How to Trade the Elliott Wave Principle

Few pleasures match the exhilaration of following a Wave Principle forecast that has you in at a market's peak and out just before it crashes. Yet, identifying these patterns requires a clear understanding of the Wave Principle's rules and relationships.

Ralph Nelson Elliott discovered that financial price trends always follow a similar structure. He identified thirteen "waves," or patterns of directional movement, that repeat in markets.

The Elliott Wave Principle

In the 1930s an American accountant named Ralph Nelson Elliott studied market volatility and concluded that certain patterns tend to repeat themselves over time. Until then investors considered price fluctuations to be random events.

Elliott discovered that the upward and downward swings in prices caused by collective psychology always showed up in the same recognizable forms. He called these forms waves and believed that if one could correctly identify them, they would have predictive value.

Using the wave principle, Elliott created a set of rules for interpreting markets and made it possible to determine the timing of market moves from minutes and hours to years and decades. Elliott also tied these patterns to the Fibonacci ratio, a mathematical phenomenon that has been recognized for millennia as one of nature's ubiquitous laws of form and progress.

Since he died in 1948, many other market technicians have continued to apply and refine the Wave Principle. In particular, Hamilton Bolton popularized the Wave Principle through a series of annual supplements of market commentary, and Robert Prechter wrote the standard text on wave analysis, Elliott Wave Principle Key to Market Behavior. 

This book rescued the Wave Principle from obscurity, and today it is used by thousands of institutional portfolio managers, traders and private investors. Traders use the wave interpretation rules and Fibonacci relationships to forecast when trends will turn and where they may end so that they can take advantage of investment opportunities.

The Elliott Wave Cycle

Elliott’s theory is that financial markets move in repetitive patterns that can be forecast. He isolated thirteen “waves,” or patterns of directional movement, and described how they link together to form five- and three-wave patterns at higher and lower degrees of trend. These larger-degree patterns, in turn, become the building blocks of other patterns of a similar nature.

In the most basic form of the Elliott wave structure, market progress takes the shape of an impulse wave followed by two corrective waves. The impulsive wave is a series of five sub-waves, while the corrective waves are each made up of three sub-waves. 

The pattern reflects the fact that market participants changed their psychology during trading periods, shifting from pessimism to optimism and back again. These changes are reflected in the market’s price movements.

When the corrective waves in a set are complete, they will typically overlap with the preceding impulse wave. If the corrective wave C does not break above the high of Wave A, it will be classified as a false signal and the market is likely to continue in the direction of the previous trend.

The application of Elliott wave analysis can help traders identify the beginning of a new sequence and predict its direction. However, it is not a standalone analytical tool and should be used in conjunction with other indicators. 

The Elliott Wave Principle identifies patterns of directional movement that are recurring in markets. It categorizes waves into two groups: impulsive and corrective. 

The Elliott Wave Impulsive Cycle

Traders can use the Elliott Wave Principle to predict market trends and identify potential buying or selling opportunities. Elliott developed a set of rules that allow investors to recognise and confirm the occurrence of these patterns.

The general model that Elliott identified consists of five-wave sequences, or "impulsive waves," that are followed by three-wave sequences, or "corrective waves." Typically, an impulsive wave is composed of five sub-waves and moves in the same direction as the trend of the next larger wave. 

Conversely, a corrective wave is composed of three sub-waves and moves against the trend of the next larger wave. This basic pattern builds to form five and three-wave structures of an ever-growing size.

Elliott observed that financial markets largely respond to swings in human psychology. These swings are reflected in price movements that can be traced in the form of a wave-count, or motive wave.

To correctly interpret the Elliott Wave Principle, it is important to understand the basics of wave counting. An impulsive wave is usually composed of a series of five waves that resemble a lightning bolt and move in the direction of the trend. Likewise, a correction is often composed of a series of three waves that resemble a triangle.

The Elliott Wave Corrective Cycle

In his work, Elliott isolated thirteen patterns of directional movement that occur regularly in financial markets. He outlined their structure, named them, and illustrated them on chart timeframes. 

He also described how these patterns link together to form larger versions of the same patterns at different chart timeframes. He also noted that these patterns exhibit self-similarity, meaning that a pattern at one level is the same as a pattern at a higher level.

The first three waves of an impulse pattern are often very complex, as they may contain a double or triple zigzag. This complexity is often diminished in the fourth wave, which is usually a flat or triangle. 

Flat corrections retrace less of the preceding impulse wave than do zigzags, and they tend to occur near the end of the trend. Triangles are found in upward trends and comprise five wave segments that move in a converging pattern.

When a fourth wave is corrective, it usually retraces no more than 38.2% of wave 3. However, sometimes the retracement is shallow and barely reaches this mark. This can be confusing, especially if the trend appears to have reversed and then resumed. 

Alternatively, the fourth wave may have an extension, which entails a greater length than a normal zigzag or a triangle. Rich Swannell, in his book Elite Trader Secrets, notes that a fourth extension occurs only 61.8% of the time and that the pattern is most likely a zigzag if it extends beyond the peak of the third wave of the same degree.

Final thoughts 

The Elliott Wave Principle offers a fascinating lens through which to view market behaviour, illustrating how human psychology drives financial markets in predictable patterns.

For traders looking to navigate the complexities of market trends, the Elliott Wave Principle stands as a testament to the enduring patterns of market psychology and its impact on financial markets. 

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