ELLIOTT
WAVE FOR
BEGINNERS
ELLIOTT WAVE BASIC T RADING GUIDE
ELLIOTT WAVE FOR BEGINNERS
DailyFX Research Team
Table of Contents
Elliott Wave Basic Trading Guide ................................................................................................. 3
Elliot Wave Theory: The Basics .............................................................................................................. 3
How to Count Waves .............................................................................................................................. 3
Impulsive and Corrective Waves ............................................................................................................ 4
ABC Corrective Waves ............................................................................................................................ 5
Wave Count Rules ................................................................................................................................... 6
Rules versus Guidelines .......................................................................................................................... 7
Waves within Waves, Multiple Degrees of Trend .................................................................................. 8
Minimize Forecasting Errors with Elliott Wave ..................................................................................... 9
English.................................................................................................................................................... 10
Disclaimer..................................................................................................................................11
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Elliott Wave Basic Trading Guide
Nearly every student to technical analysis has heard of the Elliott Wave Theory and is probably
fascinated by the concept. However, despite its popularity, I see others using Elliott Wave incorrectly
in forums, blogs and other media leading to a misunderstanding of its application. While traders are
attracted to EWT due to the few simple rules, they find the real time application into the live market
to be complex and prone to errors thereby stamping the theory as “too subjective.” For those who
correctly understand the rules, Elliott Wave Theory can be a reliable basis for interpreting and
forecasting price action. For those who misinterpret the rules, incorrect forecasting will lead many to
conclude the Elliott Wave Theory is obsolete. Nevertheless, many traders have used Elliott Wave
Theory to successfully identify turning points in price action.
Elliot Wave Theory: The Basics
Developed by Ralph Nelson Elliott in the 1930s, Elliott Wave Theory was originally designed to forecast
stock price movement. Overtime however, the theory has been applied to a variety of markets,
particularly foreign exchange. Elliott Wave Theory is now a very popular analytical strategy frequently
used by the technicians of leading investment banks and intermarket players.
The Elliott Wave Theory is founded on the notion that markets are not perfectly efficient. As a result,
prices from one moment to the next are not random but rather subject to changes in overall investor
behavior—changes that can be predictable with an understanding of mass psychology.
How to Count Waves
Before understanding the waves within the Theory, it is important to remember the tenet that every
action creates an opposite reaction. Applying this thought to Elliott Wave, let us take a look at the
most basic wave structure. The center of the Elliott Wave Theory rests on the idea that security prices
move in waves: motive (going in the direction of the underlying trend) and corrective (going against
the underlying trend). As indicated in the diagram below, there are five waves defining the direction
of the near term trend followed by three corrective waves. There are of course waves within waves
that we will touch upon later in the guide.
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Impulsive and Corrective Waves
To fully understand the Elliot Wave Theory, it is important to understand the psychological rationale
for each of these waves since the zigzag movement of prices represents the ebb and flow of investor
optimism and pessimism. Given in an up trending market:
Wave 1 (Impulsive): Minor Up wave In Major Bull Move – In Wave 1, prices rise as a relatively small
number of market participants buy a currency pair for either fundamental or technical reasons,
pushing prices higher.
Wave 2 (Corrective): Minor Down wave In Major Bull Move ‐ After a significant run‐up, investors may
get fundamental or technical signals indicating that the currency is overbought. At such time, Wave 2
develops when original buyers decide to take profits while newcomers initiate short positions. Price
action reverses, but generally does not retrace beyond its initial low that attracted buyers at Wave 1.
Wave 3 (Impulsive): Minor Up wave In Major Bull Move ‐ Often the longest wave of the five, Wave 3
represents a sustained rally, as a larger number of investors use the Wave 2 dip as a buying
opportunity. With a broader range of buyers, the security enjoys a stronger push higher, with prices
extending beyond the top formed at Wave 1
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Wave 4 (Corrective): Minor Down wave In Major Bull Move ‐ By Wave 4, buyers begin to become
exhausted and again take profits in reaction to overbought signals. Generally, there is still a fair
amount of buyers, so the retracement here is relatively shallow.
Wave 5 (Impulsive): Minor Up wave In Major Bull Move ‐ Wave 5 represents the final move up in the
sequence. At this point, buyers as a whole are motivated more by greed than any fundamental
justifications to buy, and bid prices higher irrationally. Prices make a high for the move before a
correction or reversal ensues. The high in Wave 5 often coincides with a divergence in the relative
strength index (RSI).
ABC Corrective Waves
Wave A: Correction To Rally – Initially Wave A may appear to be a correction to the normal rally.
However, if it breaks down into five subwaves, it indicates that a new market trend may have
developed.
Wave B: Bear Market Correction – Wave B tends to give bears an opportunity to sell as others take
profit on their short trades or exit their long positions.
Wave C: Confirms End Of Rally – Wave C is the last wave of the cycle. At this point, Wave 3 typically
breaks key support zones and most technical studies confirm that the rally has ended.
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Wave Count Rules
While determining waves in real time can be challenging, there are three rules to counting waves that
always hold. These rules form the basic tenets of Elliott Wave Theory.
Rule 1: Wave 2 cannot retrace more than 100% of Wave 1
Violation of Rule 1:
Rule 2: Of waves 1, 3, and 5, wave 3 can never be the shortest wave (it is, often the longest)
Violation of Rule 2:
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Rule 3: In an impulse, wave 4 cannot overlap wave 1
Violation of Rule 3:
Rules versus Guidelines
Though the list of rules is concise, there is a much larger list of guidelines for Elliott Wave Theory.
Rules cannot be broken. If you find a violation of a rule, that means your interpretation of the market
is incorrect and look for another wave count where all of the rules are satisfied. Guidelines are
different. Guidelines have a tendency to appear, but they may be violated. Though guidelines do not
have to be followed, finding them in patterns typically leads to higher probability wave counts.
Here are some examples of Elliott Wave Theory Guidelines:
In an impulse:
•
Wave 2 typically retraces 38-78% of wave 1
•
Wave 3 tends to have Fibonacci proportion to the length of wave 1 (1.618, 2.618, 4.23)
•
Wave 4 typically retraces 38% the length of wave 3
•
Wave 5 can become 38% or 61% then length of waves 1 through 3
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Corrective waves:
•
Alternating waves tend to have equality or Fibonacci relationships to their distances (ie- wave
C = wave A, or wave C = .618 x wave A)
•
In a complex correction, the distance of wave Y tends to have an equality or Fibonacci
relationship to the distance of wave W
•
Corrections to a completed impulse wave tend to retrace back to the previous 4th wave of
that impulse
Waves within Waves, Multiple Degrees of Trend
Elliott Wave Theory can be difficult to understand because waves frequently occur at many different
levels or at different degrees of trend. In other words, there are minor waves within larger waves. That
is why at many points in time, multiple correct wave interpretations usually exist. A good Elliott Wave
technician will use deductive reasoning to figure out which combinations of patterns are not feasible
and eliminate those. Then, of the remaining patterns, determine which wave counts are higher
probability.
The major waves determine the direction of the trend, while the minor waves help to form the major
waves. Used in conjunction, traders can apply Fibonacci ratios and guidelines to Elliott Wave Theory
to help determine when markets will reach a top or bottom. It can also be used as a tool to identify
points to trade within the trend or to participate in the shorter minor wave cycles. It is important for
Elliott Wave traders to be aware of both the minor and the major waves that may exist. The following
is an example of a minor wave appearing within the larger waves:
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Minimize Forecasting Errors with Elliott Wave
Since many different waves can exist during the same time frame that increases the risk of
forecasting error, traders should follow certain guidelines to minimize risk. The most important of
which is to follow the principle that the “the trend is your friend.” This means that it is more prudent
to only look for opportunities sell into minor waves when the major wave is a downtrend and to buy
when the major wave is an uptrend. More rules can be used though to determine levels for placing
stop‐loss orders or to exit the trade. Fibonacci ratios are one of the most useful ways of identifying
possible peak or bottoms of wave cycles. A popular relationship that exists is that Wave 2 retraces
38% to 78% of Wave 1. 50% and 61.8% retracements are also frequently seen.
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Below is an example of a five‐wave move in GBP/USD:
Jeremy Wagner is a Certified Elliott Wave Analyst (CEWA-M). Follow his articles and webinars for
current market analysis using Elliott Wave Theory:
https://www.dailyfx.com/authors/bio/Jeremy_Wagner
English
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