Are Elliot Waves a Solid Trading Technique (for a beginner)?

...a technique every trader should know, but not necessarily for the reasons you think.

6 minute read

If your aim is to trade the markets to a professional level, then it is crucial you understand the thought process and rationale which other traders (your competition) are using to base their entries. Elliot Wave Theory is one of the most popular charting techniques, and one which novice traders often give unjustified credence to (in my opinion) when they first discover this form of technical analysis. As with all market theories, Elliot Wave is open to interpretation, and one individual may see a wave in a chart where another person sees a different price move which fits their own market narrative more accurately.

Elliot Waves
The basic principles of Elliot Wave Theory dictate that the market is subject to 5 wave impulse movements, which are then proceeded by 3 wave correctional moves (ABC). These waves can supposedly be found across all time frames, and all charts.

It is important for you to understand Elliot Waves so that you can predict what might happen in certain chart locations. My advice would not be to trade the Elliot Wave per se, since it is impossible to know what the market will do next, but you can definitely use the waves in order to give yourself a relatively good idea of where competing traders might enter or exit the market. Your fundamental goal shouldn’t be to say that you predicted a wave, traded it and made profit (egomaniacs look away now); but is far better focused on outsmarting your opponents by predicting what moves they might make (sniper assassin style). This is a crucial point to remember, and one which should help you to see trading the markets more as a competition, as opposed to an ego boosting endeavor.

 

The way in which Elliot Waves are made up, a 5 move impulse wave followed by a 3 move corrective wave, means that they will inevitably show up in charts by pure chance as opposed to any underlying market patternation properties they may or may not have. There are certainly charts where you can find many instances of 4 move impulse waves followed by 2 move corrective waves, so what should you make of these, and is it possible that an occurrence of different numbered impulse and corrective waves (ie. 7 move impulse wave followed by 3 move corrective wave) could come about as we enter a new era of algorithmic trading?

 

If it were possible to identify a new wave structure then that would surely prove extremely advantageous in gaining an edge, especially over retail traders. Carrying out your own analysis of the markets, which is not biased by any pre existing model is extremely good practice, and will likely prove more profitable than basing your trades on an assumption that a method somebody else developed, and everyone else is using, will work for you.

 

It is important to note that Elliot Waves can show up across different time frames, which by default means that they will always be part of a larger wave. One of the most critical aspects of trading the markets involves identifying the main price move, whilst fine tuning the chart time frames down to a level which provides you with a viable entry location. It is this particular market nuance which causes contradictory thought behavior, and makes finding an optimum entry point so difficult. This is the reason why some schools of thought allude to using one time frame exclusively, and placing trades based on that one chart alone; whilst others recommend building up a comprehensive picture of the market in order to make trades more favorable.

"Trading on the basis that an Elliot Wave pattern will come to fruition is really no different to placing a trade on the assumption that a double top will result in strong down move, and it’s in these areas of the charts that you are likely to see the most volatile price action."

It is more often than not, that these locations are where large financial institutions will enter the market, since they are fully aware that if they can use this opportunity to push the price level into a new trading range, then it offers them a relatively low risk entry point.

 

Elliot Wave Theory is purely technical, and as such, fails to recognize any global events, political changes or monetary policies which may occur intraday. It is for this reason that, where in the past it may have been possible to trade the markets using this method exclusively, it would be negligent to do so in present times. High speed Internet means that news travels fast, and its effect on the markets has never been greater. When you consider that organizations develop algorithms to constantly scan the Internet for breaking news articles, and then place trades if enough selective keywords have shown up within an allocated time frame, then it’s easy to see how a price move that may have formed an Elliot Wave sequence historically, can now fail to materialize.

 

There is no doubt that the market does indeed move in waves, but the chances of being able to accurately predict what wave might occur next is a 50/50 bet that offers little promise in the way of accumulating a profitable trading account. The biggest opportunities with regard to trading Elliot Waves lie in being able to identify locations where it is likely that large amounts of market participants will either enter or exit the market. Furthermore, you should be knowledgeable enough so that you can accurately draw on a chart the area where the most stop losses will be placed. Entry into the market is still a crucial factor, and waiting for an opportunity where the price has traveled far away from those stop locations, will likely offer up the highest risk versus reward ratio.

 

Elliot Waves are derived from trending markets, and they can provide you with opportunities to profit substantially. The market participants who are using this trading method as the fundamental basis for their positions, are effectively giving you an insight into where their stops might be located, with a fair degree of accuracy. Those that adopt this strategy do so to give them increased confidence in their position, and implement a set of boundaries whereby they feel able to predict what price move will happen next, as opposed to seeing the bigger picture; that this is a competition whereby the most profitable participants are those who are able to identify the trading methods others are using, and outsmart them by being able to either hit their stop, or push them to an area which forces them to throw the towel in and cut their position.

 

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