Trading Strategy: How to use Elliot Waves

Trading Strategy: How to use Elliot Waves

Some traders have a much higher success rate than others. The difference is usually down to the amount of research spent following the economic calendar, but another massive factor is the type of analytic tools being used. One golden tool every professional trader swears by is the Elliot wave oscillator. This is perhaps one of the more complicated tools and it is highly recommended that you take a practical approach using your MT4 or MT5 terminal when learning to use it.

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What is the Elliot wave oscillator?

Elliot waves are a type of cycle analysis used by traders to help forecast financial markets. Elliot waves were invented - or discovered - by Ralph Nelson Elliot, a convalescing railroad accountant who decided to take hourly readings of the Dow stock index from his sickbed during the 1920s. After painstakingly following the market for years, Elliot formulated a market wave structure which he said repeated over a set time. The wave became a celebrated tool for forecasting future moves. His theories later became known as the 'wave principle'.

Falling into obscurity in less than a decade due to complicated calculations, Elliot's ideas weren’t revived until the 1970s  when super-computing became reality. The world took note when Robert Prechter, an analyst at Merrill Lynch, used them to win the US options trading championship with an impressive 444% gain.

 

How does it work?

The wave principle rationalises the market into alternating 5-wave trending moves, interspersed by 3 wave corrections. Waves can be bearish or bullish depending on the direction of the overall trend.

Idealised
The 5-3 basic Elliot Wave Pattern

The diagram above shows an idealised bullish Elliot wave followed by a three-wave correction and the start of a whole new cycle. This wave is commonly used to predict direction shifts that are independent from economic calendar releases.

For example, if a trader correctly identifies that the market is evolving a wave 2, they know that when it ends it will be followed by a long wave 3. Theoretically, this information can then be used by traders to profit from the markets.

Notable is that Elliot waves are fractal, which means smaller waves fit into large waves which themselves fit into even larger waves. Think of the Elliot waves like a set of Russian dolls. No matter how big you go, you overall always have the same predictable form.

 

How to set the Elliot Wave Oscillator

The first task an Elliotician must face is identifying which Stage of the Elliot wave the market resides in. This is where the Elliot Wave Oscillator (EWO) comes in. Once you’ve logged into your account and you have your MT4/5 platform in front of you, try playing around with the settings for a while. When you're ready, set the indicator on a specific 5, 34, 5 setting. This will give you technical analysis that can identify which of the 5 trending waves the market is currently in. Take a look at the waves on the graph below.

GBP-JPY-Oct24-macd.png
The Elliot Wave Oscillator (EWO)
  • Wave 3 can be identified as the wave which is always the strongest and longest of the 5 waves. Wave 3 is a 'higher' peak which stands head and shoulders above the others.  
  • The end of wave 4 is always identified by the EWO falling back below the zero-line (after it has peaked at wave 3).
  • The end of wave 5 always occurs when the EWO has risen back above the zero-line and formed a second lower peak or hump.

Top tip for forecasting with Elliot Waves

Most Ellioticians analyse the market in real-time, assigning different “labels” to waves as they unfold. Checking on your MT4/5, make sure the tranche of the market under analysis is between 90-140 bars long, as this helps improve accuracy significantly.

A real-world example of Elliot Waves in action

The Australian Dollar sold-off heavily versus the US Dollar in 2018, losing circa 8% of its value in the process. The fundamental catalysts for the fall have been the China trade-war slowdown fears, and relatively lower interest rates in Australia compared to the US. As the exchange rate starts to look increasingly stretched and oversold, the question now on many analyst’s minds is whether the sell-off has reached a bottom. Elliot waves are one tool which can help to determine this, and indicate what orders will be most effective. 

Looking at the overall structure of the decline on the monthly chart, we note a clear Elliot bearish wave structure to the long-term decline – not just in 2018, but ever since it began in 2011.

GBP-JPY-Oct24-line
The long-term Elliot wave on AUD/USD 10.05, 25-10-2018

The EWO in the lower pane supports this interpretation. It is possible to label the waves as follows:

  • wave 1 probably ended in 2013
  • wave 2 in 2014
  • wave 3 at the end of 2016 (when the EWO troughed)
  • wave 4 in 2017 (when the EWO moved back above the zero-line)
  • wave 5 is currently in progress

If the current move down is a wave 5, it suggests the extent of the downtrend may be limited, because wave 5s are always the last waves in any Elliot formation. Although they can be truncated, wave 5s normally reach as far as the end of wave 3, which in this case is at the 0.6827 lows, making them the next target for the downtrend.

Beware, there is a possibility that wave 5 could extend well below wave 3 and it is impossible to accurately forecast where it will end. The formation of a bullish monthly candlestick pattern or monthly pivot swing, for example, would be viable signals that wave 5 is at an end. That, in turn, would signal the opportune time for traders to enter long positions, buying the pair so as to trade the market higher, with a good initial target at the psychologically significant 0.8000 level.

Using Elliots may seem daunting at first, but once you put the process into practice a few times, it becomes an easy set up that yields incredible forecasting power. Set up your exness account, install the free MT4 or MT5 trading platform, and try running a few Elliot tests on the demo account. You’ll know when you're ready to start targeting real and significant profits.

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