Elliott Wave Theory
How do Elliott Waves Work?
Elliott Waves are a five wave pattern of a fractal nature that emerge when examining price movements in the stock market, whether that be for stocks, commodities, currencies, or anything else. The basic principle is that there are 5 waves in the wave pattern – three impulse waves, and two corrective waves. Three of these waves are in the same direction, with the other two corrective waves being in the other. Understanding these wave patterns can allow you to predict the perfect entry and exit points to maximize your investments. Even a basic understanding of Elliott Waves will put you in a position to trade better, and begin to learn about my Tramline Trading method to further increase your profits.
My Tramline Trading method has three components:
- Elliott Wave Theory
- Fibonacci trading
In this section, we learn about the basic elements of the Elliott Wave Theory.
John Burford explains the Elliott Wave Theory
Most traders believe Elliott Wave Theory (EWT) is a subject too difficult to understand and use. Yes, it can be daunting to understand these wave patterns at first, but with a little work and experience, you can at least gain enough knowledge and understanding to be able to use Elliott Wave analysis to boost your trading performance.
- Would you like to project major market turns ahead of time to plan your trades so that you are not stumbling in the dark?
- Would you like to be able to set sensible and accurate price targets for profit-taking?
- Would you like to be able to forecast a large price move just before it starts?
- And crucially, would you like to know when your wave count is wrong so that you can limit loss to a fraction?
Well, you can with a basic Elliott Wave Theory understanding! It is definitely worth getting to grips with it. Even a basic understanding of Elliott wave theory allows a technical analysis of the stock market that other market analysis methods cannot provide. Getting a basic understanding of these waves (impulse and corrective waves) you can use the analysis to choose the ideal times to enter and exit on certain goods.
It all starts with being able to count to five
Impulse waves and corrective waves
That’s right – five. That is because the major market moves either up or down occur in five main waves. Waves 1,3 and 5 moves with the main trend (impulsive) and waves 2 and 4 are corrections to the main trend.
Back in the 1930s, Ralph Nelson Elliott was studying the (paper, of course) charts of the DJIA and made the basic observation that the major thrusting moves up or down were in fives and not some other number. The number five was the key to understanding market growth and decay. And when the five waves were complete, the market turns tail and moves in the other direction.
That is the Wave Principle of markets.
Of course, he only had rudimentary charts back then (probably only dailies), but today we have the luxury of seeing his Elliott Wave Principle at play in every time frame available, from the 1-minute to the monthly. No matter what time frame you look at the charts in, the Elliott wave structure is usually the same.
In fact, show me a 1-minute chart and a monthly chart and I probably would not be able to tell them apart. That is because markets trace out fractals in all time scales. It is patterns of changing sentiment that drives them.
Here is a great current example in the S&P 2-hr chart:
From the start at the low, the market moved up in wave 1, down in wave 2 and then started a vigorous thrust in wave 3. This strong action characterises all third waves which is usually the longest and strongest of the five (except for some commodity charts where the fifth wave can show the most power).
Rule 1 – Third waves are ‘long and strong’
The high price bar half-way along this wave gives the game away that we are indeed in a powerful third wave so that in real time, it gives you confidence in your forecast that the move has further to run (you can pencil in waves 4 and 5 to come) and there is more profit available.
This is seriously useful knowledge. Think about it – we have here a simple method that can offer high probability trend forecasts in real time. Many traders without this understanding may take profits early as they believe the uptrend ‘has gone far enough’, which is a poor reason.
Then the market made a slight correction in wave 4 before moving up in the final fifth wave to completion where profits can be taken.
Rule 2 – After wave 5 completes, the market reverses
And what a reversal in this example! In fact, the move down is also in a five. Note that the rate of descent is steeper than the rate of ascent – and this is entirely normal. Traders have an expression ‘Markets climb the stairs slowly, but fall out of the window quickly!’.
Here is another example in the S&P – the monthly chart from 2009 showing the great bull run:
Once again, wave 3 is the longest and strongest (Rule 1). And wave 5 completed in October 2018 and is now reversing (Rule 2).
Of course, the wave labels are obvious in hindsight, but in real time, it is an entirely different matter. In fact, there are usually alternative wave counts to be considered – and that is where experience comes in.
But with different counts, we have strict tests in terms of price action that can rule out some of the alternatives as time moves on. Sometimes, I have to amend my count in light of subsequent action and that allows me to re-set my near-term direction. What other method is so flexible?
No matter what method you use, all forecasts are probabilistic and sometimes, I get it wrong. But that is what stop losses are for.
John’s Top Tip
If you want a really simple strategy using Elliott waves, then trade only the third waves, which are usually identifiable by their relentless movement in one direction. They suffer few corrections which are minor price deviations from the trend. This can be done on any time scale from day trading with the 5-minute chart to the daily where weeks-long trades are sought.
I know members of my VIP Traders Club who do just that – and are very happy with results.