Lesson 3: Elliot Wave Trading: 3 Rules of Elliot Wave Theory

The previous lesson opened a new theory for you to use and profit from in the forex market: the Elliot Wave theory. By analyzing the Elliot wave pattern, you can;  

1. Identify the market trend based on the emotions of the market participants on news releases.
2. Tell the where the price will (or will not) move based on the repetitive wave patterns.

However, analyzing the Elliot waves is not rainbows and butterflies; it requires a great understanding of the theory and the market. 

Here are the three cardinal rules for analyzing the market using the Elliot Wave theory.

Lesson Highlights

• Analyzing the market using the Elliot Wave theory gives you an idea of where the market will or will not move based on the wave patterns.
• While profitable, spotting Elliot waves is challenging because of its complex data presentation. However, three rules govern Elliot Wave traders in spotting one.

Rule #1. Wave 3 should never be the shortest impulse wave 

This rule is based on the observation that in strong trending markets, the third wave tends to be the most powerful and dynamic.  

Wave 3 is often characterized by significant price momentum, high trading volume, and widespread participation from market participants.  

It typically represents the meat of the trend, where most price movement occurs.  

As a result, Wave 3 is rarely the shortest among the three impulse waves (Wave 1, Wave 3, and Wave 5) within an Elliott Wave sequence.  

Traders and analysts often look for the length and strength of Wave 3 as a key indicator of the underlying market trend and potential trading opportunities. 

Rule #2. Wave 2 should never trend beyond the start of Wave 1 

Rule number two emphasizes the corrective nature of Wave 2 within the Elliott Wave sequence.  

After the completion of Wave 1, which represents the initial impulse move in the direction of the trend, Wave 2 serves as a retracement or correction of part of Wave 1's gains.  

This corrective wave typically occurs as market participants take profits or re-evaluate their positions after the initial surge in prices.  

According to Elliott Wave Theory, Wave 2 should not retrace beyond the starting point of Wave 1, as doing so would violate the basic structure and integrity of the Elliott Wave pattern.  

Traders often use the depth and duration of Wave 2 retracements as a gauge of market sentiment and potential entry points for trades in the direction of the larger trend. 

Rule #3. Wave 4 should never cross the price area of Wave 1 

The third rule highlights the principle of alternation within Elliott Wave Theory, which suggests that corrective waves tend to exhibit different characteristics compared to their preceding waves.  

After the strong upward movement of Wave 3, Wave 4 represents a corrective phase where prices consolidate or retrace part of the gains from Wave 3. According to the third cardinal rule, Wave 4 should not overlap with the price territory covered by Wave 1.  

This guideline helps maintain the overall structure and symmetry of the Elliott Wave pattern, as overlapping waves would indicate a lack of clear directionality in the market.  

Traders often analyze the depth and duration of Wave 4 corrections to anticipate potential entry or exit points for trades within the larger Elliott Wave sequence. 

Best Practices in Trading Elliot Waves 

Like any trading theory, Elliot wave analysis will be in its most effective and reliable form when used in conjunction with other practices. 

Here are the practices you should apply when you analyze the Elliot waves:  

1. Understand Elliott Wave Principles 

Of course, the first thing you must ensure is your mastery of the theory.  

Before you position a trade using the Elliot wave theory, you should first develop a solid understanding of its core principles. This includes the wave structure, wave degrees, wave types, and the rules and guidelines about the wave patterns. 

2. Identify Trends 

Before analyzing the Elliot wave, you should identify the prevailing market trends. Determine whether the market is trending upward, downward, or moving sideways. 

If you find that the market is trending, it's your signal to use Elliot wave analysis because it works best during the trending markets.  

3. Use Multiple Timeframes 

Looking at multiple timeframes helps you gain a better perspective on the market. With this clearer understanding of the market trend, identifying the Elliot waves will be much easier. 

Basically, you must confirm wave counts and patterns on longer timeframes with those on shorter timeframes for increased reliability. 

4. Combine with Other Indicators 

A trader who has multiple indicators in their arsenal is likely to ride and profit from the market. So, you should use Elliott Wave analysis in conjunction with other technical indicators and tools to confirm signals and validate wave counts.  

This includes indicators like moving averages, Fibonacci retracements, trendlines, and support and resistance levels.