Trading Strategies with Elliott Waves

All traders have been there before. There are times when it seems that you watch a chart move randomly: up and down, strong upticks, random selling, and sideways movement. It feels difficult to recognise or identify anything. But over eighty years ago, Ralph Nelson Elliott developed a theory that theorised that markets do not move randomly, and that they move in identifiable manners, or sequences, resulting from the psychology of the crowd.

Elliott developed a theory that came to be called Elliott Wave Theory, which may be confusing to use at first, but provides traders with a way to achieve meaning from chaos. The real benefit of wave theory is not only to identify waves but also to design trading strategies based on waves. One of the goals of this article is to show how you can utilise Elliott Waves practically in the field, from finding entry opportunities to managing risk, so you can start trading with less ambiguity and more confidence and discipline.

Understanding the Basics: Impulse & Corrective Waves

When you read anything about Elliott Wave, there are two basic building blocks of Elliott Wave Theory.

• Impulse Waves: Five-wave moves in the direction of the larger trend.

• Corrective Waves: Three-wave counter-moves to retrace part of the impulse.

These building blocks form the rhythm of the market: five steps forward and three steps back. Understanding this rhythm is essential to creating strategies that work in both bullish and bearish trends.

Strategy 1: Trade with the Impulse Wave

The easiest way to trade with Elliott Waves is to trade the trend when the market is in the impulse phase. Here is how.

1. Identify the Start of Wave 3

Wave 3After the reversal of Wave 2 is finished, and the price breaks higher, that is the time for you to get long and trade with the trend.

As long as the price continues to create higher highs (during an uptrend) or lower lows (during a downtrend), the trader can remain in the trade until Wave 5 concludes.

Use tools like Fibonacci extensions to project target levels for both Wave 3 and Wave 5, enabling the trader to enter and exit the trade at specific levels and set realistic expectations for target achievement. This strategy works best with volume or momentum indicators confirming the trend's strength.

Strategy 2: Trading Corrective Waves

Corrections often frustrate traders; however, they can also provide opportunities for them. By learning to identify zigzags, flats, or triangles, you will receive the corrective trade OR prepare for the subsequent impulse waves.

- Zigzag Corrections- Enter at the conclusion of Wave C, meaning the corrective sequence has completed and the wave two trend is continuing.

 - Flat Corrections- Trade once Wave C is complete after identifying the prior horizontal price range.

 - Triangles- Triangles typically form right before the last impulse wave begins. Once the triangle is through the breakout point, you will earn the last leg of the trend.

Although corrective trading is not as easy as trading through impulse waves, it allows for discipline to take advantage of trading during market spars rather than being out of the market entirely.

Strategy 3: Fibonacci and Elliott Waves together.

Oftentimes, Fibonacci ratios work well with Elliott Wave Theory. Many traders will use Fibonacci retracements and extensions to find good points to enter or exit a position.

- Wave 2 retracement- This approach typically measures anywhere between 50 - 61.8% retracement of Wave 1. The Zone is a typical area of entry for Wave 3.

• Wave 3 Extensions: A standard extension of Wave 3 is to 161.8% of Wave 1, which naturally provides a target for managing partial profits.

• Wave 5 Projections: Wave 5 is often also related to the Fibonacci relationships to Wave 1 or Wave 3, which can help you confirm when the trend may be running out of momentum.

Utilising Fibonacci tools, create your structure for a wave trading strategy.

Strategy 4: Utilising Alternation for Better Forecasts

A core tenet of Elliott Wave Theory is the idea of alternation (if Wave 2 is sharp and deep, then Wave 4 is likely to be shallow and sideways – or vice versa).

Traders can use the principle of alternation to:

• Anticipate the type of correction to expect

• Do not be blindsided by sideways price action

• Plan entries more holistically and accurately, based on what type of price action to expect

When traders are aware of alternation, they avoid forcing incorrect patterns, and their forecasting improves.

Strategy 5: Identifying Divergence in Wave 5

Momentum divergence usually appears during Wave 5, when price is registering a new high (or a low). Still, momentum indications, such as the RSI or MACD, do not confirm the new price level.

This provides a clear signal and an opportunity to:

• Close out-of-the-money positions before the correction begins

• Start to prepare for potential reversal by an expected labored or non-momentum price action associated with a corrective A - B - C pattern. Applying divergences to Elliott Waves also gives traders a higher degree of protection and an exit strategy rather than just giving away profit.

Elliott Wave Risk Management in Practice

There is no trading method without risk management. The rules of Elliott Waves give a natural stop loss level. For example:

• If Wave 2 moves back past the start of Wave 1, this invalidates the setup - this is a rational place for stops.

• In trades for Wave 3, stops can be located just below the low of Wave 2 for up trends, and vice versa for down trends.

This will allow the trader not just to use their best guess and have a clear field of separation in price levels for invalidation that protects capital if the wave count is wrong.

Missteps in Trading Elliott Waves

Traders new to Elliott Waves are confused about the different patterns because they are:

• Forcing a pattern when there isn't one, aiming to label all movement of the price as corrective or impulsive structure.

• Only focusing on 1 time frame, even though in a shorter time frame, the indicative price looks like it is in an impulse, it might be a corrective structure in a longer time frame.

• They read a comment in Elliot Wave about "rules" and take it too literally, very confused by the flexible guidelines Elliot explains.

Avoiding these common pitfalls comes with time and patience. Elliott Wave, as much as it isn't science, it's art, takes time, practice, and looking at the charts to master it.

Tips For Mastering Elliott Wave Strategy

1. Chart Cleanliness: Too many indicators distract from identifying the wave structure.

2. Question a set of confirmations: Moving averages, momentum oscillators and Fib can help reinforce your Elliot Wave count with validity.

3. Practice Elliott Wave on higher time frames: Higher time frames, like the daily or weekly, present the waves with less "noise."

4. Flexibility: Wave counts can change as price action challenges the wave's validity.

Understanding Why Elliott Wave Strategies Work

Elliott Waves work as they provide representations of human nature in the market. Expectations, fear, taking profits and "guessing" create order on the chart. Now, combining the order of the chart's anticipation with a process, traders can:

• Trade with the trends.

• Enter those trades anticipating a high-probability pullback.

• Exit these trades before those corrective movements take profits away.

• And manage risk at objective levels with stops.

Conclusion

Uncertainty will always be part of trading, but the Elliott Wave Theory will give some structure to try to understand. By adhering to the guidelines and structuring your trading with science-based principles, we can create processes that aim to transform the chaos of the market into an opportunity.

Whether riding the power of Wave 3, sizing the change of the corrective wave, or just using a divergence to exit a Wave Five, Elliott Waves provide a process to structure and discipline. While we can't predict the future with certainty, we can use it as a guide to a map. Above all, always remember, when trading, it is better to have a map than no map.