Trading with the Elliot Wave Theory: Part 2

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The moving averages stand at the top and the bottom of every wave.

The picture below illustrates how the moving averages and the Elliot wave theory work hand-in-hand. The yellow 50 MA stops the move upward, thus ending the first wave and starting the second corrective wave. The 20 MA in gray now turns into support and holds the price from moving lower, which means that the second wave is over. In the third wave, the 100 MA in red comes into play and the wave fades when the price gets close to it. After that, the fourth wave commences and ends only when it reaches an area where there´s a confluence of the 20, 50 and 100 moving averages which have now turned into support. Then starts the final wave, which takes the price above the 100 smooth MA in red.

You can also trade the Elliot wave theory with moving averages by using the moving average to identify the start of a new wave. The small period moving averages like 5 MA, 8 MA, 10 MA or 20 MA work best for this strategy. Basically, you wait until the price moves above or below the moving average, which confirms that the new wave has started. You can open a position in that direction immediately after the break, but there´s the risk of a fake-out. So I prefer to wait until the price retraces back to the moving average and then sell with a stop – either above the moving average or above the previous wave´s high in a downtrend.

A wave starts after the price crosses over the moving average.

To refresh your memory about moving averages: Trading Moving Averages – Forex Trading Strategies

Trading the Elliot wave principle with support and resistance levels

Support and resistance levels are widely used in trading. They are easy to see, so a lot of people base their entries and exits on them. They can be used in range trading, but in the case of the Elliot wave theory, they are used in trend trading. This method is similar to the Darvas Box system.

As we know, in an uptrend, once a resistance level is broken, it turns into support. So when an upward wave of this pattern breaks above a resistance level, the next corrective wave is supported by the previous resistance. This means that this level will be the end of the second wave; we can buy here with a stop either below the resistance or below the starting level of the first wave. The opposite applies to a downtrend Elliot wave pattern.

The downside to this method is that you can only start trading after the end of the second wave. You can see in the chart below that the top of the first wave provides resistance, turns into support and holds the price at the bottom of the fourth wave of the motive phase (Fig. 4). In the corrective phase, it provides support and forms the bottom of the A wave.

The resistance level of the first wave provides support in the fourth wave of the motive phase, as well as in the first wave of the corrective phase

To review Support and Resistance Levels:  Support and Resistance Levels – Forex Trading Strategies

Trading the Elliot wave principle with Stochastic and RSI indicators

RSI is another very popular indicator amongst professional traders. However, I prefer the Stochastic indicator. Though it is similar to RSI, in my opinion, it works better. It signals tops and bottoms faster than RSI. They are both easy to read and interpret; you buy when the indicators reach the oversold area (30 for RSI and 20 for Stochastic), and sell when they reach the overbought area at 70 for RSI and 80 for Stochastic.

You can do the same when you apply these indicators to the Elliot wave theory. When these indicators are overbought it means that the up wave is over, therefore, you have to sell. When the indicators are oversold it means that the retracing wave is over and you can buy in order to ride the next wave up.

The Elliot wave pattern working well when combined with Stochastics

The chart above explains this strategy very clearly; as you can see the Stochastic is a very good indicator. Rinse and repeat five times for each of the five waves of the impulsive phase. Then do the same with the three waves of the corrective phase. Even though the difference between the overbought and the oversold levels in these two indicators is always the same, in an uptrend pattern the waves are faster, thus the price gains are bigger by the time the Stochastic and RSI reach the overbought levels. You apply the same method but in the opposite direction in a downtrend Elliot wave pattern.

We know that most of the trends happen in waves, so the Elliot wave theory is very useful. But in order to turn it into a strategy, you have to combine it with other indicators like the ones explained above. If I rank the indicators depending on how well they work with the EWT, in my opinion, it would go like this:

1. EW with moving averages
2. EW with Stochastics and RSI
3. EW with support/resistance levels and
4. EW with Fibonacci

If you look at the charts above you can see that I keep most of these indicators on, so I don´t have to guess or chose one strategy over the other. I just see how the waves progress and which indicator works at the moment for that particular pattern, so I suggest that you do the same.