 1 to 5. One of the Elliott wave rules, states that in the three impulse waves, waves 1, 3 and 5 move in the same direction as the trend and the remaining impulsive waves 2 and 4 are price movements in the direction opposing the current trend.
The Elliott wave rules also describe 3 corrective waves in the counter-trend direction. These corrective waves are labeled as waves a, b and c. In the Elliott wave theory, the five waves in the direction of the trend are also known as the motive waves.
Three Elliott Wave Rules:
The wave analysis of Elliott wave theory states three basic rules about the Elliott waves
- Wave 2 never retraces more than 100% of wave 1
- Wave 4 never retraces more than 100% of wave 3
- Wave 3 will always travel beyond wave 1 and is never the shortest wave
The Elliott wave principle will have to abide by these strict rules in order to uphold the five-wave move.
As discussed above, the Elliott Wave Theory identifies the market as fractal in nature. Due to this fractal nature of the Elliott waves, there are 9 different wave degrees Elliott identified which are given below
- Grand Super Cycle
- Super Cycle
Let us have a look at how these fractals can help us understand the technical analysis of Elliott wave theory better. The wave degrees in Elliot Wave theory expand ever-larger and smaller than listed above due to their fractal nature.
Practicing Elliott Wave theory
For practical applicability of Elliott wave theory in everyday trading, you must identify the upward trending motive waves, and sell when the pattern completes five waves and the reversal is approaching.
While there are several methods to start an Elliott wave count, the best method is to count from where there is an extreme swing high or extreme swing low.
Practicing Elliott wave analysis along with other technical analysis tools will give you extra merit to understands the peaks and dips of the market.
The best technical analysis tools that can be used are following:
- Elliott wave with Fibonacci: Using Elliott wave along with Fibonacci, here is how you can succeed - the first secret of Elliot wave theory is that each wave cycle contains an equal number of waves as equal to the Fibonacci sequence.
- Elliott wave with RSI: Elliott wave technical analysis can also be used alongside supporting indicators, such as RSI oscillators to confirm the wave count. The most challenging part of Elliot Wave theory is to perform technical analysis to know the upcoming peak or bottom. This is where the RSI oscillators come into play.
There are two applications to Elliott wave with RSI Indicators
- It helps the Elliott wave practitioner to identify the third wave in any cycle
- The RSI will create a divergence in the fifth wave
- To determine this in real-time, you must know that if the RSI reading reaches an extreme of greater than ninety or less than ten for overbought or oversold respectively, then this indicates to the top of the third wave. When the price reaches for the final fifth wave the RSI needs to make a lower high creating a divergence. That's how we validate the accuracy of the Elliott wave count.
- Elliott wave with MACD: MACD can be combined with Elliott wave to identify the end of a corrective wave. The corrective wave consists of waves a, b and c.
Although the Elliot wave is used internationally by many traders, Elliott's wave theory practitioners also believe that just because the market is fractal does not make the future price movement predictable to trade financial markets.
A tree, according to scientists, is fractal. But you can never predict in which direction a branch might grow. Similarly, the price movement in the market is also like the branches of a tree.
Now that we understand the basics of theory the Elliott wave and, let's have a look at the trade setups and entry points.
- The idea is to trade in the same direction as the trend, attempt to catch the fifth wave. To get there, it is advisable to wait for the development of the first three waves of a five-wave Elliott wave pattern.
- Sell between 38.2% and 50% Fibonacci retracing of Wave 3. This is because we never know for sure how far the market will retrace and we don’t want to miss the move.
- Take Profit when Wave 5 is equal to Wave 1 or when we break below wave 3
The Elliott trade strategy leaves a lot of room for experimenting with new trade ideas. To be on top of your game, it is advised to take a technical analysis course to understand the market trends better before investing in it.