Elliott Wave Patterns

Trading the Elliott Waves

The Elliott Wave Theory is a leading technical analysis method used to explain and understand the behavior of financial markets.

Elliott Theory’s Background

Ralph Nelson Elliott was an American investor (1871–1948) who studied the wave-like behavior of the U.S. stock market. In 1938, Elliott published The Wave Principle, and in 1942, he also released Nature’s Law. As Elliott explained in Nature’s Law, the mathematical foundation of the Elliott Wave Principle is the Fibonacci sequence {1, 2, 3, 5, 8, 13, 21, 34, etc.}. Every significant number in Elliott Wave Theory is also a Fibonacci number.

Introduction to the Elliott Wave Theory

Developed by Ralph Nelson Elliott in the 1930s, the Elliott Wave Theory is a widely respected and influential framework in technical analysis. It is based on the idea that financial market prices do not fluctuate randomly but follow recurring, identifiable patterns of directional movements known as “waves.” These patterns are thought to reflect the collective psychology of investors, cycling naturally between phases of optimism (greed) and pessimism (fear) in a rhythmic manner.

The Elliott Wave Theory is based on a five-wave pattern analysis that consists of two phases.

Chart: The Basic Elliott Wave Pattern and the Two (2) Phases

Phase-1: Impulsive Phase

According to the theory, any financial market advances in three upward waves—1, 3, and 5—separated by two downward waves, 2 and 4.

Phase-2: Corrective Phase

The correction of any advance occurs in three waves: A, B, and C.

Chart: The Elliott Wave Pattern and its full extension consists of 34 waves.

Elliott Wave Principles:

• Wave 2 must not fall below the starting point of Wave 1. If it does, the pattern remains part of the prior trend.
• Wave 3 must not be the shortest wave compared to Waves 1 and 5.
• Wave 4 must not overlap the range of Wave 2.

Key Points

Traders who apply Elliott Wave Theory carefully examine price charts to recognize these wave patterns. By pinpointing the market’s current stage within the wave cycle, they strive to predict the market’s probable direction, the potential magnitude of upcoming moves, and possible reversal points. Although many traders value the theory for its ability to clarify complex market behavior and highlight high-probability turning zones, it is also known for its subjective nature and complexity. Mastery requires considerable experience to use it reliably. Fundamentally, Elliott Wave Theory is a probabilistic approach rooted in crowd psychology rather than a precise forecasting tool.

Here are some key points of the Elliott Wave Theory:

• It can be applied to any financial market to analyze any financial instrument.
• It can identify formations across all timeframes (historical trends, long-term, mid-term, or even short-term trends).
• It can detect trends in both upward and downward price movements.
• It offers a fully visualized framework for analysis.
• It is highly effective when combined with indicators or other technical analysis tools.
• It provides reliable stop-loss levels.

Implementing the Elliott Wave Strategy & Tips

As with any other theory, the Elliott Wave Theory does not always unfold in clear patterns under real market conditions. Therefore, traders must remain patient and trade selectively. Here are some basic steps to apply the Elliott Wave Strategy:

1: Selecting the Right Timeframe

Generally, the longer the timeframe, the more reliable the technical analysis becomes. Avoid very short-term patterns. You can also combine two different timeframes to create a multi-timeframe strategy. For example, use a daily chart (D1) to track the main Elliott waves and an hourly chart (H1) to follow the sub-waves. This approach can enhance the reliability and accuracy of your entry and exit levels.

2: Trading Only the 5th Impulsive Wave or the 3rd Corrective Wave

The 5th Impulsive Wave for long trades and the 3rd Corrective Wave for short trades are considered the most reliable and dynamic waves in the Elliott Theory.

■ 5th Impulsive → when trading long (↑)

■ 3rd Corrective Wave → when trading short (↓)

Waiting for these ideal entry points requires discipline and patience. To simplify the process, consider setting alerts on your platform or placing a pending order that triggers only when your conditions are met.

3: Improving Your Entries by Combining Elliott Waves with Indicators

To reduce the risk of false signals, confirm your entries using one or two indicators.

■ Using the Zig-Zag Indicator

The Zig-Zag Indicator, pre-installed on MT4, can help beginners more easily identify Elliott Waves.

■ Combining Elliott Waves with Customized MACD

Adjust the MACD settings to {5, 34, 5} and look for extreme values and/or divergences between price patterns and MACD signals.

• MACD Line: (5-day EMA – 34-day EMA)

• Signal Line: 5-day EMA of the MACD Line

• MACD Histogram: MACD Line – Signal Line

■ Combining Elliott Waves with CCI

The Commodity Channel Index (CCI), originally developed by Lambert to identify commodity trends, can be applied to any financial market, including Forex, stocks, and indices.

Set the CCI to 34 to evaluate the strength of any trend.

• CCI = (Typical Price – 34-period SMA of Typical Price) / (0.015 × Mean Deviation)

• Typical Price = (High + Low + Close) / 3

• Constant = 0.015

CCI measures the strength of the current trend relative to a median over a set period. A positive CCI (CCI > 0) favors bullish trends, while a negative CCI (CCI < 0) indicates bearish trends. Additionally, if CCI moves above -100 in a downtrend or below +100 in an uptrend, it may signal a potential price reversal and confirm that a new Elliott Wave is forming.

■ Using the Fibonacci Retracement for Interpreting Corrective Waves

To help define the end of a corrective wave, apply the Fibonacci Retracement Tool.

4: Exit Plan (Stop-Loss and Take-Profit)

For your exit strategy, you can use a simple trailing stop order. The number of pips set for the trailing stop should reflect recent price volatility as well as the trade’s profit potential.

Manually, take-profit orders can be placed just before major resistance or just above major support levels. The Fibonacci Retracement tool can help identify these support and resistance levels, and pivot points may be useful as well.

Since the 5th Impulsive Wave and the 3rd Corrective Wave tend to be long and very dynamic, avoid rushing to take profits.

You can also set price targets using the Fibonacci Expansion tool.

If the wave count changes to something other than the Elliott Wave 5 pattern, adjust your stops accordingly or prepare to exit the trade soon.

5: Entering the Right Order Size

As with any trading strategy, money management is crucial. You need to apply the appropriate level of capital leverage. Here are two practical approaches to effective money management:

■ MM Practice-1

Start by executing any order on a Demo Account. Then open the same order on a Live Account, adjusting the size according to your desired risk exposure.

■ MM Practice-2

First, decide how much of your available funds you are willing to risk on a trade—for example, $200.

Next, determine the size of your stop-loss—for instance, 30 pips.

Place a pilot order, such as 0.1 lot size, with the 30-pip stop loss and check the dollar amount at risk. If you risk $25 on the 0.1 lot, and want to risk $200 total, your optimal order size is 0.8 lots. Therefore, you would open an additional 0.7 lots. This method helps you trade accurately and manage risk effectively.

■ Elliott Wave Theory

G. P. for TradingFibonacci.com (c)