By Admiral Markets
All traders struggle to understand why the market moves the way it does. A sudden turn, a failed reversal, or a long lasting correction occur regularly but could torpedo your trade setup.
The benefit of the Elliott Wave Theory is simple – it allows you to understand the psychology of the Forex, CFD and other financial markets.
The problem is that traders often complain to me about the difficulty of implementing the Elliott Waves correctly. To solve their problem, I decided to write this article which explains exactly how to apply waves in a simple and practical way.
Get our Weekly Commitment of Traders Report: - See where the biggest traders (Hedge Funds and Commercial Hedgers) are positioned in the futures markets on a weekly basis.
Get Our Free Metatrader 4 Indicators - Put Our Free MetaTrader 4 Custom Indicators on your charts when you join our Weekly Newsletter
Emotional markets are an opportunity
The single biggest benefit of analysing the Forex, CFD, and financial markets with the Elliott Wave Theory (waves) is comprehending the psychology of the market. Simply said, it allows traders to understand the psychology behind the price movement.
I often remind traders in live webinars that the financial markets are not rational but emotional. The markets exaggerate in their movements and reactions.
The emotional reaction is actually a place of opportunity for the trader if they manage to recognise the wave patterns and manage their own emotions (trading psychology) sufficiently.
The main question is, how can traders recognise and benefit from wave patterns?
Please see the video below for me info about the theory behind Elliott Wave patterns:
Real secret behind wave trading
The best solution might surprise you. For beginning traders, I do not recommend to to start with labelling waves, nor to rely on waves for trading decisions. There is nothing wrong with waves’ labels but it does require a lot experience.
Recently I already explained the best process for learning the waves and how waves are more valuable than traders realise. The best answer is what I call a practical application of the Wave Theory when the Forex, CFD or financial markets show a clear and concise pattern.
Rather than continuously update the charts with a new estimate of the wave structure (good for experienced wave traders), you can leave that daily wave analysis up to me (for EUR/USD, GBP/USD and USD/JPY) and focus on the most important, clear, and visible patterns.
Waiting for the best wave patterns
In my view, there are a couple of wave patterns that are easiest to recognise. Let’s walk through two of them. In a future article, I promise to reveal all of my favourite wave patterns.
Scenario 1 Wave 3 Momentum
Third waves are exciting because price action is showing lots of momentum or impulse. Why is that interesting for traders?
Impulsive price action is a swing where most of the candles are pushing strongly in one direction (either bullish or bearish). The exact opposite is called a correction, which is slow and sideways price movement.
During momentum, I am able to get the best reward-to-risk (r:r) ratio because price can push far. In fact, third waves are known for their quick moves.
Here is a list of 3 patterns I look for at the start of third waves. For all 3 patterns, I use the recent top or bottom for stop loss placement. The main targets are always aimed at Fibonacci levels, Pivot Points, and major tops and bottoms.
Key pattern number 1: three strong and sizeable candles is one of the clues that confirms a potential momentum start. The candle close should be near the high (uptrend) or low (downtrend) plus the candles need to be rather large (not too small).
Key pattern number 2: another opportunity I often look for is when 6 candles fail to break the opposite support or resistance. That means I need to see 6 candles fail to break resistance in a downtrend or 6 candles fail to break support in an uptrend.
This is my potential signal that the correction into the opposite direction has been completed.
Key pattern number 3: last but not least, the break of the previous top in an uptrend or the previous bottom in an uptrend confirms the continuation of the trend with a higher high or lower low.
My favourite way of trading this breakout is by zooming into one, two or even three timeframes and waiting for a consolidation zone on that level. Then I will wait for and trade the continuation breakout.
Scenario 2 End of Trend
The trend is your friend until it bends. When the end of the trend is nearby, I should see clear divergence pattern on multiple timeframes. This indicates a weakness between wave 3 and wave 5.
Preferably, there is also strong support or resistance from a higher timeframe. If the analysis is correct, a new trend in the opposite direction could emerge.
Key pattern: I keep an eye out for a 5 wave pattern into the opposite direction of the trend on one or two timeframes lower than my analysis chart.
Example: if a day chart downtrend is showing exhaustion signs, I will keep an eye on 60 minute and 4 hour charts for a clear bullish 5 wave pattern.
Critical part: this is my favourite signal because the market psychology of the 5 opposite waves is telling me to watch out for reversal.
The good news is that it’s relatively simple to recognise 5 waves compared to complex corrections. However, the best news is that nobody has to continuously update the wave count, because most 5 wave patterns instantly hit the radar (once you are aware of the 5 wave pattern).
My approach: once the key patterns becomes visible, I place a Fibonacci tool from on the 5 wave pattern and look for price to retrace to the Fibonacci levels, preferably the 61.8% Fib.
I either place a pending order at that Fib or wait for market order after a candlestick pattern at the Fib becomes visible. Stop-loss is above or below the origin of the Fib (below bottom with long and above top with short). Target is aimed at the -161.8% Fibonacci target and a trail stop-loss is used to follow fractals.
Cheers and safe trading,
Admiral Markets is a leading online provider, offering trading with Forex and CFDs on stocks, indices, precious metals and energy.