Contents

What is the Elliott Wave principle and why is it used by so many traders and investors? What does the basic Elliott Wave pattern look like? The six most important rules in Elliott Wave Theory that are needed to become a profitable EW trader. Four simple Elliott Wave trading strategies. Summary

Written by Luca Williams

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1. What is the Elliott Wave Principle (EWP) and Why is it Used by so Many Traders and Investors?

In the 1930s an accomplished accountant called R.N. Elliott spent his retirement days meticulously analyzing the stock market. He eventually discovered a pattern, completely unknown to anyone else in the world at the time, that could not only make sense of every single up and down movement in the market for from as far back as when records began, but it could also make predictions for future price movement by using Fibonacci ratios. Unlike most new market theories published at the time, Elliott’s theory actually worked and gave a valuable insight into the near and longer-term future for price movement. The popularity that the theory has today is a result of its usefulness, but it has to be used in the correct way. This article will outline the ways in which you can yield the power of his theory in the most streamlined way possible.

During the time he was discovering the theory Elliot was severely ill, but he managed to publish his findings in a book called ‘The Wave Principle’ in 1938. Elliott expanded his findings to cover all human behaviors and presented his work in his subsequent book called ‘Nature’s Law –The Secret of the Universe’ just two years before he passed away in 1946. Robert Prechter and A. J. Frost wrote a more comprehensive guide to use Elliott’s Wave Theory. It was published in 1978 and was called ‘Elliott Wave Principle: Key to Stock Market Profits’. This is the modern-day textbook for the EWP that I highly recommend traders to read.

One of the beauties of the EWP is that it is not necessary to follow world events because the price chart reflects the current cumulative knowledge of everyone in the world in real-time. Thus, the chart is itself the most up to date news on the financial asset. Any news you read has very likely already translated into a movement in price. This is because the largest players, e.g. hedge funds and banks, will have received these stories before the general public and will have had a head start. Even when there is a shocking news event that causes huge volatility in financial markets, the long term trend shown by Elliott Wave analysis is always unchanged.

One of the downsides to the EWP is that is has a steep learning curve. However, the time is very well spent as this can be a consistently profitable strategy once you become an Elliott Wave Master.

How To Benefit Most From This Article

1. Read through the 6 essential rules in Section 3 and the trading strategies in section 4.

2. Try to identify a possible trade setup on a live chart of any financial asset.

3. Once you think you have found one, check that your count is correct by comparing it to the rules in Section 3 and use the recommended strategies in Section 4 to help you execute a profitable trade.

At first, these principles may seem difficult to grasp, so if you don’t understand them the first time around, this is normal and it will usually take a few repetitions to fully understand each concept.

For those who want to go straight into trading with The EWP, please skip to Section 4 to learn about the four simple Elliott Wave trading strategies. However, it is HIGHLY RECOMMENDED to first read through the six essential rules of the EWP. This will help you avoid some of the traps that most traders fall into when starting out with the EWP. This can save you money by preventing you from entering into losing trades, so its worth the time!

2. The Basic Elliott Wave Pattern

Elliott analyzed stock market data intensely in the 1930s and noticed that charts of financial assets tended to repeat the following pattern on all time frames.



The basic Elliott Wave pattern consists of 5 waves up followed by 3 down. A ‘wave‘ is a term used to describe an upward or downward movement that can be labeled with a letter or number placed at the end of the wave, as shown in Fig. 1. It is important to note that in Fig. 1 the waves (1), (2), (3), (4) and (5) (in blue) make up green wave 1 and waves (A), (B) and (C) (in red) make up green wave 2. Waves (1), (3), and (5) can be divided into 5 waves that move in the direction of the main trend. Waves (2) and (4) move against the direction of the main trend and tend to move sideways in a 3 wave pattern labeled A, B and C. Wave 4 will sometimes form into a triangle that will be divided into five waves with an overall sideways motion (not shown here, but triangles will be discussed further in section four).

The basic Elliott Wave pattern

The green waves 1 and 2 in Fig. 1 above refers to the highest ‘degree’ on this chart. The higher the degree, the longer the time period the waves develop over. The lowest degree in Fig. 1 is shown by the black numbered waves 1,2,3,4 and 5. Thus, when I say an ABC will follow after 5 waves, it does not matter whether I am referring to the orange waves A, B, and C or the red waves (A), (B) and (C) because a 3 wave move always occurs after 5 waves up at all degrees of the trend.

As you look closer at a smaller section of the pattern, for example, if you were to focus on just the blue waves (1) and (2) (as shown in Fig. 2 below), you would see that blue wave (1) is made up of 5 waves 1, 2, 3, 4 and 5 (in black). Blue wave (2) is made up of waves A, B, and C (in orange). A similarity is seen between these two diagrams as Fig.1 contains 2 waves shown by the green waves 1 and 2 which are essentially the same as in Fig. 2 which has 2 blue waves (1) and (2). If you were to zoom into only the black waves 1 and 2 (within blue wave (1) for example), you would see again that black wave 1 would be divided into 5 waves and black wave 2 would be divided into 3 waves. Thus, the Elliott Wave pattern is a fractal.

The Elliott Wave Pattern is a fractal. Fig. 2 shows a time frame of 3 months while Fig. 1 spans over 10 months, but the same five up three down pattern is seen.

To Summarise:

Waves 1, 3 and 5 can be divided into 5 waves and move in the direction of the main trend.

Waves 2 and 4 are sideways patterns and occur after 5 waves have completed. They move against the direction of the main trend.

Wave 4 will sometimes develop into a triangle that contains 5 waves in a sideways motion (triangles will be discussed further in section four).

3. The Six Essential Elliott Wave Rules

To be able to use the EWP to make sound predictions on future prices, you must first learn these six rules that will help you to label charts in the correct way.

Rule 1: Wave 2 Cannot Retrace More Than 100% of Wave 1

If wave (2) moves below the red line, the wave count is invalid and must be changed (see Fig. 3).

Wave 2 must not move below the low of wave 1

Rule 2: Wave 3 Is Usually The Longest And Never The Shortest

Wave 3 MUST be longer than wave 1 and/or wave 5. If wave 3 is shorter than waves 1 and 5, the labeling (as in Fig. 4) is false and this pattern cannot be a five wave structure.

Wave 3 is usually the longest and never the shortest

Rule 3: Wave 4 Cannot Move Into The territory of wave 1

As shown in this 4-hour chart of Bitcoin against USD (Fig. 5 below), the white horizontal line represents the high of wave 1. Elliott Wave theory states that wave 4 CANNOT move below this white line and if it does, this wave count must be false.

Fig. 5 shows the exception of rule 3. Wave 4 moved below the high of wave 1, but only momentarily shown by the wick, so this wave count is valid.

There is one exception however because in highly leveraged markets, there are often moments when traders get liquidated. This can cause long ‘wicks’ to appear. See below for what is a wick.



Thus, EW theory also states that in leveraged markets, wave 4 CAN move below the high of wave one (the white line), BUT ONLY for a very brief period of time and only by a small amount. A real example of this exception is shown in Fig. 5 above. As shown by the pink box, the low of wave 4 was below the white line, but price closed above the white line, therefore this is still an acceptable wave count.

What is a candlestick?

A candlestick is a way to illustrate the high, low, open and close price during a chosen amount of time. If you choose a time period of one hour, then every hour, a new candle will start. If the candle is red then price finished the hour lower than when the candle opened. A green candle means that price was higher when the candle closed than when it opened. THE UPPER WICK shows the highest point that price reached during the time period and the LOWER WICK shows the lowest price point.

If many traders get ‘liquidated’, the exchange that they trade on will automatically close their entire position which can result in a large spike in demand. This will appear as a long wick on a price chart. Thus, in leveraged markets, we can often ignore very long wicks as they will often invalidate many Elliott Wave counts.

Rule 4: A Leading First Wave Diagonal (LFWD) Can Be Wave 1 or A

A LFWD is a 5 wave pattern seen only as wave 1 or A and has the following rules:

Wave 2 must retrace less than 100% of wave 1 Wave 4 can move below the high of wave 1 but must retrace less than 100% of wave 3. Wave 3 must not be the shortest compared to waves 1 and 5. Waves 1, 3 and 5 can be divided into 5 waves while 2 and 4 into 3 waves. Thus, a LFWD can be denoted by (5-3-5-3-5).

See Fig. 7 below for an example of what a LFWD will look like. Usually, wave 1 will be the longest, but not always.

A LFWD, as shown above, usually has converging trend lines.

Rule 5: An Ending Fifth Wave Diagonal (EFWD) Can Be Wave 5 or C

An EFWD can only be seen in the 5th or C wave (see waves labeled with blue numbers in Fig. 8). In the same way as a LFWD, wave 2 cannot retrace more than 100% of wave 1, wave 4 cannot retrace more than 100% of wave 3. It takes the form of two converging trend lines (as shown in Fig. 8 below) and wave 3 cannot be the shortest. Once the pattern has completed all 5 blue waves a dramatic reversal will follow.



The MAJOR difference between a LFWD and an EFWD is that within a LFWD, waves 1, 3 and 5 can be divided into 5 waves and during an EFWD ALL 5 waves are divided into 3 waves. This is because an EFWD is an ending pattern and there is not enough buying pressure for waves 1, 3 and 5 to unfold into 5 waves. Thus, this pattern can be denoted as (3-3-3-3-3). A LFDW is only seen in waves 1 or A, thus it is at the start of a trend and there IS enough force for waves 1, 3 and 5 to unfold into 5 waves.

An EFWD most commonly has converging trend lines and is a warning of a sharp reversal ahead.

Rule 6: Alternation

This is more of a guideline rather than a rule, but it is very useful to know. Alternation means that waves 2 and 4 will tend to alternate in terms of depth (i.e. how much they retrace the prior wave) and complexity (if wave 2 is a simple pattern and takes a short amount of time, then wave 4 will likely be more complex and develop over a relatively longer time period and vice versa). A powerful phrase to remember this rule is, if wave 2 retraces a lot, 4 will not and vice versa. See Fig. 9 below for an example:

When wave 2 retraces a lot, wave 4 will not.

Fig. 9 is an example of a typical wave that can be seen repeated all the time in any financial asset. The diagram shows that wave 2 retraced 61.8% of wave 1 (0.618 is the golden ratio that is related to the Fibonacci sequence). As wave 2 retraced a lot, it is now very likely that wave 4 will not retrace a lot and will usually fall between 23.6% to 38.2% of wave 3 (these percentages are Fibonacci ratios that often act as support after 5 waves). Thus, if there is a deep retracement of wave 2, you know that wave 4 will very likely retrace less.



Why is this useful? If you see that wave 2 retraced a lot to around 62% of wave 1, you know that wave 4 will likely not retrace much. This tells you that a short position at the top of wave 3 is very risky because the drop will not be very large. Also, you could buy during wave 4, and profit from wave 5 up, because you know that it is unlikely that wave 4 will drop heavily.



Refer to Fig. 10 for the following example. If on the other hand, blue wave (2) only retraced around 23.6% of wave (1), you know it is highly likely that wave (4) will drop relatively more than wave (2) to around 62% of wave (3). Thus, there is a better chance of you making a profit from entering a short position at the top of the blue wave (3), when wave 2 only retraces a small amount. You also know to avoid going long (buying) early on during wave (4) because you expect a relatively larger drop compared to wave (2).

4. Four Simple Elliott Wave Trading Strategies

The most profitable waves to trade are waves 3, 5, A and C.

Why are waves 3, 5, A, and C the most profitable? Wave 1 can only be identified once it has completed, thus it is hard to predict this wave. Waves 2 and 4 are advised to be avoided because they travel a shorter distance compared to waves 3, 5, A and C.

If you think you have identified either a wave 3, 5, A or C before it has started, make sure you check that the wave count satisfies all 6 of the essential rules in section 3 (although alternation is not a must, seeing alternation will improve the probability of a successful trade).

Strategy 1: How To Trade Wave 3

As wave 3 is usually the longest and never the shortest, it can offer the highest rewards. The best way to trade wave 3, is to wait for waves (1) and (2) to complete, as shown in Fig. 11 below. The best place to start adding to your long position (buying) is at the end of the wave (2). Note that wave C ALWAYS ends in 5 waves. Since it is impossible to know exactly when wave (2) will end, we can use probability to our advantage. It has been found that wave (2) will usually end in a zone between 50% – 61.8% of the height of wave 1 (100% being at the bottom of wave 1 shown by the red line). This zone is shown in Fig. 11 below by the two blue lines.

Wave 2 will most often end between the 50% – 62% retracement of wave 1.

It is recommended to enter around 50% of your position between the 50% to 61.8% retracement of wave (1). The other 50% can be added once price moves above the high of wave (1), as shown by the red arrow. This method will reduce your risk and over time will make you a more profitable trader.



If you decide to take this trade, you must place a stop loss 1 tick below the base of wave 1, shown by the red line in Fig 10. This is necessary because a move below the red line will invalidate this wave count and it means that it would not be possible for a wave 3 to occur as you predicted.

Where Should You Take Profit If Wave (3) Does Unfold?

A common length for wave (3) is 1.618 times the length of wave (1) added to the end of wave (2). This can be easily calculated by:

Select the Fibonacci extension tool (available in most charting software). Click on the start of wave (1), shown by the black arrow in Fig. 11. Click on the top of wave (1) shown by the red arrow. Click on the end of wave (2) shown by the orange arrow.

By double-clicking on one of the lines that should now appear, you can select the 1.618 box and this will be shown on the chart as a line that represents the precise point at which (wave (1) x 1.618) added onto the end of wave (2) is.



1.618 is a ratio well known by many traders and mathematicians. It is found all over the universe and also in the stock market. It is known as the golden ratio.



A great profit target is slightly before the price where wave (3) would be equal to 1.618 x wave (1) added to the end of wave (2). Wave (3) will almost always hit this golden ratio, but sometimes it may fall slightly short.

Strategy 2: How To Trade Wave 5

If you can identify wave 5 before it unfolds, you may have before you a highly profitable trading opportunity.



The entry point (the place where you want to enter most of your position) for a wave 5 trade depends on whether wave (4) is a triangle or an ABC.

Trading Wave (5) After A Triangle In Wave (4). Difficulty = Easy

Fig. 12 shows the trading opportunity when wave (4) is a triangle. A triangle is a sideways 5 wave pattern (wave (4) in Fig.12 is a triangle) where each wave can be divided into 3 waves and can be labeled ABCDE. A triangle can ONLY be seen in wave 4 or B position and NEVER in wave 2.



This is my favorite pattern to trade because there is relatively very little risk compared to the potential reward as shown below.

Important checklist before entering a long position after a triangle in wave (4):

Does each wave in the triangle have 3 waves? Is C the same level or higher than A? Is D the same level or lower than B? Is E the same level or higher than C?

If the answer to all of the above is YES, then as long as waves (1), (2), (3) and (4) comply with the 6 essential rules in section 3, then you have yourself a very nice high probability trade set up.



Simply go long (buy) once 3 waves have completed in E of (4) and set your stop-loss slightly below the low of C. A profit target should be between the 61.8% – 100% Fibonacci extension of wave 1. In other words, select the fib-extension tool in your chart software, measure the length of wave (1), add it to the end of wave (4) and target a 61.8% to 100% zone to take profit. A more simple profit target is the high of B of (4) (profit target 1 in Fig. 12) and the high of wave (3) (profit target 2 in Fig. 12).



It is important to note that wave 4 will usually end within the price range of wave 4 of the previous wave. Fig. 12 is an example of this because wave (4) ended at the same place as wave 4 of (3). The end of the 4th wave often acts as strong support.

Trading Wave (5) After An ABC In Wave (4). Difficulty = Easy

When wave (4) is an ABC (as shown in Fig. 13), read the following guide to profit from this opportunity.



Remember this as it is a very important point. Wave C always ends in 5 waves. Thus, if you think an ABC is forming you should simply be patient and wait for the 5th wave to form in wave C and then go long (buy). For example, see how the blue wave C contains 5 waves in Fig. 13 below.

Once you think that the 5th wave of C has finished, enter a long position (buy) and set a stop-loss slightly below the high of wave (1), as shown by the red line. This is because a move below that point will invalidate this count.



A conservative profit target can be to take profit between the high of blue wave B in (4) (profit target 2 in Fig. 13) and the high of wave 2 of blue C (profit target 1 in Fig. 13). A more precise target can be obtained by taking the Fibonacci extension of wave (1) and adding that distance to the end of wave (4). The 61.8% to 100% extension of wave 1 added onto the end of wave (4) is a great place to take profit.

Strategy 3: Trading Wave (A). Difficulty = Hard

The reason why this strategy is the hardest is that to make the most out of this trade, you must identify the very top of wave (5) to get the best entry price for a short position. This strategy requires a lot of experience and practice. If you do not have the experience, then it is recommended to spend a lot of time backtesting this strategy or first practicing with a demo account. It may be the most difficult strategy to execute, but it is the easiest to identify and can be found abundantly in charts of all financial assets.



To be successful when trading wave (A), you must exercise extreme caution and patience. For example, you should ‘ladder’ your position. This means that instead of going all in at once, you should scale into your position by adding 10% at a time, every 5 – 10 minutes for example.



Laddering will limit potential losses because if the asset you are trading decides to suddenly skyrocket, you will only have entered a small amount of your position which will result in a much smaller loss compared to if you went all in.



In order to improve your estimations of the end of wave (5) in real-time, you can use a combination of different tools including Candle Sticks, RSI, MACD, and Volume. By using a combination of all of these methods of technical analysis, you can hugely improve your chances of identifying points of reversals. This can make you a very profitable trader.

See Fig. 14 above for a guide on how to trade wave A.



The diagram shows how you should enter this trade when you think the end of wave (5) has occurred. Wave (5) must have 5 waves within it before it will end, so count these waves carefully.



To get a good idea about where to take profit:

Select the fib-retracement tool on your charting software. Select the bottom of wave (1) and then the end of wave (5). Between the 23.6% and 38.2% retracement is where you should take profit (see the pink box in Fig. 15). Another good place to take profit is the top of wave 1 of (5), as shown by the green line labelled ‘Profit target’ in Fig. 14.

Strategy 4: How To Trade Wave (C). Difficulty = Medium

See Fig. 16 below. Wave B in an ABC ALWAYS can be divided into 3 waves. Wave C ALWAYS will divide into 5 waves and wave A can be divided into either 3 or 5 waves.

The best possible entry price is shown in Fig. 16 above by the green line labeled ‘Entry’. To identify this in real-time, you should count as best as you can, 5 waves in wave c of (B) and when you see the 5th wave form in wave c of (B), you should enter a short position (sell).



To take profit, simply wait for 5 waves to unfold downwards and take profit when the 5th waves forms in (C) (shown by the green line labeled ‘profit target’ in Fig. 16). Or you can take profit when price reaches the end of wave (4) as this price level often shows a strong support.



When trading wave (C) your stop loss should be quite generous, but at the same time, you should try to maintain a risk to reward ratio of at least 1: 1.5.



This has a medium difficulty because this requires accurate counting of waves. After a bit of practice, this will become easy.

Summary

Congratulations on if you made it through this article!



Most people will give up after the first few paragraphs when trying to learn the Elliott Wave Principle because it is not easy to learn. The most important thing to do now is to practice every day and apply the theory to live charts as it WILL 100% pay off in the end.



Thank you for reading! If you have any questions or would like one of your Elliott Wave counts to be checked, feel free to email me at luca@bbod.io and I will be more than happy to help out.

Thank you for reading and I warmly invite you to send any feedback or questions to luca@bbod.io.

I highly recommended that you should join the best trading group on Telegram: https://t.me/BBODCommunity. There are many top traders to chat and free educational content which helps you to be a better trader. See you there!

To improve your skills trading, be sure to also read about RSI, Volume, Candlesticks Part 1, and Part 2. By combining all of these methods together, you can develop a great trading strategy to help you gain financial freedom.

This educational series is brought to you by BBOD – the largest non-custodial cryptocurrency derivatives trading platform. Trade altcoins with leverage at the most diverse cryptocurrency derivatives marketplace. Preview live trading here.

Written by Luca Williams

Disclaimer

This article has been prepared solely for informative purposes and should not be the basis for making investment decisions or be construed as a recommendation to engage in investment transactions or be taken to suggest an investment strategy in respect of any financial instruments or the issuers thereof. BBOD will not be liable whatsoever for any direct or consequential loss arising from the use of this publication/communication or its contents.