How to Trade Forex Using the Elliott Wave Theory

History of Elliott Wave Theory

• In the 1930s, Ralph Nelson Elliott, an American accountant and author, analyzed 75 years of stock market data, from yearly charts down to 30-minute charts.
• The theory he developed was one of the first to recognize that prices do not move randomly but unfold in predictable patterns.
• Ralph Elliott famously predicted the bottom of the stock market in 1935 within one day of accuracy after it had declined for 13 months. The subsequent bull market lasted nearly 2 years and almost doubled the value of the Dow Jones Index.
• Ralph Elliott stated that his theory tracked changing investment sentiment as it cycled from pessimism to optimism.
• Other market professionals have since modified Elliott wave theory with their own rules. Today, there is no single interpretation of Elliott wave theory, but all interpretations have similar underlying principles.

Understanding Elliott Wave Theory

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Elliott Wave Theory states that prices make 5 swings in the overall direction of the long-term trend and then typically 3 swings against it. Elliott called these swings “waves”.

• Together, the 5-waves in the direction of the trend (called the “impulse sequence”) followed by the 3-swings against it (called the “corrective sequence”) is known as a complete Elliott cycle.

Full Elliott Wave Cycle

• Each wave in the 5-wave cycle in the direction of the larger trend is labelled either 1, 2, 3, 4 or 5.
• Each wave in the 3-wave cycle against the larger trend is labelled A, B and C.
• To avoid confusion, traders label the waves at their endpoint—never in the middle or beginning of a wave. For example, “1” is written at the end of wave 1.
• The diagram above shows a bullish 5-wave move followed by a bearish 3-wave correction, but the first 5-wave pattern can be bearish followed by a 3-wave bullish correction.

Two Types of Elliott Waves

The waves in the direction of the larger trend are “motive” waves. The waves against the larger trend are “corrective” waves.

• In the above chart, waves 1, 3, and 5 are motive waves, and waves 2 and 4 are corrective waves.
• Waves A and C are also motive waves, and wave B is a corrective wave.

Corrective vs Motive Waves

Elliott Waves Subdivide into Smaller Waves

Each Elliott wave can be subdivided into smaller Elliott waves. That also means that each wave cycle is part of a larger sequence of waves.

• In Elliott terminology, the smaller subdivided waves are called “waves of a lesser degree.”
• You can use Elliott wave analysis on both small timeframes such as 1-minute charts and higher time frames such as the monthly time frame. Ralph Elliott had nine different timeframes (or “degrees”) in his research.

Waves of a Lesser Degree

• Today, some traders describe Elliott wave theory as “fractal”—a mathematical term for a pattern that repeats itself on different scales.

3 Rules for Elliott Waves

There are three rules that all Elliott wave traders agree on:

Rule 1: The end of wave 2 cannot go past the start of wave 1.

Elliott Wave Rule 1

Rule 2: Wave 3 cannot be the shortest motive wave.

• That means wave 1 or wave 5 (or both) must be shorter than wave 3. The length of the wave is how much price it covers, and not how much time the wave lasts.

Elliott Wave Rule 2

Rule 3: Wave 4 cannot go into the price territory of wave 2.

• This means waves 2 and 4 must have some clear separation of price.

Elliott Wave Rule 3

If you are ever stuck on where to place your Elliott wave points, always remember to follow those three rules.

Have you noticed that wave 5 is the furthest point in each diagram? That does not always have to be the case—sometimes, wave 5 does not go past the end of wave 3. This is called “Truncation.”

Truncation

So far, we have looked at neat diagrams of Elliott waves. Let us look at them on some actual price charts.

First, here is a daily chart of EUR/USD with a 5-wave bullish formation:

Bullish 5-Wave Formation

The S&P 500 made a classic A-B-C correction during the 2020 covid panic:

A-B-C Correction

So far, I have shown all the 5-wave moves as bullish to keep things simple. However, they can also be bearish depending on where they are in the market cycle. Here is a bearish 5-wave example in a Bitcoin daily price chart:

Bearish 5-Wave Formation

Corrective Sequences Can Be Messy

Anyone who has spent time looking at price charts will know that they can be very messy, and you may look at the chart and wonder how 5 waves or 3 waves can fit neatly onto the price moves.

• Elliott wave traders recognize this tendency to messiness, especially in corrective sequences, which tend to be more complicated than impulsive sequences.
• There are many types of corrective sequences beyond the simple 3-wave A-B-C pattern, and they fall into three categories:

Zig Zags

Simple Zig Zag

In this diagram, I have marked the waves of the lesser degree in the zig zag. This example is a simple zig zag, but it can extend where two or three zig zag formations are joined together.

Flats

Flat Correction

Triangles

Triangle Correction

Elliott Wave & Fibonacci

After Ralph Elliott identified wave structures, he connected them to Fibonacci levels to help find turning points.

• Elliott Wave traders use Fibonacci retracement percentages to help find their entry points.
• There are a variety of retracement levels, but the most popular used by Elliott Wave traders are:

1. 23.6%
2. 38.2%
3. 50% (not strictly a Fibonacci level, but often grouped with Fib retracement levels)
4. 61.8% (the Fibonacci Golden Ratio)

Let us look at how a retracement works:

Waves and Fibonacci Retracement

Here, wave 2 bounces against the 61.8% level before starting a wave 3.

Here is a notable example of a trade I took when the S&P 500 Index was collapsing at the beginning of the 2020 covid panic:

Wave Testing Fibonacci Retracement Level

It made a clean bounce against the 50% level and tested it again, providing plenty of time to enter a short trade.

• In addition to Fibonacci retracements for entries, you can use Fibonacci extensions as price targets. For example, Elliott wave traders often use 161.8% of the size of wave 1 as a potential target for the end of wave 3 (starting at the end of wave 2).

How Do You Trade Using Elliott Wave?

There are lots of ways to trade with Elliott wave theory, but here are some of the best bottom-line principles to keep in mind:

• The most popular place to enter using Elliott wave is at the beginning of wave 3, for two reasons:
  • Wave 3 is a motive wave in line with the higher timeframes.
  • Wave 3 is often the longest wave: under Elliott wave rules, wave 3 cannot be the shortest wave. This means it provides the best risk reward ratio opportunities.
    • If you are trading the beginning of wave 3, a good place for a stop loss is the beginning of wave 1, because wave 2 should not go past the start of wave 1.

Using Elliott Wave Analysis to Place Stop Loss

• Wave 2 tends to retrace more deeply, so when traders consider Elliott wave Fibonacci levels to enter the market at the start of wave 3, they often use 50% or higher.
• Wave 4 usually has a shallower retracement, so Elliott wave traders are often looking at 23.6% or 38.2% retracement levels as entry points at the start of wave 5.

The biggest criticism of Elliott wave analysis is that it is very subjective. This criticism is true—many Elliott wave analysts will disagree when analyzing the same market. Many other areas of technical analysis are usually less controversial—for example, most traders will agree on key support and resistance levels.

• To help make Elliott wave analysis more accurate, traders will use additional tools and indicators on their charts. I have seen successful Elliott wave traders use standard support and resistance levels, Fibonacci levels, MACD, and volume profile.
• Elliott wave trading is one of the hardest methods of technical analysis to practice well without guidance. Consider subscribing to an Elliott wave service that provides analysis or signals with explanations.

Final Thoughts

• Elliott wave trading is a method that can help you find structure in the markets with a set of rules to implement on price charts.
• Even with the rules, there is much subjectivity in Elliott wave analysis. You will probably need additional tools and indicators to make the method accurate enough to trade profitably.
• Treat this article as a starting point for further Elliott wave study. It is not a comprehensive piece trying to cover every aspect of Elliott wave theory, but a foundation in the subject. You might consider using an Elliott wave service that provides analysis or signals to help you on your journey.

FAQs

Does the Elliott wave theory work?

Like any branch of technical analysis, Elliott wave analysis is a tool, and it can work if you apply it intelligently and control risk.

Which time frame is best for Elliott wave analysis?

Elliott wave analysis can work on any timeframe because it is fractal. Most traders consider higher-timeframe charts in technical analysis to be more dependable, for example, 4-hour charts and above.

How do you use Elliot’s wave theory?

The central premise behind Elliott wave theory is that there are 5-waves in the direction of the primary trend known as an impulse sequence followed by a 3-wave corrective sequence. Using Elliott wave means mapping out these wave counts on different timeframes.

What is NEoWave (or Neo Wave) theory?

NEoWave (sometimes incorrectly written as “Neo Wave”) is an Elliott wave methodology developed by Glenn Neely, a U.S. trader. NEoWave offers a trading course and a forecasting service across different markets.

What is the Elliott wave oscillator?

The Elliott wave oscillator (EWO) is the difference between two moving averages plotted as a histogram below the price on a price chart.