1️⃣ The Elliott Wave has the following 3 principles.
◐ Principle ①: The duration of the 3rd wave in the driving wave cannot be the shortest among waves 1, 3, and 5.
◐ Principle ②: The 2nd wave in the driving wave cannot exceed the starting point of the 1st wave during the adjustment.
◐ Principle ③: The bottom of the 4th wave in the driving wave cannot be lower than the peak of the 1st wave.
Once the above principles are met, the Elliott Wave Theory will be established, making it easier to predict future adjustments. However, even if the above principles are satisfied, the price movement may not necessarily fluctuate according to the Elliott Wave rules, so caution is still needed.
The basic form of the Elliott Wave is '5 waves driving, 3 waves correcting,' forming a complete '8 wave cycle.' The purpose of the driving wave is to push the main trend of market prices, while the corrective wave serves as a pullback or correction of the trend.
However, waves can be more complex than this ideal model, introducing the concept of 'extended waves.' In the Elliott Wave Theory, an 'extended wave' refers to a wave within an 8-wave cycle where the driving wave (usually the 1st, 3rd, or 5th wave) becomes particularly long, exceeding the lengths of other waves. In this case, this particularly long wave will be broken down into several smaller waves instead of being a single wave.
2️⃣ Rules of the Elliott Wave Theory
In simple terms, traders can view wave theory as changes in three blocks: 1. Form: The transformation between upward waves and corrective waves
2. Ratio: The ratio changes between upward waves and corrective waves
3. Time: Analysis of the duration between two waves, balance changes
The wave rules during bullish and bearish markets generally still adhere to foundational rules of the Elliott Wave Theory, but the market changes rapidly. The following shares the three iron rules with traders. When noticing that price movements contradict the iron rules, it is crucial to remain alert to the applicability of wave theory.
Bullish Three Iron Rules:
◑ The low of wave 2 cannot completely retrace below the low of wave 1 (false breakdown)
◑ Wave 3 is usually the relatively long wave among the driving waves
◑ The low of wave 4 cannot overlap with the peak of wave 1 (not breaking the neckline)
Bearish Three Iron Rules:
◑ The rebound of wave b must be less than the peak of wave a (false breakdown)
◑ Wave c is usually large in amplitude, long in time, and has a large overall trading volume
◑ When wave c rebounds, the highest point cannot overlap with the lowest point of wave a.
In simple terms, prices will naturally follow the market trends of rising and falling, which is an alternating process. The wave theory involves a continuous cycle between driving waves and corrective waves, and once all 8 waves appear, it represents the completion of a large cycle, and the price movement will enter the next 8 waves.
※ Note: Wave theory represents a bullish and bearish cyclical movement, which does not mean that after a price drop, it will definitely end a long-term uptrend or downtrend. It is very possible that in the new wave, the price will reach new highs or break new lows.
3️⃣ Three methods to trade Elliott Waves
◓ Trade the third wave
An important principle of trading the Elliott Wave Theory is that within the basic waves, at least one wave is extended and must exceed the size of other non-extended waves by at least 161.8%.
Simply put, an extended wave is also the longest wave. In most cases, the third wave will become the extended one, while the preceding second wave may retrace to about 50%-61.8% of the first wave.
In such situations, it is clearly a suitable trading opportunity. In a bullish basic wave, just set a buy limit order between 50%-61.8% of the first wave, set the take profit at about 161.8% of the size of the second wave, and the stop loss must be placed at the starting point of the basic trend.
◓ Trade flat waves
In corrective waves, flat patterns frequently form. Elliott identified no fewer than 10 such patterns. Although there are many, they all share a common point: wave b must retrace at least 61.8% of the previous wave a.
Therefore, the key to trading flat waves is to analyze wave a. Is it a basic wave or a corrective wave? Flat waves also have an a-b-c structure, and wave a and wave b show corrective activity, allowing wave c to form a complete 5-wave structure.
If wave a does not look like a basic wave, then it must be a corrective wave. The next step is to check whether the condition for a 61.8% retracement is met.
◓ Trade the fifth wave
Another strong rule in trading the Elliott Wave Theory is that wave 1 should not be equal to wave 5. Therefore, Elliott Wave traders will simply compare the lengths of the first and fifth waves.
If the fifth wave is only 61.8% of the first wave, then it is suitable to short in the bullish five-wave structure. Set the stop loss at the end of the extended wave.
However, the risk of trading the fifth wave is relatively high because multiple possibilities may arise in the market here.
4️⃣ Trading strategy using Elliott Waves combined with Fibonacci retracement lines
The Elliott Wave consists of 5 upward waves and 3 downward waves during an upward trend. There will be pullbacks during the upward process, but at what price level will the pullback occur? And at what price level will it stop after the pullback? Although there isn't a rigorous rule regarding these Elliott Waves, there are some general standards.
At this point, we need to use Fibonacci retracement lines (golden ratio lines). Using Fibonacci retracement lines can help determine the percentage of support after a pullback or resistance after a rebound when connecting the highest and lowest prices with a line. Generally, most traders pay attention to 23.6%, 38.2%, and 61.8%.
Rather than saying that wave theory was created, it is more accurate to say it is a 'discovery.' Wave theory is more like observing the phenomena revealed by the market, seeking and defining market rules through verification, rather than creating or inventing a method to explain market fluctuations. It is about discovering that market rules can be explained this way, akin to Newton discovering gravity rather than inventing it.
Just as Su Shi once wrote in a poem: 'From a distance, the ridge looks like a peak; near and far, high and low, all look different. Not recognizing the true face of Lushan Mountain, just because I am in this mountain.' In the market, knowing what you are doing and understanding your positioning is a vital part. Accompanied by changes in the trader's psychological aspect and competition, wave theory is essentially an attempt to discover this fluctuation. When you are clear about which stage you are in, the rhythm of trading won’t be disrupted. Mastering wave theory is akin to mastering breathing techniques, allowing traders to respond easily to market conditions.
Let’s encourage each other!