Elliott Waves Theory

Elliott Waves

Elliott waves are one of the few studies that able to tell where the market is now, where it is likely to go next and, of course, what are the opportunities there for traders.

However, it's not a secret that to many traders Elliott waves theory is one the most difficult studies whether it comes to understanding, using it or following someone's forecast.

Elliott Waves were introduced by Ralph Nelson Elliott in the 1930s for stock trading.

The theory is based solely on the phenomenon of mass psychology, which more often than not predetermines the outcome of the market behavior.

mass behavior => market behavior

Elliotticians, among which are many top tier technical analysts from banks and leading investment institutions, like to use the knowledge of Elliott wave principles to understand mass investor behavior and thus make forecasts about the market behavior.

Polar opinions on Elliott Wave theory

Against

• Elliott waves have a huge degree of subjectivity. If you ask a group of Elliotticians to identify Elliott waves on the same chart they will most likely come up with several different wave counts.

• Elliott waves have a complex myriad of patterns and rules.

• There are only 3 hard-coded unbreakable rules recognized in Elliott Waves theory, while the rest of the rules can have alterations, exceptions and are allowed to fail, which makes it the endless world of possibilities.

For

• The key to trading Elliott waves lies in not being always correct on the wave count, but rather finding the ways to get the least penalty for being wrong. While there are certain small windows in each price move, which promise some amount of profit regardless the actual wave count as long as direction is known, and that's what the Elliott wave theory does.

• Elliott wave traders look for an entry price that is close to support & resistance levels. Then if the level is broken, they exit with minimal losses and the wave pattern will be nullified. However, if the wave count was correct, it will make profits two to five times the amount risked.

Elliott Waves Basics

Every complete Elliott Wave move consists of 5 impulsive waves in the direction of the main trend followed by 3 corrective waves (a so called "5-3 move").
This rhythm of 5-3 move remain true for any time frame.

This is an Uptrend, where:

1-2-3-4-5 - is an impulsive move, where waves 1-3-5 are Impulsive waves, 2-4 are corrective waves.
A-B-C - is a corrective move, where A-C are impulsive waves, B is corrective wave.

But, what does this all impulsive/corrective thing mean..? how it works according to Elliott?

Wave 1 - represents an impulsive optimism among the first group of Buyers - they have found a good reason to Buy (for technical or fundamental reasons), and so they begin pushing the market higher.

Wave 2 - the impulse fades out as the original Buyers begin to close trades with profits, while other investors who missed the train, stay outside waiting for a new opportunity.

Wave 3 - usually the longest and the strongest wave. Every investor who wanted to Buy (those who missed Wave 1 and those who didn't) will start Buying now. In addition to that, in the middle of the wave 3 those who weren't convinced about an Uptrend will be convinced by now. Altogether this will bring a large acceleration to the main trend.

Wave 4 - sooner or later it's time to take profits, an impulsive move starts to fade again. However, the correction will be shallow as there are still many Buyers who want to join the trend.

Wave 5 - and so the uptrend restores, but the markets are already overbought and it becomes obvious that a reversal is due. The end of wave 5 is often marked by oversold (in an uptrend) markets and divergence.

Waves A, B, C - these waves develop in the counter-trend style to the major trend. At this point a new trend may develop, but may also not, and the new sequence of 1-2-3-4-5-A-B-C waves may begin.

Degrees of Elliott Waves and cycles

It would be great of we could take those 5-3 waves and go trading, but on practice when we look at price charts there are no such smooth 5-3 waves, instead, it'll look like a maze of up and down swings. Where to go from here?

Elliott Wave theory says that every wave has smaller waves within it. 

And so, if we now view every wave as a series of smaller waves, the picture will look like this:

Elliott wave cycles

According to Elliott every complete set of 1-2-3-4-5-A-B-C waves becomes a wave of a larger degree ( a wave of a larger cycle).

Bellow is the table with all known Elliott Wave cycles and their corresponding styles of wave numeration.

Note: online trading platforms due to their graphical limitations won't be capable of drawing circles around your wave numbers, so instead of circles traders use square brackets [ ] to label waves: [1], [2] etc.

Elliott Wave Patterns

Impulsive Wave Patterns

1. Extended waves - waves that is elongated in nature with smaller sub-waves that are distinctively visible.
Among impulsive waves 1, 3 and 5 only one wave should become an extended wave. 

2. Diagonal triangle - applies to wave 5, which is prone to producing a weaker move/wave and as a result the sub-waves within it can evolve into a diagonal triangle.

3. Complete 5th wave failure - applies to wave 5, where it can be so week that it fails to surpass the wave 3, resulting in a double top formation. (See the second illustration on the image above)

Corrective Wave patterns

Corrective Wave forms are more complicated in nature. They we can be categorized into six major forms:

Zig-Zag:
an ABC pattern composed of 5-3-5 sequence, where wave B doesn't exceed the start of wave A while Wave C moves far beyond the end of wave A.

Flat:
an ABC pattern composed of 3-3-5 sequence, where all three waves are of the same lenght.

Irregular:
an ABC pattern composed of 3-3-5 sequence, where wave B exceeds the start of wave A while wave C moves close to (or beyond) the end of wave A.

Horizontal Triangle:
5-wave triangular pattern composed of 3-3-3-3-3 progressively smaller waves. Usually such triangles happen in the 4th wave in the impulsive sequence. 

Double Three:
an ABC-x-ABC pattern composed of any two patterns (zigzags, flats, irregulars or triangles) and linked by x wave.

Double Three wave examples:

Triple Three:
an ABC-x-ABC-x-ABC pattern composed of any three patters (zigzags, flats, irregulars or triangles) and linked by two x waves.

Triple Three wave example:

Double Three and Triple Three are very complex corrective patterns, so don't be discouraged if you can't count them accurately. Be sure to use additional technical analysis (or indicators) if your waves aren't lining up for the moment.

Always seek for the clarity in any Elliott wave pattern before pulling a trigger, but don't get stuck if the patterns don't emerge, instead use another other analysis methods that can offer a better edge in challenging market conditions.

Note: In all ABC corrections (ZigZag, Flat, Irregular, Double Three, Triple Three) Wave C consists of a 5-wave pattern. This knowledge is very useful when planning entries after wave C on an new impulsive wave.

Elliott Wave Rules

The 3 main rules of Elliott Wave count

1. Wave 2 should not break below the beginning of Wave 1.
2. Wave 3 should not be the shortest wave among Waves 1, 3 and 5.
3. Wave 4 should not overlap with Wave 1.

These are the only 3 unbreakable rules that can't be altered. The rest of the Rules, and there is a considerable number of them, can have alterations, substitutions etc, which again explains the fact that markets can't be totally predictable.

4. The Principle of Alteration

Waves 2 and 4 within an Impulsive wave will unfold in different forms: if wave 2 is a simple ABC form ( zigzag), the 4th wave is likely to be a complex wave (triangle, double three etc.)

Over years Elliott followers tried to collect the rules and improve the interpretation of the waves. As a result, today we can find hundreds of new Elliott wave rules and guidelines, which try to cover every aspect of the price behaviour.

But is it possible to put every price move to the rules? Will such classification be worth studying, or will it simply be a description of every possibility in the market, which we don't need to read about to know that it exists? It's up to you to decide.

Just keep in mind that Elliott wave trading is not about being right and knowing the next move every single time. Elliotticians make mistakes and they make a lot of them, even most experienced professionals like Robert Prechter aren't correct every time. What's important is that they are ability to accept being 100% wrong and re-do the analysis while accepting losses when necessary.

*Prechter's record at the end of the twentieth century has not been so perfect: his book "At The Crest Of The Tidal Wave" (1995), calling for the end of the great bull market in 1995, was nearly five years off the target.

Elliott Waves - beginner steps

1. Start by adding Fractals indicator. Each Elliott Wave top or bottom should be backed up by a fractal.

2. If you can't find the waves yourself, start with someone's wave count version

3. Settle on a time frame: no less than 1 hour for the accuracy. Most common time frames to work with are 1 hour and 1 day. Daily will be, as a rule, most accurate & easier to follow for a beginner.

4. Put up Elliott Wave indicators or mark waves manually.

5. Watch the moves unfold and try to keep up with the wave count free website scanner or software.

6. The goals are to catch the following waves:
- trade during wave 3 in the direction of the trend.
- keep out of the market during wave 4
- trade during wave 5
- catch the end of the wave 5 (usually ends with a distinctive market divergence) and take counter trend ABC waves.

...This is also where all the difficulties seem to begin - many traders just can't figure out how to start and keep the correct Elliott wave count.

There is no secret pass-way to an easy start. The best way to start the count for any novice Elliottician is to use the resent wave count provided by more experienced Elliotticians, and, of course, read more books about Elliott wave trading.

Elliott Waves - the Trading Plan 

(The step-by-step guide to planning your trades with Elliot waves)

Step 1

A downtrend ends with Wave 5.
Besides the end of the wave 5 in a downtrend, we also want to see the first indication of a trend reversal - an establishment of a new Higher High.

Step 2

Once a new Higher high is found, its the first opportunity to plan an early entry with a new trend. Use Fibonacci retracement tool to find price retracement levels (38.2%, 50% and 61.8%).
These levels will give an Entry zone area.

Step 3

Once a Buy order is open, place an initial Stop order below the beginning of the Wave 1.
If price goes past Fibonacci levels resulting in a wrong trade, accept the Loss and at that point place a Sell order with a profit target set cover up the previous loss.

If price reverses at Fib levels as expected, set Profit target #1 at the first resistance level, which is the top of Wave 1. Close 1/2 of the position at that point. Why to take profits this early? Because if the market decides that it's not the time yet for an uptrend (double top and reverse), we'll have some reward left.

When the TP #1 is reached, move the Stop order to break even.

Step 4

The key point area consists of 2 considerable points:

1. When the length of the new wave matches the length of Wave 1
(Length 1 = Length 2) - we have reached a new resistance level

2. When the market finds the upper line of a channel (built based on the initial trend line) - we have reached a new resistance level.

Those resistance levels if passed successfully, present an immediate opportunity to add 1 more Buy order to an existing trade. As we know Wave #3 is the strongest wave, so that's a good opportunity to make more profits.

Step 5

Using Fibonacci Expansion tool find the Profit target at 161.8% area.

At this point we want to close all remaining trades. Why? Wave 3 was the strongest most profitable Wave. Wave 4 will be slower and will take longer time to complete, while Wave 5 may not be that high after all, so the time spent for waiting & hoping is not fully justified).

Step 6

If you want to try counter-trend trading with Wave 4, your profit target for a new Sell position will be around 38.2% - 50% Fib retracement level, as well as around the lower band of a new channel (see example below).

Step 7

Wave 5 is the last point to take profits and close any remaining positions.

Same rules (which you've hopefully already learned) apply for finding the best zones for profit taking:

- draw a channel (Tip: if Wave 3 is too steep, instead of drawing a parallel line thorough Wave 3, draw it through W1. The line in this case will cut through candlesticks of Wave 3, but it'll provide a valuable target for Wave 5).
- close 1/2 position at the top of Wave 3 (resistance and possible double top - not uncommon for Wave 5).
- use 61.8% Fibonacci Expansion as the final TP

Step 8

Immediately upon closing all Buy orders & upon favorable indications of an immediate reversal (shift down to smaller time frames to find signs of reversal) consider Selling.
Place the Stop order not too far from the entry.

Another selling opportunity should be found at Wave b - around 32.8%-50% Fib retracement level.
Measure the length of Wave a to project the target for Wave c. Wave a = Wave c. Take profits and close all trading positions.

Elliott Waves and Fibonacci

Fibonacci numbers play an huge role in Elliott Wave trading.
Elliott didn’t discover the Fibonacci relationships himself, but this was brought to author's attention by Charles J. Collins who had published Elliott's "The Wave Principle" and helped introduce Elliott's theory to Wall Street.

Using known Fibonacci ratios (38.2%, 50%, 61.8%, 161.8% and so on) traders can project the length of waves, the depth of corrections, move extensions etc.

 

Wave 1
The first impulsive wave, which Elliott traders don't use for trading, but rather for analysis of the wave 2. 

Wave 2
Wave 2 should not retrace below the beginning of wave 1.
Normally the retracement is from 50% to 61.8% of Wave 1. At times it can go below the 61.8% due to the fact that wave 2 retracement is quite aggressive since many traders don't acknowledge the change in the main trend yet.
The minimum retracement to expect is 38.2%. 

 

Wave 3
Wave 3 is never be the shortest among waves 1, 3 and 5.
At the very least it should be equal to wave 1 in length.
Wave 3 as the longest wave normally tend to be 161.8% of wave 1.
If goes beyond 161% - the next target is 261.8%, and rarely extended target - 425% of wave 1. 

 

Wave 4
Wave 4 is one of the shallowest waves: at this stage many traders take profits, while there are few others who are willing to trade counter-trend.
It often retraces slowly for an extended period of time and reach normally only 38.2% of wave 3.
It rarely retraces to 50% of wave 3. 

Wave 5
Wave 5 should move at least 61.8% of the length of wave 1.
If wave 3 is greater than 161.8% of wave 1 in length, the targets for wave 5 will be 100% of Wave 1,
or 161.8% of wave 1, rarely 261.8% of wave 1.
If wave 3 is less than 161.8% of wave 1 in length, wave 5 will often be extended with targets of:
61.8% of wave 1 + wave 3
100% of wave 1 + wave 3
or 161.8% of wave 1 + wave 3

Tips: Fibonacci projections - completion of wave 5

As you can see, as soon as wave 1 is completed we can already make a projection of the first possible target for wave 5.
To do so we multiply the height of wave 1 by 161.8% and project the result from the end of wave one.

Later when wave 3 is completed we can add yet another projection of the second possible price target for wave 5. To do so we have to examine wave 3: if wave 3 is greater than 161.8% of wave 1, the targets for wave 5 will be 100% of Wave 1, or 161.8% of wave 1. If wave 3 is less than 161.8% of wave 1 in length, wave 5 will often be extended with targets of at least 61.8% of wave 1 + wave 3.

In the end, the closer are the results for wave 5 targets calculated by different methods the higher will be the chances to see a trend reversal in between those levels.

Elliott Waves and Bollinger bands

Indicators required: Bollinger bands (period 25, shift 2)
Time frame: could be any, suggested 1 hour, 4 hour or daily.

The concept lies in easy spotting & counting Impulsive and Corrective Elliott waves
with the help of Bollinger bands channel.

Rules for an Uptrend:
1. As long as the price continuously touches the Upper Bollinger band, the Impulsive wave (1, 3 or 5) is in progress.
2. If price retraces down approaching lower Bollinger band - the corrective wave is in progress.
3. Once the price touches the lower Bollinger band - the correction will most likely be over and a new wave should follow.

Rules for a Downtrend:
1. As long as the price continuously touches the Lower Bollinger band, the Impulsive wave (1, 3 or 5) is in progress.
2. If price retraces up approaching the upper band - the corrective wave is in progress.
3. Once the price touches the upper band - the corrective wave will most likely be over and a new wave should follow.

Chart tip: To make the middle Bollinger band line invisible in MT4, draw additional bands (period 22, shift 3) and match their color to your chart background color.

Summary: Bollinger bands indicator can help with Elliott Wave count: to find impulsive waves, as well as search for patterns in during corrective waves, however, it's not recommended to build trading solely around the Bollinger bands, as you'll get many losing trades.
Use the method to count Elliott waves, and then apply additional analysis to make trading decisions.