The theory is somewhat based upon the Dow Theory inasmuch as the price movements move in waves. It was understood by the technicians at the time that because of the fractal nature of the markets, Elliott was able to break down and analyze the markets in much greater detail.

The interpretation of the Elliot Wave Theory is as follows:

• Every action is followed by a reaction.

• There are five waves in the direction of the main trend followed by three corrective waves (a "5-3" move).

• A 5-3 move completes a cycle.

• This 5-3 move then becomes two subdivisions of the next higher 5-3 wave.

• The underlying 5-3 pattern remains constant, though the time span of each may vary.

Let's have a look at the following chart made up of eight waves (five up and three down) which are labeled 1, 2, 3, 4, 5, a, b and c.
 

In the 70s, this wave principle gained popularity through the work of Frost and Prechter. They published a legendary book on the Elliott Wave, entitled "The Elliott Wave Principle – The Key to Stock Market Profits". In this book, the authors predicted the bull market of the 1970s, and Robert Prechter called the crash of 1987.
 

The corrective wave formation normally has three, in some cases five or more, distinct price movements, two in the direction of the main correction (A and C) and one against it (B). Waves 2 and 4 in the above picture are corrections. These waves have the following structure:

 

Elliott Wave: The Best Of The Theory

For those not familiar with Elliott Wave theory its most basic tenet is that market movements are based on crowd behavior, which is seen as predictable given similar situations. Creator R.N. Elliott showed that these movements occur in a series of impulse and corrective waves. (To learn more, see Elliot Wave Theory.)

For example, a bearish impulse swing consists of three waves down and two waves up (see Figure 1). Major impulse waves down (1, 3 and 5) can be further broken down into smaller five-part impulse down waves and corrective up waves, depending on the time frame over which the waves are observed. Bullish waves move in the opposite direction.

But this is where it starts to get more complicated. These smaller waves can be further broken down into more waves, which are interrelated by Fibonacci numbers (1, 1, 2, 3, 5, 8, 13, 21, 34, etc.), and on it goes. (Read more about how these numbers are used in technical analysis in Fibonacci And The Golden Ratio.) Wave analysis runs the gamut from supercycles lasting hundreds of years to sub-minuets that may last only a few minutes on an intraday chart.

One of the hardest things about trading Elliott Wave is its degree of complexity. To make it even more challenging, there are alternates to every potential move, which basically tells the trader that if this move doesn't go up, it will go down, but he or she will know that only after the fact! The rule of alternation also means that the corrective waves 2 and 4 will alternate. If a wave 2 down is a simple wave, then wave 4 will probably be complex, but not necessarily. Then there are X waves. These are waves that connect complex corrections.

It is easy to see why many novices shy away from using Elliott Wave and why many traders who have invested thousands of hours into it (and lost dollars trying to develop working trading strategies) finally abandon it altogether.

Starting with the End in Mind

To begin with, the trader must have realistic expectations. Most new traders spend the majority of their time looking for a system that has an unrealistically high win/loss ratio. Those still seeking a system that consistently produces more than 50% winners in the long term haven't learned that surviving the market means knowing how to deal with losses. Such traders are looking for the Holy Grail, and it doesn't exist.

It's worth remembering what well-known author and professional trader Perry Kaufman had to say after years of exhaustive testing of various trend-following systems, some of which were discussed in his book "Trading Systems And Methods" (1998): "You can expect six or seven out of 10 trend trades to be losses, some small some a little larger."

And yet, Kaufman says that trend-following systems are some of the best trading systems around. In other words, trend-following systems have more losers than winners, but professional traders who use them make money consistently. 

Renowned technical analyst John Murphy echoes this sentiment when he states that veteran professional traders experience winning trades 40% of the time. Granted, it is possible to outperform this record over short-term periods, but expecting any system to do much better over the long haul is unrealistic.

This means that for any system to be profitable long-term, money management is key. If a trading system cannot be profitable with more losses than winners, find another system or spend more time on money management. In short, losses must be kept small and profits must be allowed to accumulate. Unfortunately, the majority of traders do just the opposite and end up going out of business.

 

Applying this idea to trading Elliott, Figure 1 shows a five-minute chart of the Dow Industrial e-mini futures with a five-part impulse wave. Colored bands show the points of support (or resistance in an uptrend) and are where the trader looks to place a trade or adjust stops on current positions.

Programming Elliott to Trade
In the 500+ page manual for MTPredictor, author and creator of the program Steve Griffiths makes an interesting observation. He says there are basically three types of people when it comes to Elliott Wave.

1) Those who are new to the principle and still completely amazed at what it promises.

2) Those who are experienced but frustrated by their lack of success/consistency.

3) Those who have completely given up (sometimes after years of trying to make it work) and are frustrated by the whole experience.

To avoid falling into the third category, the modern trader needs to ask how Elliott Wave theory can be used to make money in today's markets. Is there a way of automating the analytical process using the complete theory, or is it possible to strip it down and isolate specific aspects of the principle to pick money-making trades? Becoming an expert but finding it impossible to make money is a waste of time.

As an Elliot Wave expert and a private trader with more than 17 years of experience, Griffiths asked himself the same questions. After spending years trying to make money on a consistent basis using alternate methods, he went back to Elliott Wave basics. He started with the premise that if Elliott Wave was to work in a program, he had to find setups that limited risk to a minimum that allowed profits to run. These setups had to be specific, identifiable and consistently profitable. If overall losses are greater than profits, what good are the longer-term forecasts for which Elliott Wave analysis is famous?

According to the theory, the strongest moves in a trend, whether up or down, are the impulse waves 1, 3 and 5. Of the three impulsive waves, the largest and most profitable is generally wave 3. Therefore, the ideal place to enter a trade is at the beginning of wave 3, which is the end of a corrective wave 2. Could the program be designed to hone in on these ABC corrective patterns (see Figure 2) that normally unfold in a wave 2 and provide the trader with a high-probability point of entry? Here is what Griffiths said in an October 2004 interview to discuss how the program came into being:

"In computer testing, we found that it was possible to enter with a minimum risk after an ABC had recently unfolded and the best were those that made up wave 2. By entering long trades very near significant support levels (and short traders near significant resistance levels), losses would be kept small if the trade turned out to be a loser. Winners had the potential to be very profitable indeed when the trader caught a wave 3 but the system had to be designed in such a way that the large gains were a bonus, not essential to the profitability of the system." 

 

This became Griffiths' goal: to design a computer program for his personal use that could search for ABC patterns that made up a wave 2 ending at or near significant support or resistance areas with a minimum risk/reward of 2:1. He could then choose only those that met specific risk/reward ratios according to his written trading plan. A more aggressive approach would be to take every trade generated by the program. A more conservative style allowed him to choose trades with a minimum risk/reward of 2.5 or 3:1.

After the first version of the program was completed four years ago, Griffiths realized that the application he had developed had commercial potential since there had to be others like him who were frustrated with the lack of success using Elliott but knew that it was based on sound technical and crowd behavior principles.