The Elliot wave pattern has two components:

a) The motive or impulse waves, which are waves 1-2-3-4-5.
b) The corrective waves, which are waves a-b-c.

The motive waves point in the direction of the trend, while the corrective waves point away from the trend in a retracement pattern. These waves form on the charts most of the time, but the time it takes for the complete Elliot wave patterns to form will differ. Using this information, it is possible to setup simple trades, trading off the key points on the wave patterns. To be able to do this, traders need to understand the rules guiding the formation of the motive and corrective waves.

We will describe a system of trading the motive wave patterns as well as the corrective waves.

Motive Wave Pattern Rules

The rules listed here will help traders identify the motive waves when they appear on the chart.

• Within the motive wave pattern, three waves point in the trend direction: waves 1, 3 and 5. Two waves go against the trend; waves 2 and 4.
• Motive waves can be bullish or bearish in orientation.
• Wave 2’s end level does not go beyond the commencement of wave 1.
• Wave 4’s end level does not move beyond the end of wave 1.
• The shortest wave in the 1-2-3-4-5 pattern is never the wave 3 sequence.
• Waves 2 and 4 can either appear as zig-zag lines or flat lines.

Motive Wave Trade Setup

If you are trading the motive wave, you have to trade with the trend. Moreover, you need to be sure that you are actually trading the correct motive wave. Therefore, trades will be setup from the commencement of wave 5. The rationale behind this is to ensure that you are actually trading a motive wave sequence, and this can be confirmed when waves 1-4 have already formed on the charts. So essentially, the trade is to buy on the dip of wave 4 to the starting point of wave 5 (long trade), or sell on the rally of wave 4 to the start point of wave 5 (short trade).

Since wave 4 is a retracement, it makes sense to use a retracement trade indicator to pull the trade off. This is illustrated in the examples that are shown below.

a) Long Trade

The trade here is to buy at the retracement of price to the starting point of wave 5. The challenge here is to identify the end of wave 4 and the start point of wave 5. This can be done using the principles of support and resistance trading, as well as a retracement indicator. The retracement indicator used is the Fibonacci retracement tool. The Fibonacci retracement tool must be traced from the start of wave 1 to the start of wave 4 so as to produce the retracement lines.

When this tool is applied to the charts, it draws up several horizontal lines which mark the retracement levels. For this trade, these lines serve as support areas. After the price action has formed waves 1-4, the price action is allowed to get to a Fibo retracement area where it can bounce off the line (i.e. touch it without closing below it). Once this occurs, a buy entry can be set at the open of the next candle so as to follow the price to ride wave 5 into profit.

This chart shows the setup very clearly. The retracement lines of the Fibonacci tool are the purple horizontal lines seen on the chart. Notice that at the BUY point, the bearish price action candle made contact with the 50% Fibo retracement level but did not close below it. This marks the end of wave 4 and start of wave 5. The trade therefore rides on wave 5.

b) Short Trade

The trade here is to set a short trade at the retracement of price to the starting point of wave 5. The challenge here is to identify the end of wave 4 and the start point of wave 5. The Fibo retracement indicator draws up several horizontal lines which mark the retracement levels. For this trade, these lines serve as resistance areas. After the price action has formed waves 1-4, the price action is allowed to get to a Fibo retracement area where it can be rejected at a Fibo retracement line (i.e. touch it without closing above it). Once this occurs, a sell entry can be set at the open of the next candle so as to follow the price to ride wave 5 downwards.

The Fibonacci retracement tool must be traced from the start of wave 1 to the start of wave 4 so as to produce the retracement lines.

Can Corrective Waves Be Traded?

The corrective wave sequence can be traded. This time, the trade as a whole should be traded as a retracement of the main motive waves. There are three waves within the corrective waves. The trader must therefore allow waves a & b to form, before trading wave c.

Steps to Trading the Corrective Wave c

a) Allow wave a & b to form on the charts.

b) Trace the Fibonacci retracement tool on the chart, starting from commencement point of wave a, and ending at the starting point of wave b. When the retracement lines are drawn, these are used to setup the trades in the same way as the trades performed with the motive wave 5.

This can be done in both directions. It is essential that traders who undertake to trade the Elliot waves do so in a practice environment until they are confident enough to trade the strategies on a real money account.