Elliott Wave theory states that prices move in waves. These waves occur in a repeating pattern of a (1) move up, (2) then a partial retracement down, (3) another move up, (4) a retracement, (5) then finally a last move up. Then, there is a (A) full retracement, followed by a (B) partial retracement upward, then (C) a full move downward. This repeats on a macro and micro time frame. A visual illustration of the basic pattern of the Elliott Wave is given below. A real life example of Elliott Wave in action is given further down:
Elliott Wave is based on crowd psychology of booms and busts, rallies and retracements. Traders often use fibonacci numbers (see: Fibonacci) to anticipate where a retracement is likely to end and thus the place where they should place their trade. The chart below illustrates the Elliott Wave pattern applied to crowd psychology (i.e. S&P 500) and Fibonacci Retracements:
Trading the Elliott Wave
In the example above of the S&P 500 ETF, if the Elliott Wave theorist recognizes that he/she just completed a the leg from (2) to (3) and the market is beginning to retrace, the trader might put a buy order at the 38% Fibonacci retracement. In the example above, that trade would have failed and the trader would have been stopped out of their long position. The trader then might consider putting an order in at the 50% retracement. In the example above, that would have been an extremely profitable trade, making up for the previous loss and more.
Next, realizing that the latest trend was the (4) to (5) upmove, the Elliot Wave theorist would next expect a downward move to (A). This retracement is larger than the previous (1) to (2) retracement and (3) to (4) retracement. A reasonable guess as to where the retracement (5) to (A) will end is the 0.618, the golden fibonacci ratio.
Selecting the 61% retracement would have proved profitable for a little while, assuming the trader didn't have extremely tight stop losses in place, but the retracement turned out to be a head fake. Subsequently, the next often used Fibonacci retracement is 100%. This trade would have been very profitable, given the S&P 500 retraced almost perfectly at 100% of the move from (4) to (5).
A likely profit target to exit at least part of the trade initiated at point (A) is the 38% Fibonacci level. This also happened to be the turning point for the next leg down from (B) to (C).
Suggested further reading is Fibonacci tools (see: Fibonacci).
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