Reblog: How to Trade Elliott Wave for Beginners
Before we begin our discussion about how to trade Elliott Wave let’s set the stage by looking at how the Elliott Wave theory was discovered and why Elliott wave strategy is so popular today. In the 1930 R.N. Elliott set out to try to learn more about the stock market after experiencing some losses in the 1929 stock market crash.
Elliott’s discoveries were quite impressive and after careful study of the markets, he began to notice that the market has some repeatable patterns and is trading in a series of five and three waves which is what we call today an Elliott wave strategy.
Our team at Trading Strategy Guides has also adopted the Elliott Wave strategy because it offers us good Elliott Wave entry points which ultimately leads to superior risk to reward ratio.
The Elliott wave strategy is similar to a trend following strategy like the MACD Trend Following Strategy- Simple to learn Trading Strategy or the very popular strategy: How to Profit from Trading Pullbacks.
Even though the Elliott Wave strategy is a trend following strategy, we can spot Elliott Wave entry points even on the lower time frames because the Elliott Wave theory can be applied to all time frames and to all markets so, in essence, is a universal trading strategy.
Let’s get a little bit deeper into how to trade Elliott Wave and how we can make profits trading.
How to Trade Elliott Wave
R.N. Elliott found out that any trend movement can be broken down into a five wave sequence and he labeled these waves 1 through 5. One of the Elliott Wave strategy rules is that the waves 1, 3 and 5 often formed in the direction of the trend and the waves 2 and 4 are price movement against the prevailing trend.
Next, Elliott Wave observed that after a 5 wave move in the direction of the prevailing trend, there is a corrective 3 wave movement in the counter-trend direction which is labeled A, B and C.
In Elliott Wave theory the 5 wave move in the direction of the trend is also called motive waves, while the 3 waves corrective move against the 5 wave move is also called corrective waves.
This is quite useful because we can now break any price trend movement into this basic 5 – 3 wave pattern. Knowing that each impulsive and corrective move is a series of waves oscillating up and down we can conclude that we can have waves within waves.
This means that a five wave sequence in one-time frame might be simply just the first wave in a longer time frame. In other words, this is simply confirming the fractal nature of the markets theory.
Let’s lay down some of the rules of the Eliott Wave strategy that can assist us in determining to find good Elliott Waves entry points.
Elliott Wave Strategy Rules
The Elliott Wave strategy needs to satisfy and abide by some strict rules in order to validate the 5 wave move. The three basic rules
- Wave 2 never retraces more than 100% of Wave 1. Typically, the retracement is between 50% and 61.8% of wave 1.
- Wave 4 never retraces more than 100% of wave 3. Typically, declines between 38.2% and 50% of wave 3.
- Wave 3 always travels beyond the end of wave 1 and it’s never the shortest one; Wave 3 will normally extend 161.8 x wave 1.
Our favourite way to play the Elliott Wave strategy is to let the first 4 wave movement unfold and then to find good Elliott Wave entry points near the end of wave 4 in an attempt to catch the last wave of the entire 5 Elliott Wave sequence.
Before we define how to trade Elliott Wave it’s quite important to highlight other key important Elliott Wave strategy guidelines:
- If wave 3 is the longest wave, then wave 5 will roughly equal wave 1.
- Wave 2 and Wave 4 will alternate. If wave 2 is a sharp correction, wave 4 is a flat correction and vice versa.
- After a five Elliott Wave sequence is completed the ABC corrective waves usually end in the vicinity of wave 4 low point.
Now, that we have a good grasp of the basic Elliott Wave strategy principles, let’s define some Elliott Wave entry points employed by our team at Trading Strategy Guides.
Note* The good thing about the Elliott Wave strategy is that it doesn’t require any technical indicator as it’s pure price action strategy.
Step #1 Wait until you can spot at least a 3 wave Elliott Wave sequence
Since we always advocate trading in the direction of the trend, as explained above, we’re only attempting to catch the last wave 5.
So, in order to find our Elliott Wave entry points we need to let the market tip his hands off and wait to develop the first 3 waves of a five Elliott Wave pattern.
We must verify that each wave complies with the Elliott Wave strategy rules in order to confirm the validity of our Elliott Wave count. In the figure above, we’ve spotted a bearish Elliott wave count that complies with the Elliott Wave strategy rules, which means we’re looking for a sell setup.
Now, it’s the time to look after our Elliott Wave entry points which brings us to the next step.
Step #2 Sell between 38.2% and 50% Fibonacci retracement of Wave 3
One of the Elliott wave rules states that, ideally, wave 4 should retrace between 38.2% and 50% Fibonacci retracement of wave 3. Our Elliott Wave entry points are at 38.2% because we never know for sure how far the market will retrace and we don’t want to miss the move.
We’re pretty much sure that with experience you can fine tune your Elliott Wave entry points and get even better entries.
Now, we can note that wave four retrace a little bit above the 50% retracement. Since the market is never a perfect place where rules are respected to the pip there will always be small variations and the Elliott Wave strategy is no exception from the rule.
Now that we have established our Elliott Wave entry points we now need to establish where to place our protective stop loss.
Step #3 Place the Protective Stop Loss few pips above the Wave 1 Ending Point
In the section “How to trade Elliott Wave” we highlight the importance of wave 4 never entering into the wave 1 territory. In this regard, it’s smart to place our stop loss exactly where the Elliott Wave pattern will be invalidated.
In the above figure, we highlighted the ideal place to hide your protective stop loss in case of an Elliott Wave bearish sequence.
The next logical thing we need to establish for the Elliott Wave strategy is where to take profits.
Step #4 Take Profit when Wave 5 is equal to Wave 1 or when we break below wave 3
With the Elliott Wave strategy is all about experimenting new trade ideas and we encourage you to find your own set of rules because once you have a firm understanding how to trade Elliott Wave you can develop many Elliott Wave strategies around it.
In this regard, we don’t have a set in stone take profit strategy because the Elliott Wave strategy looks to maximise profits and the only way you can do this is through flexibility because no two Elliott Wave structure is the same.
Note** The above was an example of a SELL trade… Use the same rules – but in reverse – for a BUY trade. In the figure below, you can see an actual BUY trade example, using a bullish Elliott Wave sequence.
Above chart was constructed by using Elliott Wave strategy Step #1.
Above chart was constructed using Elliott Wave strategy Step #2 through Step #4.
Billionaire hedge fund manager Paul Tudor Jones is well-known for being an Elliott Wave practitioner. If the 120th richest person on the Forbes 400 list is using the Elliott Wave strategy you should not be the fool who ignores it. The Elliott Wave strategy has stood the test of time and if you’re just getting your feet wet in the trading business this is definitely a good starting point if you want to build a fortune.
There are many different strategies on how to trade Elliott Wave and ultimately it all comes down to your experience and how good you’re in identifying Elliott Wave entry points.
The original post appeared on tradingstrategyguides.com and is available here.