The Ultimate Guide to Mastering the Elliott Wave Principle
Every new trader is looking hard to find the best strategy to beat the market.
In this guide, we will explain how to use advanced trading techniques in order to master the use of the Elliott Wave Theory.
What is the Elliott Wave Theory?
Ralph Nelson Elliott was an accountant responsible for developing the Elliott Wave Principle in the 1930s.
Prior to Elliott’s theorem, most analysts believed that the market moved in a random, unpredictable way. Elliott, however, was able to discern that the market often moved in specific, repetitive and – most importantly – identifiable patterns.
In this article, you will learn about Elliott’s theory in-depth, and how you can apply it to your trading setups.
Fundamental Rules to Master
It’s important that we start with the basics first and move on to more advanced techniques once you have a grasp of the fundamentals.
The idea is that after studying this guide your trading skills will be enhanced even if you decide the Elliott Wave is not the perfect theory for you or your trading setups.
At its most basic level, Elliott’s theory is that the market always moves in a series of waves. An overarching impulsive wave moves the price in the direction of the main trend-line, while a corrective wave moves against it.
In the case of an uptrend, the impulsive wave is made up of five waves that pushes the price higher.
In a period of a downtrend the opposite occurs; the impulsive wave is made up of five waves that push the price lower.
After every impulsive wave, the Elliott Theory posits that there should also be a rebound that corrects the impulsive phase, which is known as a corrective wave. The corrective wave is made up of three individual waves.
Elliott’s hypothesis is that every price move in any given market can be labelled with an impulse phase, formed by five impulsive waves and a corrective phase, characterised by three corrective waves.
The major trend of a Bullish Cycle is upwards.
The impulse wave thus consists of five individual waves, three of which (1, 3 and 5) move with the direction of the main trend and two of which (2 and 4) move against it.
After the impulse phase, a corrective wave consisting of three individual waves then emerges. Two of the corrective waves move against the main trend (a and c), whilst one moves with the direction of the main trend (b).
Generally, the second impulse wave (2) will resemble a zigzag, whilst the fourth (4) resembles a triangle. However, any correction against the main trend (2, 4 or b) can be a triangle, flat, zigzag or a combination of the three.
In a Bearish Cycle, the opposite occurs. The impulse wave moves downward while the corrective wave pushes the trend back up.
2. Golden Rules
Elliott created three “golden rules” to help an analyst validate whether the Wave Principle is present:
Elliott created three “golden rules” to help an analyst validate whether the Wave Principle is present:
- Wave 2 cannot retrace more than 100% of Wave 1;
- Wave 3 should not be the shortest, but does not necessarily need to be the longest; and
- Wave 4 cannot enter the zone of Wave 1.
If one of those three golden rules is not satisfied, then stop trying to apply the Elliott Wave Principle to a trend and search for another one.
If you intend to utilise the Elliott Wave Principle in your trading then it is essential to memorise those rules and apply them ad nauseum. Once you do, you’ll soon find yourself noticing that all (or at least most) charts come in waves of five and three.
Additionally, the Elliott Wave principle is something that can be applied to a wide variety of charts you will see in your life.
3. Fibonacci Sequences
If you are an active trader, there’s no doubt you should already be aware of at least the basics of Fibonacci ratios. However, what you may not know is how to use them in Elliott Wave Principle.
Fibonacci ratios help traders to set targets and stop losses, but with regard to the Elliott Wave principle, they also help us identify at which level each wave will retrace and extend.
The most commonly used of Fibonacci’s ratios is 1.618. So, why is that?
The Italian mathematician Leonardo Fibonacci was the first to discover that the relationship of 1.618 is found in a startling number of situations in nature. For example, if you take the length from the top of your head to the end of your finger, this represents 61.8% of the whole length of your body. Or, if you divide the female bees by the male bees in any given hive, you’ll find that the answer 1.618
Fibonacci’s discovery also applies to the financial market. If an asset’s price was in an uptrend and a rebound occurs, it is reasonable to expect that the rebound will form 61.8% of the main trend.
The most common retracement trends for a wave (as per Elliott Wave Principle) are as follows:
- The most common retracement for Wave 2 is 50% of the level of Wave 1. However, you’ll often see Wave 2 retrace 61.8% of Wave 1.
- Wave 4 typically retraces about 38.2% of Wave 3. The next most likely retracement of Wave 4 is 50% of Wave 3.
- Wave B usually retraces either 61.8% or 50% of Wave A.
The most common extension trends for a wave (as per Elliott Wave Principle) are as follows:
- Wave 3 will generally extend 161.8% of Wave 1.
- Wave 5 should ideally represent either 38.2% or 61.8% of the length from Wave 0 to Wave 3.
- Wave B retraces between 50 to 61.8% of Wave A in the form of a zigzag. In case of a flat, there’s a chance it retrace to the beginning of Wave A.
4. The Personality of the Waves
This last section is more important than all of the above because forming the ability to identify each wave’s personality will allow you to apply Elliott’s Principle like a master trader.
How to differentiate between Wave 3 and Wave 5?
Very simply, Wave 5 is nowhere near as sharp as Wave 3. You’ll also notice that there is a significant amount of volume in Wave 3, whilst in Wave 5 the momentum starts to decrease and divergences are noticed.
Another indication pointing towards Wave 5 is that the volume is still increasing but the price is moving at a slower pace.
What’s the Difference Between Wave 2 and Wave 4?
The simplest way to differentiate between Wave 2 and Wave 4 is that they tend to alternate; if Wave 2 is a simple correction then you would expect to see a complex rebound in Wave 4.
Usually, Wave 2 resembles a zig-zag shape, whilst Wave 4 is a combination of a zig-zag, a flat or even a triangle.
The Structure of the Corrective Wave (A-B-C)
If Wave B did not retrace deeply towards the beginning of Wave A, it’s reasonable to expect a sharp movement in Wave C. However, if Wave B retraces to the top of Wave A then it is reasonable to expect Wave C to reach 138.2% of Wave A.
If Wave B surpasses the top of Wave A then there will be sharp movement in Wave C.
Elliott believed that the market moves according to the collective psychology of the investors. He recognised that the market does not move in a chaotic, disordered way and was able to identify many repetitive patterns that showed up during many periods.
Many analysts argue that the price behaves or reacts according to news and events. Elliott did not believe in this theory. To the contrary, he noted that the news and events follow the patterns that he discovered. Many people criticised this aspect of his theory, but it is evident once you begin using the Elliott Principle that he certainly has a valid argument.
With the fundamentals established, it is now appropriate to delve deeper into the Elliot Waves Principle by providing you with some common mistakes to avoid.
Mistakes to Avoid
The Elliott Waves Principle is a tough strategy to wrap your head around and there are many mistakes you can fall into while using it to trade.
Firstly, there are some waves that is preferable to avoid entirely. The behaviour (a.k.a. at what point they will end) of Waves 2, 4, A and B is extremely hard to predict. It is usually advisable to stay out of the market until these waves have already formed.
Secondly, if you are planning to “long” an asset is generally advisable to avoid Wave C, as it is generally characterised by a steep decline in the asset’s price.
Examples of EWP in Practice
Here’s how the Elliott Wave Principle might be applied to a real-life scenario.
We can use the Elliott Wave Principle to make a brief analysis of this chart.
You can see that Wave 2 retraces 61.8% of the upward movement made by Wave 1. Wave 3 then travels 161.8% of Wave 1 – take note of how steep Wave 3’s upward movement is.
Wave 4 then makes a slight retracement of Wave 3, not a deep one like Wave 2. Also, note that there is an alternation here between Wave 2 and 4; Wave 2 is a zig-zag correction while Wave 4 is flat.
Wave 5 then represents 100% from the beginning of Wave 1 to the end of Wave 3, however, the slope of Wave 5 is nowhere near as steep as Wave 3.
At the end of an impulsive wave, we should then expect a corrective wave with A-B-C structure. In this case, there is a zigzag movement after Wave 5, beginning with Wave A and followed by an upward movement in Wave B which retraces 61.8% of Wave A.
To finish the corrective wave, Wave C unfolds with five waves downward that have an equal length to Wave A. Look out for the sharp decline in Wave C!
There are many different levels to which a wave can retrace and extend. If you are interested in more detail, feel free to visit this website:
How to Trade EWP
There are many ways to trade using the Elliott Wave Principle, however, we will show what we believe are the most effective ways to use it in your favour.
Some analysts prefer to trade at the point of Wave 3, while others choose to trade Wave C. We will teach you what we have learned the hard way.
The best method we have found is to wait for the entirety of the cycle to be complete and then trade on the new cycle that inevitably emerges afterwards. The chart above shows how a whole cycle can be completed within a 15-minute period.
The idea is to find the main direction of the trend and trade along with it – never against it.
On the 30-minute chart above you can see what happens after the initial cycle completes; another cycle emerges which continues trending downward along the direction of the main trend.
Tricks to Master
To finish this article, it is appropriate that we should give you some tricks about how to excel when trading forex using the Elliott Wave Principle.
Firstly, our major point of advice is not to force the counting of waves. If you are finding it too difficult to count the waves then don’t persist and try to find a pattern that isn’t there; jump across to another currency and see if you have any better luck there.
The financial market will give you opportunities every day. Stay patient.
Secondly, don’t just rely on Fibonacci sequences when trying to identify an Elliott Wave cycle. Focus more on the personality of each wave; find the alteration between Wave 2 and Wave 4; look at the slope of each wave to work out which wave you are on.
Thirdly, and particularly if you are a beginner, don’t ever try to trade against the trend. Follow the famous quote and act always as if “the trend is your friend”. Moving averages, MACD, Price Volume and stochastic are all fantastic tools to combine with the Elliott Wave Principle, but if you remember the trend is your friend you’ll always be alright.
Finally, at first, you might find you have difficulty understanding this principle and even applying it. What we recommend you do is to take your time to learn about it.
The time and effort invested in learning this theory is worth it, speaking from experience.