The primary reason why Elliott Wave is so important is because many successful traders use it to predict the market’s movement from down to up and back again. The Elliott Wave is not infallible but it does show the underlying structure of the market. This is similar to a river. The underlying structure will tell you if the river is fast, shallow, has lots of eddies or is just smooth flowing. The Elliott wave gives us an idea on how the market is behaving from a wider viewpoint. Most of the criticism of the Elliott Wave comes from those who do not understand what it is and how it works. We are not here to argue whether or not the Elliott Wave is a good trading tool or not. We are obviously practitioners of the theory.
Basic Rhythms of the Elliott Wave
The sequence consist of a basic rhythm of fives corrected by threes. This remains constant regardless of what degree of wave you are analyzing. After a 5 wave sequence is complete, it will usually become a wave of a larger degree. The complete Waves 1 through 5 will complete the next higher tier of wave sequences. Therefore a smaller wave 1 through 5 completes either a wave (1) , (3) or (5) while the a-b-c sequence completes either a wave (2) or (4). One development we have realized, is that once in awhile, the A-B-C corrective wave becomes a 5-wave. If this is not the case, all your up trends will be 5 waves and your downtrends will be A-B-C’s and vice versa. However, they do switch. We recommend you do some reading on your own but here are some basics on the wave pattern:
Wave 1
First waves are always a change in trend movement. The beginning of wave 1 is either the end of wave 5 or end of wave C. This is the best point to enter allowing us more profit. However, it is the hardest one to predict and a lot of “head fakes” occur during this time.
Wave 2
Second waves are counter trend waves created by new selling (buying) as opposed to the fourth waves which are created by profit taking (long liquidation or short covering). The most common target for the end of a wave 2 is between a 38%-62% retracement of the range of wave 1. About 75% of the wave 2's will end in this area. Only one in six will have more than a 62% correction. If wave 2 ends with less than a 38% correction, it will be an irregular wave and may end up being a complex wave. There is also a rule of alternation: If wave 2 is complex, wave 4 will be simple. However, the majority of the wave 4's are complex. It is seldom we see complex wave 2.
Wave 3
The best way to tell a wave 3 is the slope. It is generally steeper and longer than the first wave. The best wave to trade is the third wave because it occurs on high volumes and of course, major price moves. Good traders mostly trade only 3 waves.
Wave 4
Hardest one to trade since profit taking sets in. About 85% of trades lose money during this period. Avoid trading a wave 4. If you want to trade it, change your time frame and trade intraday. Generally, a wave 4 lasts up to 70% longer (time wise) as the entire 5-wave pattern. If you have lost count of your Elliott Wave, chances are you are in wave 4.
Wave 5
Wave 5 is the last struggle to create a new high (low) prices. The slope is weaker and it is where the professionals get out of the market. This is also the place where a lot of non professionals get in figuring they are missing out on a trend.
Wave A
May contain 3 or 5 waves. If it contains five waves, it is a tip off that you will have a zig zag type of correction. If it contains 3 waves, it is most likely a flat, an irregular or a triangle correction.
Wave B
Wave B will normally not retrace more than 62 % of Wave A. Wave B always contains 3 waves.
Wave C
Has the same characteristics as Wave 3 and is a tradable on a smaller time frame. Wave C is always a 5 wave pattern.
Wave D-E-F-G etc.This rarely happens but when it does, the market is range bound. We normally change strategies on this kind of markets.