The Elliot Wave Trading Strategy

The future direction of an asset price can be calculated in several ways. One of the most interesting is the Elliot wave trading strategy introduced by Ralph N Elliot. The wave theory is predicated on sentiment which generates the ebb and flow of the market. Elliot described 5-waves sequences and 3-corrective motions.

Waves

The conventions used in the labeling of waves describes the size of the uptrend along with the length and depth of the wave. There are two types of Elliot waves, impulse waves and correction waves. An impulse wave moves in the direction of the general trend while the corrective wave moves in the opposite direction of the impulse wave. When the general trend is up, the impulse wave is the up wave, and the corrective wave is the down wave. The impulse waves are labeled 1-5. The corrective wave forms with three waves, typically labeled using a, b and c. The complete Elliot wave sequence is 5-waves up and 3-waves down.
Elliot waves are fractal in nature. This means that the structure of the wave sequence that applies to the larger wave structure also applies to mini-phases within the larger wave structure. So there are always 5-waves in one direction and 3-corrective waves.

Rules

The Elliot wave theory is made up of rules and guidelines, making the theory somewhat subjective. While the rules are hard and fast, the guidelines are left up to the trader’s interpretation. The rules only apply to the impulse waves and not the corrective waves.
• Wave 2 cannot retrace all of wave 1
• Wave 3 cannot be the shortest impulse wave
• Wave 4 cannot overlap wave 1
Although wave 3 is generally the longest of the 3 impulse waves, there is no rule that states that it cannot be the shortest. The theory states that the third impulse wave must exceed the high of the first impulse wave in an uptrend. If this does not occur, the wave series starts from the beginning.

Guidelines

The first guideline is that wave 3 is the longest of the impulse waves within the Elliot wave structure. Wave 5 is generally the same length as wave 1. The second guideline is that wave 2 and wave 4 will alternate in terms of their corrective nature. For example, if wave 2 is a sharp correction, wave 4 will be a flat correction. Another guideline is following wave 5, the correction ABC usually ends in the prior wave 4 low point.
The guidelines are very useful in targeting the end of specific waves. In a large uptrend, you can use percentages to target the end or beginnings of each wave. For example, the percentage decline in wave 1 could be applied to the high or wave 4 or wave 5. Each guideline is helpful. The third guideline is helpful in estimating the end of the wave 2 correction.

In closing, this article covers the very basics of the Elliot wave principal. Traders can greatly improve their counting by applying the 3-rules and 3-guidelines to their wave counting. If you apply the rules for the first count and guidelines for the second you are likely to evaluate the waves in the proper manner. By eliminating false wave, you will be able to target specific areas of a trend and improve levels to initiate a trade or take profit.

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