Elliott Wave Theory - Top 3 Rules
Updated: Mar 23, 2021
Elliott waves (Sometimes misspelled at Elliot Wave Theory) are a basic element of most trading strategies, if you are just starting out in the markets this information is essential for you!
Knowing and more importantly understanding this concept will allow you to understand why the market moves how it moves, no matter your experience level this is simply a 'must-know' topic, as it forms the basis of the majority of the analysis tools out there today!
In this article we will cover...
Elliott Wave degrees
3 Step Guide: How to use Elliot waves in Forex Trading
The 3 Elliot wave rules!
The main use of Elliot waves in trading is to identify strong and reliable trends in the market. This allows traders to time their trades well as it identifies strong trends…
But how do traders know whether a trend is strong or not?
Elliot sets out his 3 main rules for identifying a strong trend…
Rule 1
Wave 2 never pulls back more than 100% of wave 1, if it does this, the trend cannot be confirmed.
Rule 2
Wave 3 cannot be the shortest of the 3 impulse waves, when we see a third wave that is too short it means that it is not a correct wave count. Therefore, the next waves remain part of the third wave rather than forming 4 and 5.
Rule 3
Wave point 4 cannot go below the price of point 1, if wave point 4 breaks below the wave point 1 it clearly tells us that this is not part of the fourth wave, instead it carry’s on within wave 3.
These 3 rules are what traders use to identify and time their trades, and there are multiple different ways to use this system to trade and we will cover that shortly, for now though we must understand how technical analysts use a combination of Fibonacci figures and Elliot waves to time their trades as accurately as possible…
Elliot wave theory and principles
The Elliott Wave Theory was developed by Ralph Nelson Elliott to describe price movements in financial markets, in which he observed and identified recurring, fractal wave patterns. Waves can be identified in stock price movements and in consumer behaviour. – Investopedia
Ralph N. Elliot’s idea developed from his fascination in the phycology of the markets…
After being forced into an early retirement in the 1930’s due to illness Elliott needed to occupy himself.
Most retirees would maybe start collecting stamps or taking holidays in Spain, but not Elliott, he decided to study, but what he studied was not art or knitting…
He decided to study 75 years’ worth of yearly, monthly, weekly, daily, and hourly price charts across various indexes and markets.
The Elliott wave principle
Elliott’s wave theory exploded into popular market theory in 1935 when he successfully predicted a market bottom, and ever since then the Elliott wave theory has become one of the very core fundamentals of professional and retail traders globally!!
Elliott wrote a number of books, articles and letters describing specific rules on how to identify and use his wave theory, eventually published in 1994, R.N. Elliott’s Masterworks became regarded as the ‘hedge fund managers equivalent to the 10 commandments’.
Carry on reading to discover the genius of R.N. Elliot and why his theories are still used today.
What are Elliot waves?
Elliott Wave Theory is a broad and complex topic, taking practitioners years to master. Despite its complexity, there are elements of Elliott Wave that can be incorporated immediately and may help improve analytical skills and trade timing. - investopedia
Elliott’s wave theory uses market psychology as its main driver, Elliott discovered swings or dramatic changes in price trends always coincided with swings in the psychological factors that drove investors and other market participants…
This basically means that Elliott figured out that changes in price mirrored the views and opinions of investors and these swings could be seen in re-occurring patterns on the price charts of different assets…
These patterns are what we now call Elliot waves, and the best thing about Elliott waves is that they are what investors call “fractal patterns”. These fractal patterns for the wider Elliott wave pattern on the next highest timeframe, almost like a zoom affect.
But what are fractal patterns?
These are patterns that can occur on any timeframe, whether its over decades or seconds the patterns that Elliott drew out work the same way no matter what timeframe you analyse.
So, what do these patterns look like!?
Elliott waves are broken up into two parts, Impulse waves (1-5) and Correction waves (A-C). We will get to explaining them in detail and the theory behind them shortly however the main thing to take from the diagram above is the fact that this forms the basis for all market moves on all time frames…
This means that the five-wave impulse, in turn, forms wave 1 at the next-largest degree, and the three-wave correction forms wave 2 at the next-largest degree.
Tips from an Elliot Wave Trader:
Elliott waves remind me a lot of broccoli, in terms of how the smaller pieces of broccoli always look like mini versions of the main vegetable, this is the same with Elliott waves, the smaller timeframes always fit into and look like the larger timeframe movements.
Impulse and Correction waves
To draw identify Elliot waves you first must understand exactly what they look like and how they are formed, as we described before Elliott wavs move in two parts…
The impulse (made up of waves 1-5) is the initial direction of the market, this is where the bias of the market will play out and it shows the big picture trend, the impulse will either be bullish (investors are buying the asset) or bearish (investors are selling the asset).
Elliott waves for the basis of how we look at actual trends in price action, basically meaning that they help map out where the market is going.
The second section is the Correction waves (waves A-C) this is what we call a retracement or a pullback, these moves in the market show up in nearly every single other strategy in the forex industry.
Elliott waves help predict where these smaller retracements are (point 2 and 4) and where the larger pullbacks will occur (the correction wave).
This famous quote gives us great insight into the Elliott wave theory as his impulse and correction strategy follows this theory, after every big move (points 0-1 or 4-5) there is a correction or ‘reaction’ by the market (points 2 and 4).
Drawing out Elliott waves…
As we can see from the steps above, the first impulsive move incudes 5 different waves, 3 with the trend and 2 against it …
On the correction wave (A-C) we can see that it is made up of 3 waves/moves, 2 against the trend and 1 with the trend.
Introduction to Fibonacci
The basis of the work came from a two-year study of the pyramids at Giza.
Fibonacci is most famous for his Fibonacci Summation series which enabled the Old World in the 13th century to switch from Roman numbering (XXIV = 24) to the Arabic numbering (24) that we use today.
For his work in mathematics, Fibonacci was awarded the equivalent of today’s Nobel Prize. – Elliot wave forecast
Various Fibonacci ratios can be created in a table shown below where a Fibonacci number (numerator) is divided by another Fibonacci number (denominator). These ratios, and several others derived from them, appear in nature everywhere, and in the financial markets. They often indicate levels at which strong resistance and support will be found. They are easily seen in nature (seashell spirals, flower petals, structure of tree branches, etc), art, geometry, architecture, and music.
One ratio stands out above all in is sequences and that is the decimal, 1.618 (also known as the Golden Ratio) this is derived by dividing any Fibonacci number in the sequence by another Fibonacci number that is found 1 place to the left in the Fibonacci summation sequence.
What on earth is the Fibonacci summation sequence?!
Put simply This sequence takes 0 and adds 1 as the first two numbers. The following numbers in the sequence add the previous two numbers and this gives us 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 to infinity.
The Golden Ratio (1.618) is derived by dividing a Fibonacci number with another previous Fibonacci number in the series. As an example, 89 divided by 55 would result in 1.618 and so would 13 divided by 8.
Today Fibonacci is mainly used by traders to identify points in price movement where there may be the end of a retracement (pullback).
Fibonacci Retracement in technical analysis and in Elliott Wave Theory refers to a market correction (pullback) which is expected to end at the areas of support or resistance (reversals) denoted by key Fibonacci levels. The market is then expected to turn and resume the trend again in the original impulse wave’s direction.
A lot of retail investors use Fibonacci Extensions as well. These measurements refer to the market moving with the primary trend into an area of support and resistance at key Fibonacci levels where target profit is measured. Traders use the Fibonacci Extension to determine their target profit.
Macro investors such as the professionals at Goldman sacks and JP Morgan (plus the team at logikfx) do not use Fibonacci Extensions to determine where to take their profits.
Global Macro traders use ATR calculations and fundamental analysis to determine where the take profit zones will be, watch the Video below to see how this works!
What are the key Fibonacci levels?
Above you can see what a Fibonacci tool looks like to traders, here I have only the key percentages showing on the tool
But what do these numbers mean for traders?
These percentages or decimals give us key levels at which prices often reach before turning back towards the impulse direction.
How do you use Fibonacci with Elliott Waves?
Fibonacci Ratio is useful to measure the target of a wave’s move within an Elliott Wave structure.
Different waves in an Elliott Wave structure relates to one another with Fibonacci Ratio. For example, in impulse waves:
Wave 2 is typically 50%, 61.8%, 76.4%, or 85.4% of wave 1
Wave 3 is typically 161.8% of wave 1
Wave 4 is typically 14.6%, 23.6%, or 38.2% of wave 3
Wave 5 is typically inverse 1.236 – 1.618% of wave 4, equal to wave 1 or 61.8% of wave 1+3
Traders can use the information above to effectively time and place their entries into the market and when combined this can be a very effective tool.
Elliott Wave degrees
Elliott described the different time frames that the wave theory works on by using what he called wave degrees, they are…
Grand supercycle: multi-century
Supercycle: multi-decade (about 40 to 70 years)
Cycle: one year to several years (or even several decades under an Elliott Extension)
Primary: a few months to a couple of years
Intermediate: weeks to months
Minor: weeks
Minute: days
Minuette: hours
Sub-minuette: minutes
3 Step Guide: How to use Elliot Waves in Forex Trading
In this section I will be giving you a step-by-step guide on how to time your entries using all the aspects that I have taught you in the article so far, plus we are going to give you exclusive access to our cheat sheet so you can download it and keep it with you for when you need to time your entries.
Once you have your bias on an asset, using fundamental analysis, then you can start to time and place your entry using a combination of Elliot waves and Fibonacci.
First
Identify the trend by drawing Elliott waves on the chart, this will help you confirm your trend.
Typical places that you will find Elliott waves is after a ranging market, where price breaks out of the range.
Using Elliott waves you can either identify past trends or identify where you think price will go based on what wave point your analysis tells you it is at.
Second
You need to then identify where you are in terms of the impulse move or the correction.
This is so that you know what Fibonacci percentage you need to use when looking at timing your entry when you bring out the Fibonacci tool in step 3.
In this example I know that I am potentially on wave 2 of the Impulse series, so then I wait for a stronger pullback to confirm this.
Third
Use the Fibonacci tool on TradingView to identify where price will reverse too.
Check the cheat sheet, and identify what part of the impulse or correction move you are at and the correct levels to place your entries at.
Wave 2 is typically 50%, 61.8%, 76.4%, or 85.4% of wave 1
Using this information above from part of the cheat sheet, and the fact that price is pulling back I know that I need to highlight where on the Fibonacci tool price may go to.
I have highlighted this 50% - 85.4% area on the chart above!
I then map this out on the chart and set my entry point on the 50% Fibonacci level (green line).
Then BOOM!!!
This is no way means that you will replicate my success, this example is purely to show the strategy and how it can be a powerful tool, with practice and fundamental analysis backing up the technical.
Bonus tip
If you also want to place your stop loss and take profit then use an ATR calculator instead of Fibonacci to work this out.
If you need help building one or if you need help using the logikfx ready to use calculator, make sure to read through our explainer and watch the tutorial!!
Best book on Elliott Waves (Amazon)
If you are looking to dive deep into Elliott waves and gain a detailed understanding, make sure to check out the book “Elliott Wave Principle: A Key to Market Behaviour” by Robert R Prechter
Conclusion
R.N. Elliott was careful to note in his masterworks that these patterns do not provide any kind of certainty about future price movement, but rather, they serve in helping to work probabilities for different types of future market action.
They can be used with other forms of technical analysis, including technical indicators like the Fibonacci tool, to identify specific opportunities.
Technical analysis should be used to time and place tour entries, when all your fundamental analysis is done and you have a confident bias on whether to buy or sell the asset.
Only after that point, can you think of what type of technical analysis tools you want to use, this is just one of many we are going to be explaining here at logikfx to make sure that you stay Tuned!!!
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