The Elliott Wave Theory is a complex and broad topic that takes professional traders a long time to master. Despite this, there are some elements of the Elliott Wave that traders can incorporate to help enhance their trade timing and analytical skills.
Here are three elements of the Elliott Wave traders can use to improve their trading.
The corrective and impulsive waves
Prices move in two waves: corrective and impulsive. Traders can look at recent waves, and also which wave is currently underway, to predict what the price may do next.
A larger price move is an impulsive wave, and it comes with associated trends. Smaller waves that exist within a trend are corrective waves.
It’s best to trade when the price makes the largest move in the direction of an impulsive wave as this gives traders a better chance of making large profits.
When traders want to capture the next bigger impulse wave, corrective waves represent an ideal time to enter into a trend trade. Traders should buy during pullbacks or corrective waves when there’s an uptrend and enter the next impulse wave as it takes price higher.
To profit from the next impulse wave down, short sell during a downtrend in corrective waves. Traders can also use the idea of corrective and impulsive waves to decide whether a trend is about to go in the opposite direction.
For example, traders can spot when an uptrend may be over with three signs on a price chart: big moves to the upside, small corrective waves in between, and a much larger downward move.
The above image shows the impulse and corrective waves of the Elliott Wave Theory
Trend and pullback price structures
According to Ralph Nelson, the developer of the Elliott Wave Theory, an uptrend usually has three large upward price moves alongside two corrections, creating a five-wave pattern.
The five-wave pattern alternates between impulsive and corrective waves, starting and ending with the former, and all waves are labelled one through five respectively.
Also, three lower waves follow in the uptrend: an impulse down, a correction to the upside, and another impulse down. These waves are labelled A, B, and C.
Nelson also discovered that the movements are fractal. This means that the pattern happens on small and large time frames. For example, a daily chart with a first impulse wave higher within an uptrend has five waves on an hourly chart.
Price structure helps traders to know which direction a trend is moving in and when to enter a trade. The moment there are three big moves to the upside, it suggests that the uptrend may be close to completion. It’s typical to find these patterns in markets that are widely-traded with a high volume.
However, it’s quite difficult to find these patterns in individual assets because they will often move based on the trading activities of a few individuals.
Image showing how a trader can use the Elliott Wave Theory to enter trades and become profitable
Typical correction size
When traders sell on corrections in a downtrend or buy during an uptrend, it’s crucial to know the size of the typical correction.
Nelson discovered that wave two from the five-wave pattern, also labelled B, is about 60 per cent the length of wave one. So, if wave one advances $3, wave two may see the price drop by about $1.80 in stocks trading.
If a downtrend started and wave one was $4, the correction to the upside is often about $2.40. Impulse wave three, which comes after wave two, is often the largest and much bigger than wave one. The fourth wave, which comes next, is usually 30 to 40 per cent the size of the previous wave.
If traders see a particularly large correction wave on the horizon, that may help them enhance their trade timing.
Incorporating the three concepts
It is a good idea for traders to use the three concepts above when taking trades during impulse waves. However, traders can also look out for entry signals the moment the price has corrected the average amount in order to take trades during the corrective waves.
Ideally, the correction doesn’t happen exactly at the percentage levels. Therefore, trading slightly below or above the described percentage level is fine.
The bottom line
The three concepts of the Elliott Waves may enhance a trader’s timing and analytic skills, but traders need to know that the theory has some drawbacks.
In addition to being difficult to apply, it could be tricky to isolate the three and five-wave patterns. Therefore, it’s best to use the theory alongside other strategies and indicators.