Elliott Wave Theory can seem like a dream come true to traders. It offers traders a description of how markets should behave, with precise rules that help identify price targets in advance. Applying the rules, traders can determine market turning points by forecasting price moves to two decimal places of accuracy. Examples that are used to explain Elliott Wave usually show that the theory has worked with amazing accuracy in the past.
Numerical relationships based on the Golden Ratio and Fibonacci numbers are used to identify possible trading signals. Combined with an almost mystical explanation as to why Elliott should work, followers of the Theory often believe they hold the key to great riches in the markets if they correctly apply the strategy.
At its most basic level, the ideas behind Elliott claim to bring order to the chaotic movement of prices over the short-term. This characteristic may also be the greatest weakness of the theory – the precise forecasts can bring a false sense of confidence to traders. Given the strong argument that Elliott works because its relationships are defined in nature and found in everything from tree leaves to the Great Pyramid in Egypt, sometimes new traders try to blindly follow the rules of Elliott suffer large losses. Perhaps more frequently, they miss opportunities in the market because their interpretation makes them believe the market is moving in the wrong direction and will soon reverse to prove them right. If this is a problem for you, it’s time to recall the first rule of trading which is that making money is more important than being right.
Elliott Wave breaks the markets down into repeating wave cycles. The idea is that price moves follow a recurring pattern, usually consisting of five waves in the direction of the major trend followed by a three wave countertrend move. In the primary trend, three up moves are interrupted by two downward corrective moves. A five wave pattern is then followed by a three wave pattern and this sequence repeats over and over again in the markets.
Fractal behavior would indicate that the market shows the same behavior over different time frames. Believing that markets are fractal, Elliott Wave practitioners analyze charts of all time frames and find the same waves occurring on one minute charts and yearly charts spanning centuries.
Fibonacci relationships define the waves. Wave two might be 0.618 times as long as wave one and wave three could be 1.618 times as long as wave one with that length added to the top of wave two to develop a price target.
The rules of the Theory can be precisely coded and tested, and the results that have been reported by those who have done this are not very encouraging. Elliott Wave does not test well, and the rules offer only a guide. For those wanting to try to apply the Theory, it is best to realize that Elliott provides only a framework for trading. Rather than relying on hard and fast rules, we can look at it as a way to spot general trends.
– Wave 1 is usually the shortest. Traders can use this Wave to recognize that there is a new trend forming.
– Wave 2 generally gives back all or most of the gains from the first Wave. This behavior is what leads to common chart patterns like double tops or bottoms and head and shoulders.
– Wave 3 will usually be longer than Wave 1 which means that it is the move that should deliver the largest gains. This should allow you to enter a low risk trade since the direction of the trend was identified when Wave 1 formed and the downside risk has been defined by Wave 2. A target for the trade can be found by adding the length of Wave 1 to the price at the bottom of Wave 2. This is a simple measured move grounded in the larger theory of market symmetry, and we do often find that markets move with a sense of symmetry.
– Wave 4 will frequently take the form of a complex pattern, such as a triangle. In the real world, prices will never move in a straight line. Since Elliott Wave Theory offers a trading framework rather than an absolute set of buy and sell rules, by knowing that Wave 4 will often look like a triangle, trend traders can use the time to prepare for a breakout from that triangle and have orders in place to catch most of Wave 5.
Another characteristic of Wave 4 is that the bottom of 4 will rarely, if ever, overlap the top of Wave 1. This means that if prices get close to that level, aggressive traders can enter orders to increase their gains from the trade on Wave 5.
– Wave 5 is often where speculative excesses occur. This is where markets will reach oversold or overbought levels and stay there. Oscillators won’t work well in this Wave, and when traders can spot a fifth Wave on a chart, they should avoid signals generated by traditional indicators.
– Following the five Wave pattern that unfolds in the direction of the trend, a three Wave countertrend move will take place.
– Wave A will break down into five individual waves, just as any of the other waves will. It is usually easy to spot the smaller wave structures in this phase of the market. We may also see heavier than normal volume as some investors are looking to sell their stock believing that the ultimate market top has been reached. Other investors and traders are trying to buy the dip because they expect the trend to resume. If the Elliott Wave plays out as expected, dip buyers will be rewarded.
– Wave B commonly occurs on light volume. The eventual price high of this wave may meet or even exceed the old top. This is why we see double top patterns appear on charts. The second peak of that top will be exceeded in the next five Wave pattern that develops.
– Wave C is expected to be only a set up for the trend move. Like Wave 4, it is a time for traders to decide where they will enter a market and the completion of Wave B offers them well defined entry levels.
Of course I am oversimplifying the actual strategy, but even with these basics, the Theory is tradable. Books have been written defining the rules and perhaps most telling the exceptions to the rules. Wave counts can be used profitably, but new traders need to understand exactly why they also face risks with Elliott. In the end, these techniques come with a number of fudge factors that explain why they don’t always work in real time.
In the old days, traders would explain to industry newcomers that you have to trade on the right side of the chart. Price charts show time with the oldest date on the left side of the chart and the present marked by blank space on the right side of the chart. We enter trades at the right edge of the chart, and the price action that follows determines whether we win or lose on that trade.
With Elliott, analysts devote most of their time to studying relationships of the past. From that, they create targets and alternate targets for the future, and when the price action doesn’t unfold as expected, they point to an alternate scenario that explains why. Unfortunately, we trade on the right side of the chart and brokers don’t allow revisions to account for alternate counts.
So, given all that, can these ideas be traded profitably? Some claim they can be, and offer the well-selected example as proof. The well-selected example is the historic chart that works out perfectly. It is a five wave pattern that turns lower exactly at the right time. The problem with this kind of proof is that there are hundreds of chart examples where the idea didn’t work.
Elliott Wave is not an objective set of trading rules. The ideas behind Elliott offer a set of guidelines to determine the direction of the trend and offer clear entry and exit points. If used that way, you could be profitable. However, it will take much more time to trade with Elliott that it will take to use a simple trend following strategy. For part-time traders, success with Elliott will probably be difficult to achieve since they won’t have the time to devote to detailed chart analysis.
By Michael J. Carr, CMT