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Understanding the Elliott Wave

Understanding the Elliott Wave
April 26
04:34 2012

If you have been exposed to technical trading strategies for any appreciable length of time, you may have seen references to the Elliott wave. While it can certainly be a useful predictor of future price movements, the key to trading an Elliott wave pattern is correctly identifying where the pattern begins. Here we’ll look at the basics of the Elliott wave and how to use it.

The Elliott wave was proposed in the 1920s by Ralph Nelson Elliott (which may give you some hint as to where the name originated) in his book The Wave Principle. Although Elliott’s work focused on psychology, and his theory was meant to formalize cyclic (and therefore predictable) changes in human behavior, it was later adapted to financial markets. Price movements in those markets are, after all, the result of collective human activity.

The core of Elliott wave theory is a 5-3 wave cycle composed of five “impulse” waves up and three “corrective” waves down. When plotted as a chart pattern, the impulse waves are numbered (at the wave conclusion, on each peak and trough) 1 through 5, and the corrective waves are labeled in the same manner A through C. (See the sample chart for clarification.)

You may have heard of fractals, which as it turns out are the basis of many patterns in nature. “Fractal” simply means that a structure has a pattern that is repeated on larger and smaller scales. In the case of the Elliott wave, each wave up or down will itself be composed of a set of waves. Look at our sample, and notice that each wave up is itself made up of a five-wave pattern with three peaks and two troughs, and each wave down is made up of three waves down. (When these sub-waves are labeled, the convention is to use i through v for the impulse sub-waves and a through c for the corrective sub-waves.)

As we mentioned initially, the Elliott wave has nice predictive power, but with all of the peaks and troughs you’ll see on a price chart, how do you correctly identify where the sequence begins? Here are some basic rules:

  • Wave 2 (down) must not exceed the start (lowest point) of wave 1.
  • Wave 3 must not be the shortest wave up.
  • Wave 4 should not overlap wave 1. That is, the start of wave 4 should be higher than the end of wave 1. However, we say “should” because this rule is not absolute, although it does hold about 90% of the time. It most often fails in very volatile markets.

Once you have properly identified a forming Elliott wave, the opportunity to make trades based on its predictive power emerges. While going long at the end of wave 2 and waiting for the peak would be ideal, identification of the pattern can be trickier early on. You are more likely to spot it as wave 3 or 4 forms, which would mean waiting until the bottom of wave 4 to go long in anticipation of the peak. Once the peak occurs, you can take a short position and ride all three corrective waves down.

Such a trading strategy raises a new question: how should you establish both upside and downside price targets to maximize profits? You can employ other technical indicators for this purpose, but one handy method is the Fibonacci retracement, which can be used to predict the length of each wave. For an explanation, please see our article on Fibonacci ratios.

With careful identification and the support of supplementary indicators, the Elliott wave’s ability to look into the future can provide a great way to locate profitable short-term trades.

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