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So You Wanna Learn Elliott Wave Analysis? Part IV
An example of how to use Elliott to establish investment strategy and reduce risk.
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So You Wanna Learn Elliott Wave Analysis?
For more reading on the basics of Elliott wave analysis, please read all parts of the series: Part I, Part II, Part III, Part IV, Part V
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In Part I of this series, you learned about the basics of Elliott wave patterns. Part II introduced you to "alternate counts" and ways to identify the market position in the wave pattern. Part III talked about the Fibonacci sequence and the ratios within the sequence that guide the shape of Elliott waves.
In this installment, Part IV, we’ll show you how to use Elliott to establish investment strategy and reduce risk.
When you combine the Three Rules of Elliott (covered in Part II) with the price-targeting utility of Fibonacci relationships (covered in Part III), you end up with a very effective rule set for deciding when to enter or exit a speculative position, or terminate the strategy entirely. The Wave Principle helps you to:
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Identify the highest probability for the direction of your market,
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Craft an optimum position to take advantage of it, and
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Guard you against the less probable outcomes.
That is a significant edge, and if you want to win in markets, you need an edge.
The chart below shows a real example from the coffee market. The lowest point on this chart is the end of a larger-degree decline. At that point, an Elliott wave practitioner would be expecting a three-wave move up (or a five-wave one) of the same wave degree to correct that larger decline.
As you can see, the move up developed as a five-wave rally, labeled 1, and it was followed by its own correction, a wave 2 decline labeled a-b-c. This particular wave 2 is a classic example of a correction, with waves a and c subdividing into five waves, and wave b subdividing into three waves. You can also see the characteristic third-wave price gaps near the middles of both waves a and c.
Once you have seen wave a fall from the top of wave 1 in five waves, you know that the wave 1 rally is probably complete. Now you can do three things:
1) Expect a rally in wave b, always a three-wave move that goes in the opposite direction of wave a.
2) Set Fibonacci price targets for the end of the entire wave 2 correction. Wave 2 most often retraces 62% of the preceding wave 1; the next most common retracements are 38% and 50%.
3) Manage your risk. One of the Three Rules of Elliott states that wave 2 cannot retrace more than 100% of wave one. So, if this chart makes you feel bullish and you buy this market once the price retraces 62% of wave 1, you know that your long position would be wrong the moment price breaks below the start of wave 1.
Study this chart and make your own forecast of what you think happens next. In Part V, the last article of this series, we’ll show you this chart of coffee with the subsequent price action, and you’ll be able to check what you'ver learned. Meanwhile, to continue your studies, the original classic, Prechter & Frost's Elliott Wave Principle – Key To Market Behavior* is the best textbook on the subject.
And to gain further perspective on how this method teaches you to think independently, you can join our free Club EWI and explore the many free learning resources we have prepared for you.
*You get a free copy of this classic book with a subscription to EWI's most popular market-forecasting package, The Financial Forecast Service. Try it risk-free.