The Elliott wave theory is a theory based on price action that can be applied to both bullish and bearish trends, which means it can be used for trend trading.
The key to trend trading is to catch a specific trend as it starts and to stay in the trade until the trend is exhausted and reverses or forms a corrective structure.
To use Elliott wave theory for trend trading, you must first understand how to trade the various waves that are described by the theory.
Breaking down Elliott waves into trends
Elliott wave theory states that five motive (impulsive) waves are typically followed by three corrective waves, as shown by the pattern shown below.
Chart 1: Illustration of the Elliott wave sequence
The chart above shows that there are two distinct trends represented by the two types of waves, with the motive waves representing an uptrend and the corrective trends representing a downtrend. Here is a look at how you can use these distinct trends for trend trading.
Identifying the trends hidden within Elliott waves
The motive waves in the Elliott wave theory represent the dominant trend of an asset, whether it is a downtrend or an uptrend, while the corrective waves represent pullbacks and, in some cases, reversals. Motive waves offer excellent trade setups for traders who are looking to use Elliott wave theory for trend trading.
Chart 2: Trend trading with Elliott waves
The chart above shows a simple breakdown of a bearish and bullish trend on the USD/CHF 4-hour chart into motive waves. However, since we are interested in trend trading, we have included the 20-period moving average to show us whether the trend we are trading still exists.
The USD/CHF 4-hour chart above shows that we would have made significant profits as trend traders by simply following the 20-period MA, which is aligned with the motive Elliott waves shown above. Therefore, as a trend trader, you might be best served by sticking to trend indicators such as the exponential moving average and the SMA instead of trying to use Elliott waves for trend trading.
With the knowledge that Elliott waves are not the best tools for trend trading in mind, here is a look at how Elliott waves are supposed to be used by traders.
Rules governing the Elliott wave strategy
Three foundational requirements must be met to confirm that the Elliot wave strategy is in place:
- Wave 2 must never retrace all the gains made by wave 1, and it should retrace a maximum of 62% of Wave 1. A full retracement immediately invalidates the strategy.
- Wave 4 should not retrace more than 50% of wave 3 as the retracement should be lower than that of wave 2.
- Wave 3 should be longer than wave 1 as the Elliott wave theory becomes invalid if it is shorter than wave 1; if that is the case, you will have to find another wave setup.
How to get the best trade entries using Elliott wave theory
There are two great points to enter into trades when using the Elliott wave strategy. The first one is at the end of wave 2, and the second one is entering after wave 4 is complete.
Chart 3: Elliott wave trade entry locations on USD/CNY 4-hour chart
The USD/CNY 4-hour chart above shows two excellent trade entry locations at the end of wave 2 and wave 4. The two entries allow you to benefit from the longest motive waves, which are wave 3 and wave 5.
In the chart above, you can see that wave 3 and wave 1 are almost the same sizes, which is usually the case. However, in situations where wave 3 is the longest, wave 5 usually has a similar length to wave 1. You could place your stop-loss orders slightly above the highs of wave 2 and wave 4 if you took any of the two trades above.
The bottom line
You can indeed use Elliott wave theory for trend trading, but other tools and indicators are better suited for trend trading. Instead, you should focus on using Elliott wave theory as a standalone strategy and consider adding other tools, such as the Fibonacci indicator, to better time your trades. The Elliot wave strategy is very diverse.