Our team at Trading Strategy Guides adopted the Elliott Wave strategy. This is because it offers us good Elliott Wave entry points, which ultimately leads to a superior risk-to-reward ratio.
Even though the Elliott Wave strategy is a trend-following strategy, we can spot Elliott Wave entry points on the lower time frames. This is because this theory can be applied to all time frames and to all markets. So, in essence, it is a universal trading strategy.
Table of Contents
How Was the Elliott Wave Theory Discovered?
Before we begin our discussion on how to trade the Elliott Wave, let’s learn how the Elliott Wave theory was discovered. You will learn why the Elliott Wave strategy is so popular today. In 1930, Ralph Nelson Elliott set out to learn about the stock market after experiencing losses in the 1929 stock market crash.
Elliott’s discoveries were impressive. After careful study of the markets, he began to notice some repeatable patterns. He believed the market was much less “chaotic” than many traders assumed. Also, he described some of the patterns he observed as different types of waves.
He noticed that the market was trading in a series of three and five waves. Elliott believed his specific waves could offer more detail and predictability than almost any other strategy. This is why we call it an Elliott Wave strategy today.
Let’s get a little bit deeper into how to trade Elliott Wave and how we can make profits trading.
What Is Elliott Wave Theory: Impulsive Vs. Corrective Waves
The Elliott Wave theory will require looking for a pattern of five consecutive waves before making a trading decision. Elliott Wave theory begins by identifying two different types of waves.
- Impulsive waves move in the same direction as the overall trend and are trend-supportive.
- Corrective waves, on the contrary, move against the overall trend. These waves occur in a series of five.
This theory will require looking for a pattern of five consecutive waves before making a trading decision.
Impulsive waves and corrective waves are two opposite wave types used in trading theories. These waves are based on the basic market structure principles, including support and resistance levels.
Understanding market structure is crucial in distinguishing between impulse moves and corrections. It can help traders make informed decisions when trading.
We will now explore how you can use impulsive and corrective waves to increase the probability of earning strong returns. Also, feel free to read the hidden secrets of moving average.
Learning How to Trade the Elliott Wave
One reason the Elliott Wave is so popular is that it combines technical and fundamental news. The theory is based on the cyclical pattern of market events.
Even if there is a disastrous recession, sooner or later, the existing conditions should revert back to how they were before the recession. Also, feel free to read the guide on how to trade using the best Wolfe Wave strategy.
The basic principle of the Elliott Wave theory is that over a certain period of time, prices move in certain patterns.
R.N. Elliott found out that any trending movement can be broken down into a five-wave sequence. He labeled these waves one through five. One of the Elliott Wave strategy rules is that waves one, three, and five often form in the direction of the trend. Waves two and four are price movements against the prevailing trend.
Next, the Elliott Wave was observed after a five-wave move in the direction of the prevailing trend. There is a corrective three-wave movement in the counter-trend direction labeled A, B, and C.
In Elliott Wave theory, the five waves move in the direction of the trend. It is also called a motive wave, while the three-wave corrective move against the five-wave move is also called a corrective wave.
This is quite useful because we can now break any price trend movement into this basic 5–3 wave pattern. Each impulsive and corrective move is a series of waves oscillating up and down. Moreover, this shows that we have waves within waves.
What this means is that a five-wave sequence in a one-time frame might be simply the first wave in a longer time frame. In other words, this simply confirms the fractal nature of market theory.
Let’s lay down some of the rules of the Elliott Wave strategy. It can assist us in determining and finding good Elliott Waves entry points.
Elliott Wave Strategy Rules
The Elliott Wave strategy needs to satisfy and abide by some strict rules in order to validate the five-wave move. The three basic rules are:
- Wave two never retraces more than 100% of wave one. Typically, the retracement is between 50% and 61.8% of wave one.
- Wave four never retraces more than 100% of wave three. Typically, declines between 38.2% and 50% of wave three.
- Wave three always travels beyond the end of wave one, and it’s never the shortest one. Also, wave three will normally extend 161.8 x wave one.
Our favorite way to play the Elliott Wave strategy is to let the first four wave movements unfold. Then, you have to find good Elliott Wave entry points near the end of wave four . This is in an attempt to catch the last wave of the entire five Elliott wave sequence.
Before we define how to trade Elliott Wave, it’s important to highlight other key, important Elliott Wave strategy guidelines.
If wave three is the longest, then wave five will roughly equal wave one.
Wave two and wave four will alternate. If wave two is a sharp correction, wave four is a flat correction, and vice versa.
After a five Elliott Wave sequence is completed, the ABC corrective waves usually end in the vicinity of the wave four low point.
How Does the Elliott Wave Work?
The Elliott Wave theory is similar to the Dow theory in the sense that both market theories describe the idea that up and down prices are influenced by crowd psychology. However, the Elliott Wave and Dow theory also differ because the trend is broken down in far greater detail in the Elliott Wave analysis.
Elliot found that the swing in mass psychology can show up on a price chart in the form of repetitive waves. This is an important concept in the Elliott Wave forecast.
Due to the fractal nature of these waves, Elliott identified nine different wave degrees:
- Grand Super Cycle
- Super Cycle
Here is how fractals can help us better understand the Elliott Wave analysis. According to Elliott, the price on your chart, the cloud formations, your neural system, and the coastline all have something in common.
Can you guess it?
If your answer is: “They all have never-ending patterns.” You’re right! These never-ending patterns are known as fractals.
The perfect example of a fractal is the shape of broccoli. Moreover, the whole trunk has the same design as one of its branches. If you cut one branch, you’re left with a smaller version of the entire broccoli.
So, in the same way, broccoli displays its fractal nature, the price on your chart displays different wave degrees.
Suppose you really want to master the Elliott Wave. In that case, we recommend getting your hands on the best Elliott Wave trading book: Elliott Wave Principle: A Key to Market Behavior by Robert R Prechter.
Many new and seasoned traders have difficulty determining where to begin the Elliott Wave count. We’ve got many messages like this from our avid readers: “I want to start counting Elliott Wave like a boss.” Well, if this is you, keep reading to understand how to begin the count.
Where to Start the Elliott Wave Count?
There are different methods traders can use to start an Elliott Wave count. However, the best method to start an Elliott Wave count is to begin at an extreme swing high or an extreme swing low.
Here’s an example:
Now, if you start your Elliott Wave count at the high, you’re basically identifying the movement to the downside. Conversely, if you start the count at the low, you identify the movement to the upside.
However, if you want to find the Elliott Wave cycles of a higher degree, you need to start counting the waves from the weekly and monthly charts.
According to the Elliott Wave principles, you need to start your EW count from the end of the previous impulsive wave.
Another challenge Elliott Wave practitioners face is that the wave count can be subjective. In this regard, you should never use Elliott Wave analysis on its own merits. However, use additional technical tools as an extra confluence.
The top three technical tools to support your Elliott Wave analysis are:
- Elliott waves with Fibonacci.
- Elliott waves with RSI.
- Elliott waves with MACD.
Let’s briefly break down how to use each of these tools work.
Elliott Wave and Fibonacci Retracement Strategy PDF
You can enhance your Elliott Wave count with Fibonacci. The first secret of Elliott’s wave theory is that within each wave cycle, there is an equal number of waves similar to Fibonacci numbers.
See figure below:
Now, let’s go one step forward and see what the relationship is between the Elliott Wave and Fibonacci retracement and extension levels:
- If wave one is extended, wave three is 61.8% – 78.6% Fibonacci extension relative to the size of wave one.
- If wave one is extended, waves two and four will usually retrace between 23.6% – 38.2% Fibonacci retracement.
- If wave three is extended, wave one and wave five are equal in length, or the 61.8% relationship is most likely next.
- If wave three is extended, wave four retraces between 23.6% – 38.2% Fibonacci retracement levels.
- If wave four is extending more than 50% of wave three, it’s not wave four.
- If wave one and wave three are equal, wave five is extended.
- If wave five is extended, then it finishes at 161.8% Fibonacci extension relative to the magnitude of wave one through to wave three.
Next, let us show you another beautiful example: you can use the Elliott Wave analysis alongside supporting indicators.
Elliott Wave and RSI
The RSI oscillator can be used with the Elliott Wave strategy to confirm the wave count.
First, let’s remember that the Relative Strength Index (RSI) was developed to measure the current strength or weakness of the trend.
I suppose you already understand how RSI divergence works? If so, that’s perfect because we will apply that when we put together the Elliott Wave and RSI.
The most challenging part of the Elliott Wave analysis is to know when to expect the final peak or bottom.Here is where the RSI comes into play. The Elliott Wave with RSI indicator has two applications:
- It helps EW practitioners better identify wave 3 in any cycle.
- The RSI will create a divergence in wave 5.
You might wonder, “How do you determine this in real time?”
Suppose the RSI reaches extreme overbought/oversold readings greater than 90 (smaller than 10). In that case, this must correspond to the top of the third wave. When the price reaches the final fifth wave, the RSI needs to make a lower high, creating a divergence.
This is how you know whether or not your Elliott Wave count is right or wrong.
Here is an example:
Next, we’ll go over how to use Elliott Wave and MACD together.
Elliott Wave with MACD
The MACD can be used in the same way we use the RSI indicator. Namely, it can identify the end of the third and the end of the fifth waves. However, we would like to combine the Elliott Wave and MACD to determine the end of corrective waves.
Here is an example of how the MACD can help us detect the end of a correction.
In the EUR/USD chart above, we highlighted a typical ABC correction.
With the help of the MACD indicator, we can see that although wave C dropped below wave A, the momentum reading on the MACD for wave C was above the level of wave A. The MACD divergence was an early signal that the price was about to reverse.
Now that we have a good grasp of the basic Elliott Wave principle, let’s define some entry points used by our team at Trading Strategy Guides.
Note: The good thing about the Elliott Wave strategy is that it doesn’t require any technical indicator as it’s a pure price action strategy.
Elliott Wave Strategy: A Step-by-Step Guide to Deciphering Market Cycles
The Elliott Wave strategy harnesses the predictive power of market patterns, offering traders a robust framework for navigating trends. By meticulously analyzing wave sequences, this strategy equips you to make informed decisions, optimizing both entry and exit points.
Step #1: Wait until You Can Spot at Least a Third Wave Elliott Wave Sequence.
Since we always advocate trading in the direction of the trend, as explained above, we’re only attempting to catch the last fifth wave.
So, to find our Elliott Wave entry points, we need to let the market tip its hands off. We will wait to develop the first third wave of a five-electronic wave pattern.
We must verify that each wave complies with the Elliott Wave strategy rules to confirm the validity of our wave count. In the figure above, we’ve spotted a bearish Elliott Wave count. The wave count complies with the Elliott Wave strategy rules, so we’re looking for a sell setup.
Now, it’s time to look after our Elliott Wave entry points, which brings us to the next step.
Step #2: Sell Between 38.2% and 50% Fibonacci Retracement of Wave Three.
One of the Elliott Wave rules states that, ideally, wave four should retrace between 38.2% and 50% Fibonacci retracement of wave three. Our Elliott Wave entry points are at 38.2%. This is because we never know for sure how far the market will retrace, and we don’t want to miss the move.
We’re pretty sure that with experience, you can fine-tune your Elliott Wave entry points and get even better entries. You can also find other great trading strategies on our blog.
Now, we can note that wave four retraces slightly above the 50% retracement. Since the market is never a perfect place where rules are respected to the pip, there will always be slight variations. The Elliott Wave strategy is no exception to the rule.
Now that we have established our Elliott Wave entry points, we need to specify where to place our protective stop loss.
Step #3: Place the Protective Stop Loss Few Pips above the Wave One Ending Point.
In the previous sections, we highlighted the importance of wave four. We never enter into wave one territory. In this regard, placing our stop loss exactly where the Elliott Wave pattern will be invalidated is a smart move.
Furthermore, the above figure highlights the ideal place to hide your protective stop loss. This is in the case of an Elliott Wave bearish sequence.
The next logical thing we need to establish for the Elliott Wave strategy is where to take profits. Let’s discover how to use this strategy in a bull market.
Step #4: Take Profit When Wave Five Is Equal to Wave One or When We Break below Wave Three
The Elliott Wave strategy is all about experimenting with new trade ideas. We encourage you to find your own set of rules because once you understand how to trade the Elliott Wave, you can develop many strategies around it.
In this regard, we don’t have a set-in-stone take-profit strategy. This is because the Elliott Wave strategy looks to maximize profits. You can only do this through flexibility because no two Elliott Wave structures are the same.
Note: The above was an example of a SELL trade. Use the same rules, but in reverse, for a BUY trade. The figure below shows an actual BUY trade example using a bullish Elliott Wave sequence.
The above chart was constructed by using Elliott Wave strategy step #1.
The above chart was constructed using Elliott Wave strategy step #2 through step #4.
Final Words about the Elliott Wave Trading Strategy Guide
Billionaire hedge fund manager Paul Tudor Jones is well-known for being an Elliott Wave practitioner. If the 120th richest person on the Forbes 400 list is using the Elliott Wave strategy, you should not be the fool who ignores it.
The Elliott Wave analysis has stood the test of time. If you’re just getting your feet wet in the trading business, this is definitely a good starting point if you want to build a fortune.
There are many different strategies on how to trade the Elliott Wave, and ultimately, it all comes down to your experience and how good you are at identifying Elliott Wave entry points.
Elliott’s strategies have frequently been compared to some of his contemporaries, such as Charles H. Dow and various others.
However, Elliott also believed that his specific waves could offer more detail and predictability than almost any other strategy.
Last but not least, you can check out our latest lesson on Harmonic pattern trading, which can be found here: Make money with Harmonic bat pattern strategy.
Thank you for reading! Please leave a comment below if you have any questions about this strategy!
Elliott Wave Forecast FAQ
Who Is Elliott Wave?
Ralph Nelson Elliott was a professional accountant born in 1871 who developed what is known today as the Elliott Wave theory. The Elliott Wave principle by Ralph Nelson Elliott reveals in detail his theory about market behavior and how prices in any market move in specific patterns.
Is Elliott Wave reliable?
Yes. The Elliott Wave analysis is a reliable form of technical analysis. At the foundation of the Elliott Wave theory, there are two cornerstones: the fractal nature of all markets and the fact that all significant changes in the price direction are a result of investor’s psychology.
Is the Elliott Wave Theory Accurate?
Yes! The Elliott Wave analysis is highly accurate as it provides a precise market sentiment analysis. However, just like with any form of technical analysis, it is subjective and relies on your trading experience to read the price action accurately.
Is the Elliott Wave Useful?
Yes! The Elliott Wave analysis is useful to pinpoint at what price and at what point in time a trend has the potential to change direction. Elliott Wave is the only form of technical analysis that gives traders a complete view of price behavior.
Why Does the Elliott Wave Work?
The Elliott Wave works based on crowd behavior and investor psychology. All prices in any market are governed by investor psychology, which is why the Elliott Wave principles worked in the past, are working today, and will continue working in the future.
Which Time Frame Is Best for the Elliott Wave?
The daily chart is the best time frame for using the Elliott Wave analysis. However, due to the fractal nature of markets, we can apply the Elliott Wave principles across any time frame and get an excellent idea of what the market will do this day, week, or month.
How to Trade Elliott Wave YouTube Video
How to Trade Elliott Wave Info-graphic Download
We are sorry that this post was not useful for you!
Let us improve this post!
Tell us how we can improve this post?