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How Can I Apply the Elliott Wave Principle?

How Can I Begin Applying the Elliott Wave Principle?

When investors first discover the Elliott Wave Principle, they’re often most impressed by its ability to predict where a market will head next.

And it is impressive. But its real power doesn’t end there. The Elliott Wave Principle also gives you a method for identifying at what points a market is most likely to turn. And that, in turn, gives you guidance as to where you might enter and exit positions for the highest probability of success.

So, how do you begin applying the Elliott Wave Principle? By starting at its most basic level. The Elliott Wave Principle works by identifying patterns in market prices. So, in other words, we start by analyzing waves on a chart.

Elliott’s pattern consists of “impulsive waves” and “corrective waves.” An impulsive wave is composed of five subwaves. It moves in the same direction as the trend of the next larger size. A corrective wave is divided into three subwaves. It moves against the trend of the next larger size.

As the figure below shows, these basic patterns build to form five and three-wave structures of increasingly larger size (larger “degree,” as Elliott said).

Impulsive Waves, Corrective Waves and Subwaves

In the above illustration, waves 1, 2, 3, 4 and 5 together complete a larger impulsive sequence, labeled wave (1). The impulsive structure of wave (1) tells us that the movement at the next larger degree of trend is also upward. It also warns us to expect a three-wave correction — in this case, a downtrend.

That correction, wave (2), is followed by waves (3), (4) and (5) to complete an impulsive sequence of the next larger degree, labeled as wave 1. At that point, again, a three-wave correction of the same degree occurs, labeled as wave 2.

So, in applying the Elliott Wave Principle, our first task is to look at charts of market action and identify any completed five-wave and three-wave structures. Only then can we interpret where the market is and where it’s likely to go.

But while applying the Elliott Wave Principle to any chart, we must keep in mind an important point. The Elliott Wave Principle does not provide certainty about any one market outcome. Instead, it gives you an objective means of determining the probability of a future direction for the market. At any time, two or more valid wave interpretations usually exist. So, it’s important for any investor or trader to carefully assess the probability of each interpretation.

View the Elliott Wave Principle as your road map to the market and your investment idea as a trip. We start the trip with a specific plan in mind, but conditions along the way may force us to alter our course. “Alternate counts” are simply side roads that sometimes end up being the best path.

Elliott’s highly specific rules keep the number of valid interpretations (or “alternate counts”) to a minimum. The analyst usually considers as “preferred” the one that satisfies the largest number of guidelines. The top “alternate” is the one that satisfies the next largest number of guidelines, and so on. Alternates are an essential part of using the Elliott Wave Principle.

Another key to applying the Elliott Wave Principle is Fibonacci ratios. Few investors realize that Fibonacci analysis of the markets was pioneered by R.N. Elliott. The use of Fibonacci ratios requires a valid Elliott wave interpretation as a starting point. Elliott had two chief insights concerning Fibonacci relationships within waves. First, corrective waves tend to retrace prior impulse waves of the same degree in Fibonacci proportion — common wave relationships include 38%, 50% and 62%. Second, impulse waves of the same degree within a larger impulse sequence tend to relate to one another in Fibonacci proportion.

Wave interpretation rules and Fibonacci relationships together are powerful tools for establishing investment strategies and reducing risk exposure. Applying the Elliott Wave Principle aids investors in deciding where to get in, where to get out and at what point to give up on a strategy. Thus, the Elliott Wave Principle lets you identify the highest probability direction for the market.

The basics of the Wave Principle remain as Elliott formulated them. Those basics are fully described in the standard textbook of wave analysis, Elliott Wave Principle — Key to Market Behavior, by A.J. Frost and Robert R. Prechter, Jr. (Prechter is founder and president of Elliott Wave International.) That book rescued the Elliott Wave Principle from obscurity and propelled it to worldwide acceptance as perhaps the most sophisticated form of technical analysis. Remember applying the Elliott Wave Principle is simple, but mastering that application takes years of practice and hard work. Yet, it is worth it to take the time and learn how to make proper counts. There are several Elliott Wave software applications out there that claim to do all the best wave counts for you, but with all the variables in the market, it is much better to make the counts yourself.

To learn more, please visit our Club EWI homepage, where we offer several resources to help you in applying the Elliott Wave Principle.


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