What Is Elliott Wave Theory, And How Do You Trade With It?

By: Wayne Duggan

One of the most popular yet mystical technical chart analysis approaches is Elliott Wave Theory. Elliott Wave Theory is based on ideas developed by Ralph Nelson Elliott back in the 1930s. While some skeptics criticize the subjective nature of Elliott Wave trading, other traders swear by its general principles. Here’s a basic overview of Elliott Wave trading.

WHAT ARE ELLIOTT WAVES

The central idea of Elliott Wave Theory is that stock prices tend to move in the same patterns on different scales due to the psychology that drives market trading. Elliott theorized that the mass psychology of the collective group of investors that comprise the market is manifested repeatedly in the trading patterns of stocks. Elliott believed the same patterns can be seen in graphical representations of other mass decision-making trends as well, including fashion trends and traffic congestion.

The basic Elliott Wave pattern consists of a five-stage series of moves in the direction of the primary market trend, followed by a three-stage correction in the opposite direction. The first five waves in the primary direction are denoted as waves one through five and collectively called the Motive Wave. The three-wave correction is denoted as waves A, B and C and is collectively called the Corrective Wave.

Source

You can see on the chart above how the Motive Wave consists of higher highs and lower lows, and the Corrective Phase consists of lower highs and lower lows.

HOW THE WAVES ARE DETERMINED

There are three essential rules for Motive Wave formation:

  1. Wave 2 must retrace less than 100 percent of Wave 1’s gain.
  2. Wave 4 must retrace less than 100 percent of Wave 3’s gain.
  3. Wave 3 must exceed the peak of Wave 1 and must not be the shortest wave.

In the end, a full Elliott Wave Cycle will appear as a series of three successively higher peaks and troughs followed by a series of two lower peaks and troughs. However, as long as the prevailing trend remains intact, chains of complete Elliott Wave Cycles can be strung together, each cycle continuing to push the price in the direction of the primary trend.

Elliott Wave cycles are also fractal in nature, meaning smaller cycles can occur within larger cycles if the time horizon is adjusted. The image below is a clear example of Elliott Wave cycles within other Elliott Wave cycles.

Source

TRADING STRATEGIES VS. TRADING PATTERNS

It’s important to note that Elliott Wave Theory is a description of trading patterns, not an explicit trading strategy in itself.

Some traders attempt to catch every up and down swing in the Elliott Wave Cycle, while others keep it simple and wait for the first four waves of the pattern to form before attempting to capture only Wave 5 of the Motive Wave. Some traders ignore the individual waves and simply trade the Correction Wave, or look to buy the bottom of the Correction Wave to play the entire next Motive Wave.

Due to the subjective nature of Elliott Wave Theory, some traders are critical of the practice of Elliott Wave trading or find it too difficult or arbitrary to consistently apply. As always, traders who trade based on Elliott Wave Theory must identify a strategy that is best fit to their own personal strengths and skill sets, and they must remain consistent and disciplined in their trading approach.

DAY TRADING WITH LIGHTSPEED

Lightspeed provides day traders with all the tools required to help them find success in stock trading, and we have been developing and honing our active trader platform to offer the best possible user experience in the marketplace. With the intuitive interface layouts and institutional quality stock and option scanners, we aim to help traders reach their goals, no matter what their strategy is. We also offer our clients some of the lowest trading fees in the industry.

For more information on a professional trading platform with Lightspeed, please call us at 1-888-577-3123, request a demo or to open an account.

Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services provided by any of the above service providers and any service used to execute any trading strategies are solely based on the independent analysis of the user.

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