By Richard K.
Introduction: Trading Using Elliott Wave Theory
The Elliott wave principle was developed by Ralph Nelson Elliott and is used as a form of technical analysis that practitioners use to determine financial market cycles and trend forecasting.
His theory proposed that market prices unfold in repeatable patterns or “waves”, as most traders familiar with his work today call it, and that these patterns are a result of investor psychology and other collective factors.
Elliott wave theory (EWT) can, however, be very subjective in nature and when trading using Elliott wave theory most traders will agree that any two analysts that apply these methods very seldom come to the same conclusion when analyzing the same market. As we have discussed before, all technical indicators have their limitations.
EWT however is a very powerful technique when used in combination with other analysis tools and this article will show you a way to use EWT with such tools in an attempt to clear up the subjectivity that plagues traders who tried using the Elliott wave principle before.
The Basics of Trading Elliott Wave Theory
EWT applied to a trend
The chart above is for illustration purposes only and like I mentioned before, many other practitioners of EWT might disagree with the way I labelled my waves on this chart.
When EWT is applied to a trending market then a trends full cycle (depending on the time frame you are looking at) will unfold in 5 waves before a change in trend or a correction of a larger degree follows. Trends follow a sequence of impulsive waves followed by corrective waves and are labelled 1 – 5.
There are 3 basic rules that one can follow when labeling a trend correctly:
- Wave 3 should never be the shortest of the impulse waves.
- Wave 2 should never go beyond the starting point of Wave 1.
- Wave 4 should never move into the same price area as Wave1.
EWT applied to a correction
Corrective waves within a trend will primarily unfold in 3 waves and they are in turn labeled a-b-c but EWT goes even further by classifying corrections into 4 types of patterns:
- ZigZag corrections
- Flat corrections
- Triangle corrections
- Combination corrections
Although these are the 4 types that exist within EWT, they in turn have different variations of each type which makes it a difficult subject to study and get right on its own. It is my opinion that correctly labeling a trend is more difficult than labeling a correction, especially when you consider that trends can go on for ages therefore making it difficult to forecast where they may end.
I have spent years trying to label trends properly and I have found that as soon as I thought a trend came to an end in a 5th wave that I either tried to trade counter-trend or not trade at all because I feared the trend was over, just to be proven wrong when the trend resumed and in most cases without me. Having trading discipline, rather than relying on our instincts, can help make this a bit less of a “guessing game.”
Never assume that a trend is over because it can and will most likely go further than you thought it would.
It is not the purpose of this article to dissect and identify each and every corrective pattern that EWT lists but what I will show you next is how I use my knowledge of corrective patterns in combination with other techniques to forecast and pinpoint the end of these corrections with a high degree of accuracy.
Trading Using Elliott Wave Theory
When I trade I only try to do one thing:
Find the end of corrections and enter a position when the main trend resumes again.
This way I always try to trade with the trend and not against it but to do this properly I need a strategy that works in a systematic fashion to assist me with this task.
My strategy was developed to perform the following steps:
- Determine trend direction or warn me when a trend might end.
- Find areas where a correction is most likely to appear.
- Identify the type of correction as it’s happening.
- Use additional technical analysis methods to determine where the trend may end.
- Enter positions using a set of entry condition rules when I think the trend is about to resume.
Step 1: Determine Trend
This is perhaps the easiest step in my strategy and it requires the use of trend lines to determine trend or a change in trend. The chart above is that of the EUR/USD on a 4 hour time frame and it is the largest time frame I use. The blue upward sloping trend lines on the Euro clearly shows that a strong uptrend is in place.
Drawing trend lines like I have is a very simple visual way to determine the trend, as long as you keep updating them to fit the current price action. Knowing that the trend is up will only allow me to take long positions and never any counter-trend trades.
Step 2: Find Areas Where a Correction May Occur
Step 2 requires that I find areas where a correction is most likely to occur and a good way to do this is to use your Fibonacci extension tool and connect it to previous major swings within the same trend. Knowing that the trend is so strong I used three important swings, after a major correction (red box), to connect my Fib extension tool to. This projected extension ratios above the price that acted as resistance as price made its way upwards.
It is at these levels that I expect corrections to appear which I would like to trade when they end and the trend resumes again. Note how the green arrows show where corrections developed after hitting those Fib extensions.
Step 3: Identify the Type of Correction
A correction was confirmed when price made a lower high (could be considered an equal high) and price broke lower than the previous low (blue horizontal line).
Once I had that correction confirmed I switched my time frame to a 30-minute chart to have a closer look at price action and knowing that most corrections follow a 3 wave structure I needed to label my correction as A-B-C.
The fact that the lower high/equal high ended in line with the high that preceded it, provided me with clues as to which correction might follow. In this case that correction was typical of an Expanded Flat correction.
Note that the chart image was drawn after the fact for the purpose of this article but as you will see in the next step, I was following this correction in real-time allowing me to plan ahead.
Step 4: Use Market Geometry to Find the End of the Correction
The chart above shows how I used additional methods to help me find the end of these type of corrections. On it I used a pitchfork and I have found over the years that they work great at finding the end of these corrective patterns.
Going into great detail about how pitchforks work and how to draw them properly is an entire subject on its own, but all you need to know for now is that they can be used to project the future path that price is most likely to follow and offer an analyst areas where price can find support or resistance.
The blue lines of the pitchfork are called median lines and the red lines are called warning lines. Corrections tend to end at these lines if you know how to draw them properly and I expected this correction to do the same.
Step 5: Entering Low Risk Trades
The last step in the process is to actually enter a trade with as little risk as possible and to do that I use an even smaller time frame. I like using the 5 minute chart, with a MACD histogram applied on it to hunt for my setups.
The MACD histogram only serves one purpose which is to spot a slowing of momentum as price reaches the price zone I want to trade from. When price keeps moving downwards, as in our example, but the MACD histogram starts moving in the opposite direction then we have what is called momentum divergence. This is one of my entry conditions that I follow together with a set of others that I reveal to students of my course.
When all of my entry conditions appear on my entry chart they give me the green flag to take a trade. Below was the details I shared with members to assist them with trade entry, stop loss placement and target orders.
Potential Entry, Stop, Take Profit Price
Potential entry: Long in the 1.2210 – 1.2230 price zone
Stop loss: IF we do get a legitimate setup consider putting your stop around the 1.2200 level while adhering to proper risk management.
Profit target: around the 1.2500 price level
By following my detailed instructions above it was possible to enter a buy order and place a stop loss once that order got filled.
My target orders are generally placed around levels close to where the correction started from and depending on the exact price that traders opened their orders the result of this successful trade shows that there was profit potential of more than 10:1 on this trade!
Those who were present at that exact low would have made a 14:1 return on their investment and these are the sort of trades that is possible with this strategy.
Trading is a game of probabilities and to stack the odds in your favor you need a strategy that can effectively achieve the goals you developed it for. My goal is to find the end of corrections and trade with the main trend while taking on very little risk.
Note that I did not even bother with using EWT to label the waves of the main trend, but I only used it to help me identify what type of correction I was dealing with. Rather than breaking my head about how to label the correction properly I used a market geometry tool, like the pitchfork, to guide me where the correction might end.
Trading using Elliott wave theory on its own is a difficult task but when used in combination with other techniques it becomes possible to remove some of the subjectivity that EWT has. It is my hope that what I have shown you will interest you enough to study Elliott wave trading principles and trading strategies in more detail so that it may help you in your own trading.
All the best,