Elliott Wave Theory is a method of market analysis, based on the idea that the market forms the same types of patterns on a smaller time frame (lesser degree) that it does on a longer timeframe (higher degree). It claims that crowd behaviour or mass psychology produces wave patterns and trends.
The Fibonacci ratio is mathematical formulas expressed as a ratio, the ratio is stated as 0%, 23.6%, 38. 2%, 50%, 61.8%,78.6% and 100%. The ratios play an important role in predicting the price movement as the behaviour prior trend is likely to reduce and retract to one of the ratios. The Fibonacci ratios can be used often with other technical analysis as RSI, moving average, and others.
Using Elliot Waves with Fibonacci Retracement levels.
The EW theory is a strict follower of, “What goes up, must come down, thus Elliot wave theory dictates that price patterns are divided into Impulsive/Motive waves and corrective waves.
A motive wave is a price movement that initiates progress in one direction, which is called a trend. Prices usually move faster and cover more distance when the market is trending. The Motive phase is subdivided into 5 impulsive waves, which move with the trend.
Guidelines to use Elliot wave and Fibonacci retracement:-
- The best entry point is ideally at the start of 1st wave but unfortunately, these waves are hard to spot and can be deceptive as they usually come after a period of consolidation. Therefore, it is recommended that entry should be taken from the start at the bottom of the 2nd and 4th wave as these waves are comparatively easy to spot. Entries should never be near the top of the third or fifth wave as these are swing high levels.
- Wave 3 mostly has the highest volume but if the volume in wave 5 is as high as wave 3, we can further expect an extended wave 5. If wave 5 is extended, then it often finishes at the 161.8% extension relative to the magnitude of wave 1 through to 3.
- If wave 2 retraces more than 78.6% of wave 1, the idea that it really is a wave 2 becomes more doubtful and if wave 4 retraces more than 50% of wave 3, it is most likely that it is not a wave 4.
- If wave 3 is extended, it will likely to overshoot the trend channel, but wave 4 often ends at the level of sub-wave 4 of 3 and is mostly retraces 23.6% to 38.2% of wave 3.
The most favorable exit is at the end of the third corrective wave but again these waves can also be hard to spot and also wave C can retrace more than 61.8% of the overall motive waves, which will impact the overall PnL of trade. Therefore, to have a safe and profitable exit, always look for consolidation that breaks outside of the final corrective wave trendline, meaning when wave C breaks out of its consolidation range.
Corrective waves can come in many shapes:-
- Zigzag combination– Zigzags can take many shapes and sizes. One of the features that can help distinguish an A-B-C zigzag from a potential 1-2-3 impulse is that wave A and B will be much more overlapping. Waves A and C of a correction tend towards equality (same size 100%). The next most common ratios are C = 61.8% of wave A. Wave B usually retrace between 38.2% to 78.6% of wave A.
- Flat combination– Wave C is usually 100% – 161.8% of Wave A in size, but it is possible that it becomes as big as 261.8% on rare occasions due to some negative news. Expanding flat patterns occur most commonly as compared to the regular flat combination.
To put things into perspective, let’s take an example of YFIUSDT.
The first wave started with a consolidation phase and since it’s very difficult to spot the first wave, therefore we will try to take entry at the low of wave 2 and wave 4.Now, suppose, we took entry at the low of wave 2, then to manage our risk and reward ratio, we will try to minimize our stop loss level, therefore, our stop loss level will be placed at the low of wave 1 and our ideal target should be at the high of wave 5, but spotting this level can be hard, therefore either we will place our target level at the high of third or we will place our target at the high of wave B. Since, spotting the top or bottom can be a tough task, therefore we will try to use Fibonacci levels for finding minor and major supports and resistances.