18/01/2024
The Elliott wave theory is based on the idea that market movements can be understood as a sequence of five-wave trends followed by three-wave corrections in the opposite direction. These trends are classified as either impulse waves or diagonals, while the corrections can be triangles, zigzags, or flats. However, it's important to follow the rules and guidelines of the theory. Personally, I find it fascinating how the patterns and waves are intertwined, which makes observing price action quite intriguing. Let me provide an example.
Looking at the attached chart, we can see that EURJPY recently completed a bearish impulse wave (trend) between November 16th (164.3) and December 7th (153.17). As expected, a three-wave correction followed. According to the theory, trends often resume after corrections end. However, corrections can sometimes be challenging. They frequently complete patterns that are difficult to identify. One issue many Elliott wave traders face is trying to impose their expectations on the market. The best approach is to wait for the price to lead, and then follow its direction. Sometimes, the corrective pattern unfolds easily, appearing simple and clear, like in the current corrective structure of EURJPY starting from 153.
In the attached EURJPY chart, the corrective rally from 153.17 is identified as a completed zigzag pattern, consisting of three sections: A (impulse), B (running flat), and C (ending diagonal). This structure aligns perfectly with the textbook Elliott wave pattern. Additionally, the final diagonal (C) seems to be concluding within an important supply zone. How exciting!
The correction from 153.17 is just a little above the 70.7% Fibonacci retracement level of the bearish impulse wave from 164.3 to 153.17.
Besides struggling with pattern identification, many Elliott wave traders make mistakes when applying the theory to actual trading. Although it's an excellent methodology for market analysis and understanding price action, traders must understand how to implement it in live trading. The theory provides useful trade parameters and precise risk definition. In the case of EURJPY, we'll explore three entry methods.
Entry Method 1 - Aggressive Entry, Conservative Risk:
An aggressive entry attempts to enter the market around the level where a wave pattern has been completed. In this example, an ideal SELL ENTRY would be at 161 and 161.3 (where the diagonal completes the larger flat). To maintain conservative risk, a STOP LOSS can be placed above 164.3 (where wave 2 is violated). This method keeps you in the trade, even if the corrective structure fails (above 161.6, where the diagonal becomes invalid). Managing trades is also easier using this approach. If the price breaks downwards as expected, the stop loss can be reduced, freeing up risk for additional trades. The only drawback is that the risk-to-reward ratio is smaller.
Projected Result: 50/50 win rate at a risk-to-reward ratio of 1:2 - 1:3.
Entry Method 2 - Aggressive Entry, Aggressive Risk:
This method seeks an entry when the pattern completes, much like the first method. However, the stop loss is placed where the pattern is violated (above 161.60, where the diagonal is invalidated). Although the risk-to-reward ratio is significantly higher in this case, the stop loss can be easily triggered, resulting in a lower win rate.
Projected Result: 30% win rate at a risk-to-reward ratio of over 1:4.
Entry Method 3 - Conservative Entry, Conservative Risk:
This method involves waiting for the price to respond after the pattern has completed, aligning with the overall bias. There are two possible entry strategies. The first is to trade the pattern breakout (the diagonal C in this case), while the second is to wait for a retracement after a solid breakout. The conservative stop loss can be set above 164.3 (similar to Method 1). The projected result for this method is a 50-60% winning rate with an average risk-to-reward ratio of 1:2.
Projected Result: 50-60% winning rate at an average risk-to-reward ratio of 1:2.
Entry Method 4 - Conservative Entry, Aggressive Risk:
Entry Method - Same as Method 3 (diagonal bearish breakout)
Stop Loss - Same as Method 1 (where the diagonal is violated)
Projected Result: A 40% winning rate at an average risk-to-reward ratio of 1:3.
Note: Methods 3 and 4 will be invalidated if the price breaks the diagonal pattern at 161.6 before the downside breakout.
These are all winning models. Traders must choose the model that suits their personality and remain consistent with it. As my mentors would say, "choose your own poison." You'll experience both losses and wins in trading, but proper risk management will help you weather the inevitable storms.
Stay blessed.
