At the present stage, traders are actively testing classical analysis strategies in relation to the cryptocurrency market. One of such strategies, originating from the stock and currency market, is wave analysis. Today we will briefly and informatively reveal what it is and what key points should be taken into account when using it.
Wave analysis – definition
Wave analysis is one of the oldest methods of graphical analysis of market trends. It was developed by American financier Ralph Nelson Elliott in the early twentieth century. The Elliott Wave Theory is based on the assertion that price charts are characterized by a cyclical structure. Each trend has recurring cycles that alternate with correction phases. R. Elliot’s understanding of cycles was based on psychology and a special view of the market as a confrontation between buyers and sellers. Increase and change of trends characterizes emotions connected with FOMO effect, expectations and disappointments of market participants concerning this or that forecast of price movement.
Impulse and correction are the basic concepts of the wave theory. Impulse is a sharp upward or downward movement of the chart, and correction is a cessation of movement in accordance with the trend, a short-term price reversal to accumulate the strength of buyers and sellers. To correctly determine the development of the trend use charts of older timeframes, which allow you to see the global situation in the market.
Ralph Elliot’s 5 waves
Graphical analysis of cryptocurrencies, based on the Elliott Wave Theory, determines the presence of 5 major waves that characterize the development of the trend and three ABC models that accompany the corrective price movement.
The main five waves:
- The first one is an impulse wave, forming the beginning of the trend development. It is defined by the beginning of an intense struggle between bulls and bears with the predominance of one of the sides;
- The second wave is a corrective one, which closes slightly above or at the level of the lower boundary of the first wave (in case of a bullish trend). This is where trend traders lock in profits;
- The third is an impulse wave, which continues the support of the trend and is often characterized by a longer length compared to the first one;
- The fourth one is corrective, characterized by less resistance to the trend. At this stage, those market players who predicted too early the stopping of the trend or the beginning of a sideways movement exit the deals;
- The fifth is the last impulse wave, which completes the cycle of trend development, after which the correction phase begins.
ABC wave models
ABC models define the end of the cycle and the corrective movement of the price chart. Latin letters A, B and C denote three waves accompanying this movement.
There are three main wave models, according to which the corrective movement develops:
- Zigzag – waves A, B and C are built in a jumping structure of irregular shape. The second wave B is the shortest and may be less than half the length of waves A and B.
- Range – represents three equal wavelengths of A, B, and C, evenly spaced horizontally. -Triangle – a structure in which three waves taper to a single point. It is believed that an impulsive upward or downward price movement can be predicted after it.
Pros and cons of R. Elliot’s wave theory
The advantages include:
- Simplicity of predicting the continuation of the trend after identifying the third wave in the 5-wave structure.
- Applicability of the theory for graphical analysis on any timeframes.
- Allows predicting price behavior over long timeframes, from the third wave to the end of the formation of the corrective ABC-model.
Criticism of the theory:
- Subjectivity of the method due to the fact that in technical analysis on the chart some traders can see the development of the trend, while others can see its completion.
- Failure to take into account the probability of small false waves in chart analysis, which lead to incorrect interpretation of the whole price movement pattern developing on the chart.