Before we begin our discussion on how to trade 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.
Elliott believed the market was much less “chaotic” than many traders assumed. 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.
Our team at Trading Strategy Guides adopted the Elliott Wave strategy. This is because it offers us good Elliott Wave entry points. This ultimately leads to superior risk to reward ratio.
The Elliott wave strategy is similar to a trend following strategy. Similar to the MACD Trend Following Strategy - Simple to Learn Trading Strategy. Or another popular strategy, How to Profit from Trading Pullbacks.
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.
Let’s get a little bit deeper into how to trade Elliott Wave and how we can make profits trading.
Impulsive Waves vs Corrective Ways
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.
- Elliott Wave theory will require looking for a pattern of five consecutive waves before making a trading decision.
Impulsive waves and corrective waves are perfect opposites. However, the trading theories that make them useful remain unchanged. The impulse moves versus correction are one of the basic underlying principles of market structure. And understanding market structure – besides the obvious support and resistance (levels).
We will now explore how you can use impulsive and corrective waves in order to increase the probability of earning strong returns. Also, read the hidden secrets of moving average.
Learning How to Trade Elliott Wave
One reason Elliot Wave is so popular is because 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, read the guide on how to trade using the best Wolfe Wave Strategy.
The basic principle of the Elliot Wave Theory is that over a certain period of time, prices move in certain patterns.
R.N. Elliott found out that any trend movement can be broken down into a five-wave sequence. He labeled these waves 1 through 5. One of the Elliott Wave strategy rules is that the waves 1, 3 and 5 often formed in the direction of the trend. Waves 2 and 4 are price movement against the prevailing trend.
Next, Elliott Wave observed this after a 5 wave move in the direction of the prevailing trend. There is a corrective 3 wave movement in the counter-trend direction labeled A, B, and C.
In Elliott Wave theory, the 5 wave moves in the direction of the trend. It is also called motive waves, while the 3 waves corrective move against the 5 wave move is also called corrective waves.
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. This shows that we have waves within waves.
This means 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 is simply confirming the fractal nature of markets theory.
Let’s lay down some of the rules of the Elliott Wave strategy. It can assist us in determining to find 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 5 wave move. The three basic rules.
- Wave 2 never retraces more than 100% of Wave 1. Typically, the retracement is between 50% and 61.8% of wave 1.
- Wave 4 never retraces more than 100% of wave 3. Typically, declines between 38.2% and 50% of wave 3.
- Wave 3 always travels beyond the end of wave 1 and it’s never the shortest one; Wave 3 will normally extend 161.8 x wave 1.
Our favorite way to play the Elliott Wave strategy is to let the first 4 wave movement unfold. Then you have to find good Elliott Wave entry points near the end of wave 4. This is in an attempt to catch the last wave of the entire 5 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 3 is the longest wave, then wave 5 will roughly equal wave 1.
- Wave 2 and Wave 4 will alternate. If wave 2 is a sharp correction, wave 4 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 wave 4 low point.
Now, that we have a good grasp of the basic Elliott Wave principle, let’s define some Elliott Wave entry points employed 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 pure price action strategy.
Step #1 Wait until you can spot at least a 3 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 wave 5.
So, in order to find our Elliott Wave entry points, we need to let the market tip his hands off. We will wait to develop the first 3 waves of a five Elliott Wave pattern.
We must verify that each wave complies with the Elliott Wave strategy rules, in order to confirm the validity of our Elliott Wave count. In the figure above, we’ve spotted a bearish Elliott wave count. The wave count complies with the Elliott Wave strategy rules, which means we’re looking for a sell setup.
Now, it’s the 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 3.
One of the Elliott wave rules states that, ideally, wave 4 should retrace between 38.2% and 50% Fibonacci retracement of wave 3. 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 much 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 retrace a little bit above the 50% retracement. Since the market is never a perfect place where rules are respected to the pip, there will always be small variations. The Elliott Wave strategy is no exception from the rule.
Now that we have established our Elliott Wave entry points, we now need to establish where to place our protective stop loss.
Step #3 Place the Protective Stop Loss few pips above the Wave 1 Ending Point
In the section, “How to trade Elliott Wave” we highlight the importance of wave 4. We never enter into the wave 1 territory. In this regard, it’s smart to place our stop loss exactly where the Elliott Wave pattern will be invalidated.
In the above figure, we highlighted the ideal place to hide your protective stop loss. This is in 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 5 is equal to Wave 1 or when we break below wave 3
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 have a firm understanding how to trade Elliott Wave you can develop many Elliott Wave 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. The only way you can do this is 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. In the figure below, you can see an actual BUY trade example, using a bullish Elliott Wave sequence.
Above chart was constructed by using Elliott Wave strategy Step #1.
Above chart was constructed using Elliott Wave strategy Step #2 through Step #4.
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 Elliott Wave and ultimately it all comes down to your experience and how good you’re in 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 into Harmonic pattern trading that can be found here: Make Money with Harmonic Bat Pattern Strategy.
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