Some have studied this, others have not. But if you’ve been around the technical analysis world – at some point you’ve heard of the Elliott Wave Theory. Let’s break it down!
Markets very infrequently go straight up or straight down. More commonly they move in impulses and corrections. Understanding them is crucial to reading price action.
This theory is employed in identifying what trending markets are doing. More particularly, it can help us understand whether the trend is continuing or reversing.
Is this theory gospel? NO. Should it be understood? YES.
While the theory implies impulses and corrections – there can also be impulses and consolidation. These sequences are going to look different every single time.
The market’s movements will always have common threads, but will never be exactly the same. Some might ask, why? Because it would be too easy and it’s not meant to be easy.
Here are a few key rules when identifying the Elliott Wave Theory in the market:
Rule #1: The shortest impulse wave will NEVER be WAVE 3.
The odds are likely that Wave 3 will be the longest of the impulse waves, but it can definitely never be the shortest. If you are viewing a chart and believe that wave 3 is the shortest, then you are probably interpreting something incorrectly.
Rule #2: WAVE 2 can NEVER go further than the start of WAVE 1.
Wave 2 is meant to be a correction for Wave 1. It has the ability to correct back to the levels of Wave 1, but it should never extend beyond where Wave 1 originated from.
Rule #3: WAVE 4 will NEVER cross the same price zone as WAVE 1.
Wave 4 is another corrective wave, and it must never cross the same price area as wave 1. If it does so, then there is a problem with how you are viewing the waves. That is nothing to be ashamed of, you just need to be aware that this is likely the case.
As I stated earlier, this is NOT gospel. But when a trend is forming you can anticipate impulses and corrections / consolidations along the way as it transpires.
Once a prior high or low in the sequence (depending on the direction of the trade) is broken, the trend has likely come to an end and a reversal is imminent.
Does that mean to take a trade in the opposing direction? NO.
This could just be a break in the timeframe you are trading, but merely unnoticeable in a higher timeframe that’s defining the longer-term trend.
Always be sure to look at what the higher timeframe is doing and to employ your odds-enhancers as well. Stick to your trade plan like it is gospel.
Consistency is the key to profitability, understanding the Elliott Wave Theory is simply another way of reading price action and can only benefit you in your trading.
If you’d like to learn more about how I interpret price action and put this knowledge to work, simply CLICK HERE to access my hands-on approach to price action trading!