Elliott Wave Theory Summary
From R.N. Elliott's essay, "The Basis of the Wave Principle," October 1940.
The Elliott Wave Theory is a popular form of technical analysis created by Ralph Nelson Elliott through the theory that, within the law of nature a multitude of things occur through a series of five-wave patterns. After he applied it to the financial markets, he realized they followed suite through an advancement of five waves.
This consists of three bullish waves, labeled with the numbers 1, 3, and 5 – which are separated by two consecutive down waves, numbered 2 and 4. In a down market, the same is true but reversed: three bearish waves separated by two bullish waves, each with the exact same number pattern of 1, 3, 5, 2, and 4.
Here's how traders can lay out a plan of action for applying the popular Elliott Wave Theory onto their own charts.
Layout Out An Elliott Wave Plan
Before implementing any new trading strategy, it’s important to have a detailed plan of action. So, here’s a fairly simple step-by-step plan for applying Elliott Wave theory to the Forex markets.
Step 1 – Find your own way of determining Elliott Wave count. While a majority of traders use their own manual analysis, there is also a number of reliable charting software for generating Elliott Waves. The ProfitSource software by HUBB is one example.
Step 2 – Be patient, wait for the beginning of a wave 5. While this sounds simple, waiting for a wave 5 to occur can actually be surprisingly difficult as it requires a great amount patience. The reason we wait for the mark of a new wave 5 is because it indicates the last leg of the current trend.
Step 3 – Find trend confirmation using one or multiple indicators. If we’re looking to confirm a buy signal, we will wait for a bullish wave 3 to turn into a bearish wave 4, and then use the following indicators to decide if the trade should be made or not: 1) If the 90-day CCI is positive with a sum greater than zero, for example. 2) The 3-day RSI makes a reversal to the upside for a single day.
Step 4 – Pinpoint a logical stop-loss area. If we’re placing a buy using Elliott Wave, then to calculate our stop-loss level we would subtract the 3-day ATR from the low of the current wave cycle. For a short sell, we would add the 3-day ATR to the high of the current wave cycle.