Elliott Wave Theory predicts prices in all sorts of markets, allowing investors to adjust their trading strategies based on historical trends.

## What is Elliott Wave Theory?

Elliott Wave Theory is a price prediction model established by the accountant Ralph Nelson Elliott in 1934. The model is based on a common pattern Elliott discovered while studying the history of stock market price patterns.

What Elliott found was that price movements moved in up-and-down waves, broken up into groups of five and then three. The first set of five waves results in an overall positive trend, broken down as follows:

- Wave one: Wave goes up, setting a new trend (wave one, along with three and five, are also known as impulse waves).
- Wave two: Wave goes down, correcting against the trend (waves two and four are also known as corrective waves).
- Wave three: Wave goes up with the trend, higher than before.
- Wave four: Wave goes down, correcting against the trend set by wave three.
- Wave five: Wave goes up, reaching a new peak.

The price movement will peak at the end of this set of five wave counts and begin to drop, leading to an overall negative trend. According to Elliott Wave Theory, the movement will drop in a set of three waves:

- Wave one: Wave goes down, correcting against the trend.
- Wave two: Wave goes up a bit, retracing some of what was lost.
- Wave three: Wave goes down, correcting against the trend.

From here, Elliott claims the eight-wave principle will repeat, leading back into five waves, converging into three waves and so on. Also, according to Elliott Wave Theory, the second set of waves will never drop below the lowest point of the initial five waves. As a result, this theory states that barring any unforeseen price shifts, such as a rug pull, the price will continue to rise on a long-term basis.

Elliott argues that these market cycles can be seen across various time frames — that the eight-wave theory applies in a 15-minute trading period to an hour-long period, to a week-long, and so on.

## How to use Elliott Wave Theory while trading in crypto

When using Elliott Wave Theory to trade in the cryptocurrency market, it’s important to note that the patterns may initially be difficult to see. They are rarely a perfect portrayal of Elliott’s theory. However, Elliott has a few rules in place to help visualize trading patterns.

- Note that wave two will
*never*retrace all of wave one’s gains. - Wave three will almost always be higher than wave one and should never be the shortest of waves one, three and five.
- Wave four should be lower or equal to wave one, as that would mean it retraced all of wave one’s gains.

Considering these rules, investors can confidently approach a crypto trading chart. That said, here’s how the theory can be applied through visuals:

- Detect whether or not the primary trend is made up of bullish waves or bearish waves.
- Label the waves to visualize the patterns.
- Utilize other trading indicators, such as the relative strength index (RSI), alongside the Elliott Wave Oscillator — a built-in wave-reading tool for most charts.
- Please note that waves can last for days, weeks or even years. The length of these waves is known as wave degrees.

The above chart provides an Elliott Wave analysis of Bitcoin’s price movement from October 2022 to April 2023. It suggests that Bitcoin experienced a significant bullish trend from December 2022 to April 2023.

However, the divergence and momentum reversal indicators, along with the irregular correction in wave 4, raise caution for traders. These signals might indicate a potential weakening or reversal of the bullish trend. Moreover, please be aware that Elliott Wave Theory is a subjective form of technical analysis, and interpretations can vary.

## What sort of trader activity fuels wave trends?

Trading is often fueled by emotion rather than logic. While logic can apply somewhat, emotion is a vital factor in wave analysis.

Also, it’s impossible to predict all of the reasons behind trader activity. Elliott applied trader emotion and sentiment to his theory, which can be broken down by wave:

- Wave one: Investors believe in the project, putting money in and causing the price to rise.
- Wave two: Earlier investors see this rise and sell for profit, but more recent investors believe this is a simple correction.
- Wave three: This price is still higher than it was at wave one and opportunists jump in. This may cause a positive news cycle, bringing in even more investors.
- Wave four: Similar to wave two, some investors cash out. However, this doesn’t deter other investors as they’ve seen this activity before.
- Wave five: As wave four is still higher than wave three’s lowest point, fear of missing out (FOMO) sets in, and more investors get involved.

As the wave peaks, the corrective waves come into play:

- Wave one: The wave peaks, scaring investors and leading to a sell-off.
- Wave two: Some traders hold on, believing this isn’t the end and hoping it was a small correction.
- Wave three: The majority of traders sell. Others begin to panic sell, and the wave drops sharply.

Many psychological factors play into this activity — there are even some tools to track these factors, such as the Crypto Greed and Fear Index. The Greed and Fear Index calculates trader sentiment through the volume of search phrases, surveys, an asset’s market dominance, social media discussion and recent volatility, among other factors. For example, many searches for Bitcoin (BTC) demonstrate greed, while recent volatility demonstrates fear.

Traders often follow the herd mentality as well. If they see others discuss buying, they’re typically optimistic, and other traders are likely to follow suit. The same mentality applies to fear and selling.

## Applying the Fibonacci ratios to Elliott Wave Theory when crypto trading

Combining the Elliott Wave Theory with Fibonacci ratios is common in crypto market forecasting. While manually applying the Elliott Wave Theory is a fine way to trade, one can combine the theory with the Fibonacci ratios for increased technical analysis.

### Fibonacci ratios

Advanced traders often combine Elliott Wave Theory with Fibonacci ratios. Fibonacci ratios derive from the Fibonacci sequence — a sequence in which one number is always the sum of the two numbers preceding it — and are commonly used in trend identification.

Common Fibonacci ratios in crypto trading are 23.6%, 38.2%, 50%, 61.8% and 100%, though there are extensions of 161.8%, 261.8%, and 423.6%. Applying these ratios to the Elliott Wave Theory uptrends works like this:

- Wave one: Bitcoin rises from $70,000 to $75,000.
- Wave two: Bitcoin drops from $75,000 to $72,000 — dropping about 61.8% of wave one’s increase, as 61.8% of wave one’s $5,000 rise is $3,090.
- Wave three: When applying the Elliott Wave Theory, one should expect wave three to be longer than wave one. Combining that thought process with the common Fibonacci ratios, wave three is often 100% to 161.8% higher than wave one. Taking the 61.8% of wave one’s $5,000 increase, $3,090, and adding it to 100% of the initial rise, $5,000, one may expect up to an $8,090 increase for wave three — 161.8% more than wave one’s rise. From wave two’s $72,000, this would mean wave three peaks around $80,090.

- Wave four: Wave four typically corrects 23.6% to 38.2%
- Wave five: Finally, wave five is often a 61.8% to 100% match on wave one’s gains of $5,000, meaning one may expect a $3,090 to $5,000 increase from wave four’s results. Based on wave four’s $76,999, one might witness a result of $81,999.

## Risks associated with utilizing Elliott Wave Theory in crypto

Elliott Wave Theory is a useful tool for understanding market dynamics and possible price moves in the cryptocurrency market, but some risks should be taken into consideration while using it. These risks include:

### Subjectivity in wave counting

The subjective nature of wave counting is one of the main concerns with Elliott Wave Theory. Divergent interpretations of wave patterns by traders could result in disparate analysis and trading choices. This subjectivity may create ambiguity and raise the possibility of inaccurate forecasts.

### Complexity and learning curve

Elliott Wave Theory requires a thorough grasp of technical analysis concepts, market psychology and wave patterns. Because of the theory’s intricacy and challenging learning curve, inexperienced traders can find it difficult to incorporate it into their crypto trading tactics. Improper implementation or misinterpretation of Elliott wave principles can lead to loss potential and imprecise market analysis or forecasts.

### Confirmation bias and overreliance

When using Elliott Wave Theory, traders may succumb to confirmation bias, using market data to support predetermined wave counts instead of evaluating price moves objectively. Making decisions based solely on Elliott wave analysis might be skewed and raise trading risks. Other technical indicators and fundamental aspects should also be taken into account.

### Vulnerability to market volatility

Elliott Wave Theory may find it difficult to explain the abrupt and sharp price swings that are typical of the cryptocurrency market, even if its goal is to find patterns within market cycles. It might be difficult to predict price trends effectively when there is high volatility since it can disrupt the typical wave patterns. Traders need to be on the lookout for quick changes in the market and adjust their strategy accordingly.

### Limited predictive accuracy

Elliott Wave Theory provides a methodical way to examine market cycles, but it cannot ensure precise forecasts of future price changes. Elliott wave projections may not always match the market dynamics due to various reasons, such as macroeconomic events, investor mood and regulatory developments. Elliott wave analysis should be used cautiously by traders and should not only be a standalone tool in their toolbox.