Elliott Wave for Traders by Mortie at Boston Wealth

Let's get into the basics of Elliott Wave (EW). I want to keep this as simple as possible, because it is simple. The other objective I have for this series, is to make it relevant to trading. This is not for the academician, this is for the trader. I will be going back and refining these lessons, so you might want to review them once in a while.  My lessons are here:  http://www.bostonwealth.net/mortiesclassroom/

So what is the Elliott Wave Principle? In its simplest form, it is that most market trends unfold in 5 waves in the direction of the trend, and in 3 waves in the direction counter to the main trend. Simple! 5's and 3's. The 5 wave patterns are impulsive waves that cause the market to trend. The 3 wave patterns are corrective, and can be thought of as the market taking a breath so it can continue the trend. EW believes that these patterns are caused by group psychology and the interplay of fear and greed.

A common mistake that is made by EW Analysts is trying to find an EW count for all charts and timeframes. These Elliott devotees or junkies as they have also been called, end up forcing counts on charts that are really not showing a clear Elliott pattern. Often you will hear me say that I can't be sure of the Elliott count. When I can't find a count on a chart, I change my timeframes and see if another perspective will give me a clearer view of market structure. Also, in a noisy market, I will often switch from a candle chart to a line chart for clarity. But, just as it's OK to stand aside from trading a market because the signals are unclear, or there is not a high probability trade setup presenting itself, it is OK to not find a count for a chart.

IMPULSE WAVES ~ BASICS

Let's talk about the waves that move the market in the direction of its main trend. I will be giving you the basics. In later lessons, I will look at more detailed information. Whenever I mention something that has trading implications, I will note that in my commentary.

1. Impulsive waves are made up of 5 waves which themselves are made up of 5 waves. This is called the fractal nature of waves by some. This fractal nature of waves can be carried down to the smallest time frames. You may hear that we are in W5 of W5 of W5 of daily W5. Fractals within fractals within fractals ... This is important to me when I am trying to catch the end of a move. I want to wait for all patterns to be complete. Trading a reversal of ES as it is completing its final wave into a strong resistance or support, is a very high probability trade.

2. Within a 5 wave pattern, Waves 1, 3, & 5 are themselves impulsive.

Below is an illustration of impulsive waves that move the market in its trending direction. Points 1 & 2 are illustrated.

3. Within this 5 wave impulsive pattern depicted above, Waves 2 and 4 are corrective. We will cover corrective waves later. These corrective waves can be either simple or complex. I find that the lower the timeframe, the more complex these corrections become. Simple corrections are 3 waves (ABC or Zig Zag) and complex corrections are combinations of 3 and 5 wave structures. The 5 wave structures in a complex correction go in the direction of the correction (counter-trend) and the 3 wave structures are corrective to the direction of the complex correction. Again we will cover that at a later date. What I just stated in a brief form has tremendous trading implications. ( Hint for the advanced: If you see a clear 5 wave impulsive move that is a corrective move, that can be the whole correction. It is probably only Wave A of the correction ~ with Wave B (3 wave) and Wave C (5wave) to come.)

4. In a 5 wave impulsive pattern, one of the impulsive waves (W1, 3, or 5) will generally extend and be longer than the other two. In the case of ES, Wave 3 is usually the extended wave. (Commodities, it is often Wave 5).

Below is a recent chart which illustrates the principles stated above. Perhaps you can better see what a timesaver my GET software is when doing counts. I often override GET's counts, buy GET gives me a great starting point.

RULES for an Impulsive Pattern

We all like rules. They tell us what is right and what is wrong. The first incident in the Bible is about man eating from the tree of the knowledge of good and evil. Man found himself in a rule-bound existence for centuries. The end of that book has a restored mankind, but without a tree of the knowledge of good and evil. Well, EW only has three rules. And guess what? Elliott didn't call them rules, others who came along later did. I like to think of them as really strong guidelines, because I will at times break two of them. There are guidelines that we will cover later when we drill down into the details of EW.

Rule 1 : W2 cannot retrace past the beginning of Wave 1.

Rule 2: W3 cannot be the shortest of the 3 impulse waves.

Rule 3: W4 cannot trade into the territory of W1.

Because of the volatility of ES as a highly leveraged market, I have been known to break Rules 1 & 3. (just a little and infrequently)

Below is an illustration of these rules.

Let's look at some trading implications of the first lesson on some of the basics of EW. These first two EW lessons are not meant to be exhaustive. My intent is to give those who are new to EW a taste of the practical side of this method of analysis. More lessons are to come, and this will be the general format. It will be didactic followed by practical applications to trading. Be patient. As you grasp the basics, the rest will come easy. We will look at the rules first.

• Wave 2 cannot exceed the beginning of Wave 1. ~ Example: You think that there is a high probability that the market has completed a corrective move. You base this opinion on your analysis of price and pattern. The market then rallies 4 points and you think this may be the beginning of an impulsive move. You think this is W1. You don't want to chase the breakout, so you decide on trading the pullback, or W2. You put a limit order at the 61.8% retracement level of what you suppose is W1. Your limit order gets hit and you are long. What's your next move? Place a stop! So where do you place your stop? Yup, you got it. You place a stop one tick below the beginning of W1. Why? because this would no longer be a W1/W2 structure, and the premise for your trade is negated at that level. Is it possible that it dipped below W1, but could take off into an impulsive wave anyway? Yes! It's possible, but that's not the question. The question is, "is it probable?". Remember, we trade based on probabilities, not possibilities. Hope is not a valid setup!

• Wave 3 cannot be the shortest impulsive wave. ~ The primary trading implications of this rule are that you need to know where you are in an impulsive move. In fact, the main goal of EW analysis is that we know as best we can where we are in the market. If the wave you are identifying as W3 is the shortest of the three impulsive waves (1, 3 & 5), then maybe you are ahead of yourself in labeling the waves, and you are looking at waves of a lesser degree. Fortunately, Advanced GET recognizes these rules and won't mistakingly label the shortest wave as W3. You will get better at counting waves as you continue to practice. Waves also have a certain proportionality or look to them.
• Wave 4 cannot retrace into the price range of W1. ~ My software allows a little overlap in a highly volatile market such as the highly leveraged ES. But, I would be looking for an alternative count if I saw overlap. Again, you have to know where you are in the count, because as you will see in the next example, we expect overlap in some impulsive waves. Sometimes ES travels too far, too fast. When it does that, it's not unusual for W5 to form an ending diagonal (ED). In an ED, we expect overlap of the waves. Other trading implications and ED peculiarities are noted on the illustration.

• This last trading implication of the first lesson is implied. Sometimes when the market is weak, we see a different reaction from Wave 5. We see a failed W5. A hint that W5 might fail is a 5 wave pattern that is completing below the level of W3. When we see a W5 failure (truncation), we can expect a deeper than normal correction.

I didn't have to look far to find at least a truncated W5 in recent ES history. This example is very instructional. Look at the correction from the weak W5!