Wave Pattern: How to Trade Using Elliott Waves?

Trading financial markets are based on many rules, instructions, and strategies. In the 19th century, several economists and analysts claimed that certain natural rules governed trading. According to these experts, trading identifies repeating and predictable cycles in price fluctuations, and Elliott Wave Pattern Theory fits into this line of thinking.

What is Elliott Wave Theory? How to Trade with Elliott Waves Indicator? What strategies to put in place with this advanced Elliott wave technical indicator? Here is some light shed on these questions that will help you to implement a wave pattern into your day trading strategy.

Elliott wave pattern theory – Origins

It was in the 1930s that Ralph Nelson Elliott, a market analyst, and trained accountant, introduced the wave theory of the same name. At a time when market movements are seen as not following any precise rule (except the chaotic nature of fluctuations), Elliott contradicts the beliefs of the time.

The theory is based on the study of 75 years of financial charts relating to different indices. At first confidential, Elliott’s theory gained notoriety in 1935 when its inventor used it to predict a fall in the stock market.

In the early 1940s, wave theory continued to develop. Elliott, in particular integrated different models of human behavior, using the Fibonacci ratio. He gathered most of his knowledge in The Law of Nature: The Secret of the Universe.

Inspired by the theories of Charles Dow and Leonardo Fibonacci, the American analyst affirms that the market is governed by several cycles, all similar in form since the latter would consist of eight “waves.”

Charles Dow’s theory implies that there are three major trends forming stock prices, namely a primary, secondary, and tertiary trend. Leonardo Fibonacci, for his part, is the origin of the theory of the golden ratio, widespread even in the world of trading.

Initially rejected, the Elliott wave theory resurfaced in the 1980s, thanks in particular to the work and publications of the American writer and financial analyst Robert Prechter.

What is the wave theory?

The Elliott wave theory sets out principles that allow technical analysts to identify “waves,” that is, cycles in the evolution of the price of a particular asset. Once the existing waves have been identified, one can try to anticipate the next wave using the general sequence described by the theory.

Elliott Wave Pattern Definition

By definition, Elliott Wave Theory is a technical analysis tool.

This method makes it possible to anticipate future market movements. It identifies patterns of different magnitudes and duration, which repeat themselves in cycles composed of waves. Recognizing these cycles and the wave that composes them at a given time would therefore amount to predicting the market’s evolution.

Elliott wave theory is based on two factors:

• market psychology;
• natural forms and phenomena 

The waves in question alternate between rising and falling, impulse and correction, and predictable and unpredictable movement. Because this pattern is repeated infinitely in the markets and at all scales, it is called a “fractal sequence” or fractal indicator.

Although it requires great expertise to be exploited in the financial markets, the Elliott wave theory is a simple concept to grasp.

Basic principles of Waves Pattern

In concrete terms, a cycle is made up of 8 waves divided into two phases:

the main trend (bullish or bearish) is made up of 5 waves;

a corrective trend that offsets (only in part) the initial trend, made up of 3 waves.

Good to know: Such a short-term cycle can be contained in another longer-term cycle.

The whole cycle is composed of alternating impulse waves (which follow the main trend) and corrective waves. This observation stems from a fundamental principle of Elliott wave theory: any market action (rise or fall) is followed by a reaction (reverse trend).

Finally, note that any ending cycle is directly followed by another cycle.

Wave Pattern Explained

The pattern consists of waves and sub-waves, notably five impulse waves and three corrective waves. 

Impulse waves

• Wave 1: This is an impulsive movement in the direction of the trend.
• Wave 2: a small corrective movement, which indicates that the “bears” are present.
• Wave 3: This is the movement that traders like the most. Usually, the trend bounce after move 2 confirms the wave uptrend at which traders enter the market. Wave 3 is usually the most violent, where prices climbed the most.
• Wave 4: Another corrective move, which takes relatively longer than the previous correction.
• Wave 5: an uptrend, which indicates the high point of the uptrend. This wave is less convincing than wave three and generally does not exceed it much. Moreover, between the “peaks” numbers 3 and 5 it is not uncommon to observe divergences when using other technical indicators such as the RSI, the MACD, the ROC, etc.

Corrective waves

Trend A: This is a movement that is contrary to the trend. Notice that this move breaks the blue uptrend. That’s the sign or confirmation that we are dealing with a trend reversal.

Trend B: This move might confuse you. It’s because, technically, it is a ”correction of the correction”.

Trend C: This is the last trend of the Elliott waves. It is opposite to the general trend and follows the direction of the correction.

Elliott waves apply on the upside but also the downside. 

What is a bit difficult with Elliott waves is to know how to distinguish the first stages and then enter “in the middle.” Thus, the most common case is trading the corrections after identifying the first 5 waves. 

High-wave trading pattern

This pattern indicates a neither bullish nor bearish trend in the markets. It points out that we have indecisiveness, where sellers and buyers compete to drive market prices in a certain direction.

The wicks indicate a lot of price fluctuations, but the overall prices are close to the opening level. While sellers are cutting the prices, buyers try to do the opposite. 

Let’s see how to read this pattern using stock market examples. If the stock price goes upward and a high wave pattern occurs, it could signify price consolidation. After a couple of swings, the price fluctuating from highs to lows could break out and keep rising. If you notice this happening on the stock market, it’s better to wait a day or so before making your trading decision. 

Advantages and limits of Wave Pattern

Elliott Wave Theory is a technical analysis tool applicable to all time frames and most assets. Stocks, Forex, and commodities are ideal case studies to implement this method.

It is wise to take advantage of the historical data of your chart to train yourself to spot the waves, and this, as well in a strategy of Scalping, as of Day Trading or Swing Trading.

Also, Elliott Waves can be used in a bullish or bearish market, in a trend riding strategy. Trading Elliott waves also requires anticipating several scenarios (impulse or correction).

Good to know: To take a position with the Elliott waves, compliance with the rules of Money Management is essential. Remember to place your take profit and stop loss orders with precision!

Make no mistake about it: despite its very schematic form, the Elliott wave theory is long and complex to implement in the financial markets. Sometimes, distinguishing and identifying the right wave of this logical sequence takes work.

Why use this new indicator if the Elliott Wave Indicator looks so much like the MACD? Simply because traders who used Elliott Wave Theory to identify market phases noticed that the indicator helped them identify the different wave phases. The basic setting allows you to confirm the presence of waves and better detect their start and the moment you switch from one trend to another.

Behind its apparent simplicity, knowing how to draw Elliott waves and trading with this theory requires a lot of practice. However, you now have all the information and techniques to implement such a strategy.

Wave Pattern – Key Takeaways

Ralph Nelson Elliott invented the wave theory in trading almost a century ago. It’s an in-depth analysis that gives you significant insight into the market price dynamics. According to this theory of wave trading, markets that are in an uptrend or a downtrend can be broken down into specific waves.

Wave trading theory is based on the psychology and emotions of investors and traders. Many followers of technical analysis use this theory. Its popularity is explained by the fact that the theory can accurately indicate the reversal areas of the price.

In this way, it is possible to predict the peaks and troughs of the price. The basis of Elliott waves is a certain sequence and properties of the Fibonacci tool.

It predicts price directions on the financial markets and consumer behavior. Besides, homeowners widely use it to switch from their currency mortgages to the new ones, with better conditions and terms.

It should always be kept in mind that this is a theory that seeks to rationalize the subjectivity of human impulses, in particular, the reactions of investors. It is, therefore, not a question of applying a simple mathematical formula. Not all traders interpret this theory in the same way. Wave analysis, on the contrary, helps to understand the dynamics of trends and offers an in-depth understanding of price movements.