The Elliott Wave Theory is a stock market theory that is based on the notion that markets even though stock markets move in more or less random and chaotic patterns, do move in repetitive waves. This theory was developed by Ralph Nelson Elliot in the 1930s. Before we identify how we can use this to trade, we have to understand the theory behind this strategy.
How are Elliott Waves formed?
Investor psychology dictates how financial assets are priced, based on fear and greed. This is how these waves are originally formed. Mass swings in investor psychology form periods of greed and those of fear. What Elliot noticed was that markets actually moved in those patterns and in fractals. Meaning no matter what portion of the market you take on what time frame it will have a wave trend within the overall wave trend. In the first wave of the theory, you are expected to see a whole Elliot wave sequence form and so on. Elliot took the Dow theory one step further from its original “wave” understanding with the use of market fractals. Being able to break down those initial waves into smaller waves and patterns that would repeat. This study is a technical analysis based. Which would soon help investors and traders predict future market movements after having identified the waves and fractals? This is another step of market structure and price action analysis.
How to predict markets based on Elliott Wave Theory Patterns?
The theory is relatively simple to understand there are two main waves that we have to first identify. The impulsive wave in the direction of the larger trend and the corrective wave which travels in the opposite direction of both the impulse and the larger trend. Each encompasses 5 fives within each pattern. Just like market structure and price action we use the Elliott Wave Theory to identify inner market fractals to expect moves in the direction of the trend or the potential reversal of the trend.
What is the Elliott Wave Theory?
The interpretation of the Theory is two-fold as we said, the impulse move and the corrective move, the 5-3 pattern creates the Elliott Wave Theory. 5 waves in the direction of the trend, the impulse, and 3 waves of corrections.
The 8-waves are usually depicted in numerical order for the first impulse move higher; 1,2,3,4,5 and the second wave, the correction is depicted in letters; a,b,c.
When you break down each wave you’ll notice it’s fractal. With the larger wave, you will find more waves that dictate the price movement. In the corrective wave, you have 3-waves of movement, 2 in the direction of the main correction (a & c), and one against the correction or in the direction of the larger trend ( b).
Notice in the Nasdaq image below, we have the Elliott Wave pattern, the key thing to notice here is that the waves are not 100% systematic, rather they are fractals and you can see the wave movement within each larger wave. The key understanding here is to identify the time frame that you want to watch markets in.
The wave theory presents the small corrective waves within the first large impulse (2,4) these are less probable trades and should be used to find entries for the overall upside move. There is more profitability in the impulse wave to the upside. The corrective waves are the “pullbacks” for the overall directional move. The reason we watch the impulse and corrective waves is to watch price action and market structure and understand when the market is changing direction. At the top of the impulse (5), we do expect a pullback or corrective move (a) but then we expect that move to continue through a higher in (5), that is typically when the trend exhausts that is why there are 5 original waves in the direction of the trend. Instead, we get a lower high (b).
Elliott Wave Theory Measuring Moves.
Understanding how to measure moves in this theory is a key aspect of its success. Knowing how far you can expect a corrective move limits the guesswork of buying a pullback in the overall impulse.
Based on the 5-wave impulsive pattern, wave one is the first impulse, wave 2 the first correction, wave three the extended impulse, wave 4 the second corrective or pullback, and wave 5 the final impulse. The second wave is typically measured at a 60% pullback of the first wave impulse.
After the corrective move of wave 2, we expect to see the largest impulse move of the whole pattern, wave 3. Then wave 4 is usually a 30-40% pullback of wave 3. Then you get the extent of wave 5. Now, these pullbacks are not 100% accurate in measurement that every time you get the first impulse wave you’re going to pull back 60% but it’s an average of what has been seen in market data. A trader could use Fibonacci retracements to better identify the pullback level and where it may start. Other tools like pure market structure can be used to understand where the fractal highs are for the pullback. Using rotations to confirm market movement stalling and finally, order flow can all help you understand how deep the pullback may actually be.
Elliott Wave Theory Trading Strategy.
The Elliott Wave Theory can be used in many different trading strategies, but the key to using it effectively is being able to notice the Elliott Wave pattern forming before it ends.
The strategy explained here is a breakout strategy at the start of the Elliott Wave pattern. Remember the largest opportunity in this pattern is the continuation of the trend in the overall impulse move. Meaning waves 1-5. Mainly the impulse waves higher, so wave 1,3,5. Ideally, you can identify waves 1 and 2’s formation so you can take advantage of the longest wave higher, wave 3.
Take the example below. It’s an example of the Nasdaq futures market. The trading strategy works best in the direction of the trend. When you identify the market structure of the move you can identify the Elliott Wave Pattern easily. In this example, we’ve identified the first two waves in the upside direction. If we manage to break through the resistance levels where wave 2 started and the prior resistance from the market we can catch a good long opportunity for the 3rd wave to the upside. The breakout trade is a little riskier because there is little certainty that it will break and continue to the upside. That is why we want to enter the above resistance because that confirms the break.
When the break occurs above the level you will be triggered into the trade on a buy stop run for wave 3 that should extend longer than wave 1. Notice in the image above the extended move from wave 3, it gives you a lot of opportunity for profit. The idea being if you have multiple lots or contracts on is taking some off along the way, especially at the beginning of wave 4 or the pullback before wave 5. Ideally, you are catching wave 5 too if you last the pullback without getting stopped. The stop of the entry should be under wave 2.
Now that you have the knowledge of the Elliott Wave pattern, and a trading strategy, practice the pattern! Identify the moves and develop a trading plan around it. If you want to learn more about equity futures like Nasdaq and day trading based on price action, check out TRADEPRO Academy’s Elite Course (Click the button below).
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.