Over the last few months I have noticed that there are some fairly widespread misconceptions regarding Elliott Wave Theory (EWT) among the “fintwit” community. In order to provide some clarity on the matter, I have constructed a quick introduction to EWT in order to separate what is and is not true of this form of analysis. This article will only discuss the interpretation and application of completed counts – if you are interested in learning how to produce a count from scratch, you can view the various educational resources provided on this site. I hope this provides some clarity and I wish you all the best in your trading endeavors.
Proper EWT IS….
- A form of analysis used to provide high probability possibilities
- Based on a rigid and objective set of rules and guidelines
- Best used in conjunction with other indicators & methods of analysis
- Constantly adjusting with price
Proper EWT IS NOT…
- A perfect system that predicts price movement with complete accuracy
- Subjective to a trader’s bias
- To be used alone and relied solely upon to predict future price action
- A rigid and unchanging prediction model
There are some who are critical of EWT and others who are blind to its limitations – both based on the same misconception, that wave counts are intended to be a high accuracy predictive model. EWT is a form of analysis that, like any other form, is used to find high probability possibilities. EWT is not meant to be a predictive model with any rigidity or certainty. In order to properly use Elliott Wave, one must understand that the paths provided are just possibilities, subject to change as price dictates… just like every form of technical analysis. Using EWT to trade is a constant “if-then” process. “If price does A, then it is likely B occurs – but if X occurs, Y is likely to follow”. Again, this is no different than the process involved with nearly every form of TA.
One of the biggest criticisms of EWT is that it is subjective – and this is (mostly) false. Proper Elliott Wave analysis is bound by strict guidelines and is not open to subjective interpretation of those rules. There are hard set invalidations and requirements for each wave structure. Many people often promote flawed examples of Elliott Wave counts, which can be extremely dangerous. These invalid counts are not Elliott Wave, but rather are subjective line drawings. The only time in which proper EWT can be subjective is when there are multiple valid counts to choose from. In those situations, it is best to use the “if-then” approach as well as additional forms of analysis to select the highest probability path. This is no different than analysis that results in a “bullish above/bearish below” level.
One of the most fatal mistakes when using EW is to be stubborn in a count. In the markets price is always changing, and so are wave counts. Of course, it is ideal that price precisely follows the wave path, and sometime it does; but when it doesn’t, we must be flexible. If price and/or wave structure change, you must be willing and able to adapt to that change. Using various indicators and finding additional evidence (divergence, supply/demand, moving averages, etc) to support wave counts will allow for less surprises and higher probability trades. Yet again, this is no different than any other form of TA.
Now, with everything above in mind, here is an example of how to interpret one of my counts:
In this post, my count shows $LI bouncing from the $23-$25 range and continuing higher out of this bull flag. There is channel and fib confluence to support this count. However, this does not mean that one should blindly buy at $24 and expect a 100% return… this is simply a high probability possibility. IF price reverses from that level, there is a high chance of a breakout to new highs – but of course, all of that could change. If price does not reverse from the level or fails to build a proper impulsive structure after, then the count will likely change. It is also important to consider other factors such as market environment, options flow, earnings or potential catalysts, etc. Trading is a constant evaluation of constantly moving parts – we must be flexible and unbiased in order to be successful.
For some of you, all of this information will have been redundant and obvious; but nonetheless a good reminder of how to approach technical analysis. No-one has a crystal ball. No-one has a system that is 100%. As traders, our goal is to make the best decision possible with the information at our disposal. We will always have losses. There will always be something unexpected. However, the proper use of EWT along with other TA and risk management can provide a massive edge over the market.
Thank you for taking the time to read this introduction, I hope this was insightful. If you are interested in learning more about Elliott Wave, I encourage you to explore the rest of the site.