Prerequisite posts:
In Strategies for Different Market States and Repeatable Conditions we introduced the concept of first aiming to determine if we’re likely to be in a range, a steady trend, a strong trend or is a possible reversal area. In this piece we’ll look at how we can use Elliott Wave theory to help to estimate what conditions we may see in the future.
The problem with market conditions is by the time they’re easy to spot they’re often close to over. By the time a market has ranged long enough to be a clear range it’s often close to a breakout. By the time a market has trended enough to be a clear trend it’s often in a PZR and can be due a pullback or range annulling trend following strategies.
For this reason, we need to have some form of forward looking indicator for what type of market conditions we may be in. When Elliot Waves are driving the market, they offer us a really good way to attempt to do this, because the different legs of Elliot have different characteristics. If we can correctly forecast the leg we’re in, we can correctly forecast the market conditions.
Elliot Wave Basics
Covering the basics of Elliot theory is outside of the scope of this training. To put it simply, there are many people out there who know more about Elliot than the person writing this. Have done more work on explaining it and with there being such an abundance of free resources it’s best to refer to these if learning the theory from the ground up.
We will not be focusing on the basics of the theory, rather how we can take actionable parts of the theory and apply them to help us build our trade plans. Please note, an extensive understanding of Elliot is not essential for this. A surface knowledge of the basic 5 leg impulse structure is.
Here’s a list of sources to learn about Elliott Wave:
Market Oracle - A website that provides free analysis and resources on Elliot Wave.
Corporate Finance Institute - A website that provides an overview of Elliot Wave Theory, its types, and market applications.
Investopedia - A website that provides an introduction to Elliot Wave Theory and its history.
Elliott Wave International - A website that provides a visual guide to Elliot Wave Trading.
Wavetrack - A website that provides Elliott Wave analysis, reports, forecasts, and price-projections based on the true spirit of the discoverer’s ultimate work published in 1946.
Typical Market States in Different Elliot Waves
Categorizing Elliott Waves into Market States:
An Elliot Uptrend
Range Waves:
1. Elliott Wave 4 (correction within an uptrend) - In this wave, the market is in a range, undergoing a corrective pullback as part of an overall uptrend. Prices fluctuate within a specific range before continuing the upward movement.
Steady Trend Waves:
2. Elliott Wave 1 (impulsive wave within an uptrend) - This wave represents the initial stage of an uptrend, characterized by a steady and gradual price increase. It signifies the beginning of a strong trend.
3. Elliott Wave 3 (strongest impulsive wave within an uptrend) - Wave 3 is often the longest and most powerful wave in an uptrend. It demonstrates a strong trend with significant price momentum.
4. Elliott Wave A (correction within a downtrend) - Within a steady downtrend, Wave A represents a corrective phase where prices experience a temporary pullback before continuing the downward movement.
Strong Trend Waves:
5. Elliott Wave 5 (final impulsive wave within an uptrend) - Wave 5 marks the final leg of an uptrend, characterized by strong momentum and often accompanied by heightened trading volume.
6. Elliott Wave C (final corrective wave within a downtrend) - Wave C represents the final phase of a downtrend, demonstrating strong selling pressure and a potential reversal zone.
Potential Reversal Zone Waves:
7. Elliott Wave 2 (correction within an uptrend) - Wave 2 occurs as a corrective wave within an uptrend, representing a potential reversal zone where prices retrace a portion of the initial uptrend.
8. Elliott Wave B (correction within a downtrend) - Wave B is a corrective wave within a downtrend, creating a potential reversal zone where prices experience a temporary bounce before resuming the overall downtrend.
9. Elliott Wave 5 (end of uptrend) - Wave 5 marks the final leg of the uptrend, typically characterized by strong momentum and potentially overextended price action.
An Elliot Downtrend
Range Waves:
1. Elliott Wave 4 (correction within a downtrend) - In this wave, the market is in a range, undergoing a corrective pullback as part of an overall downtrend. Prices fluctuate within a specific range before continuing the downward movement.
Steady Trend Waves:
2. Elliott Wave 1 (impulsive wave within a downtrend) - This wave represents the initial stage of a downtrend, characterized by a steady and gradual price decrease. It signifies the beginning of a strong trend.
3. Elliott Wave 3 (strongest impulsive wave within a downtrend) - Wave 3 is often the longest and most powerful wave in a downtrend. It demonstrates a strong trend with significant price momentum.
4. Elliott Wave A (correction within an uptrend) - Within a steady uptrend, Wave A represents a corrective phase where prices experience a temporary pullback before continuing the upward movement.
Strong Trend Waves:
5. Elliott Wave 5 (final impulsive wave within a downtrend) - Wave 5 marks the final leg of a downtrend, characterized by strong momentum and often accompanied by heightened trading volume.
6. Elliott Wave C (final corrective wave within an uptrend) - Wave C represents the final phase of an uptrend, demonstrating strong buying pressure and a potential reversal zone.
Potential Reversal Zone Waves:
7. Elliott Wave 2 (correction within a downtrend) - Wave 2 occurs as a corrective wave within a downtrend, representing a potential reversal zone where prices retrace a portion of the initial downtrend.
8. Elliott Wave B (correction within an uptrend) - Wave B is a corrective wave within an uptrend, creating a potential reversal zone where prices experience a temporary rally before resuming the overall uptrend.
9. Elliott Wave 5 (end of downtrend) - Wave 5 marks the final leg of the downtrend, typically characterized by strong momentum and potentially oversold conditions.
Let’s look at how these potentially look on a macro scale. Here’s an analysis using the Elliot wave I posted back in 2021. The thesis here is the rally from 1990 to 2021 represented a complete 5 wave Elliot impulse leg. This is obvious highly speculative and forecasts a very uncommon event (Big bear market), but whether or not the forecast plays out, the rally is a good expression of what the 5 legs looks like when we are in Elliot waves.
If we’d be able to work out back in 1990 we were in a wave 1 of Elliot, we’d know the market condition we’d be looking for would be a steady trend.
If we’d seen the 2008 crash as potentially being wave 2, we’d have known we may be in a potential reversal zone heading into 2009.
If we’d known we were heading into wave 3, we’d have expected a steady trend through the 2010 - 2018 rally.
If we’d expected to enter wave 4 we’d have been looking for choppy range action 2018 - 2020 (Often with a false breakout, which we had in 2020).
If we’d known we were heading into wave 5 we’d have expected the strongest rally yet after 2020.
If we’d known we were completing wave 5, we’d have started to bet on a downtrend when the market was spiking.
The 2022 drop and 2023 rally may have been waves A and B, if they are, we should expect a strong downtrend.
While we’re yet to see if the market does drop hard from here, it’s already been of great benefit to understand that when the market was rallying sharply in 2021 this may be us heading into a potential reversal zone and it being very risky to be long. Obviously if the full move played out, the value of this foresight would be immeasurable.
Here in green areas we’d have been looking for a steady trend. In orange areas we’d be looking for possible reversal trades and in the blue area we’d have expected the market to be choppy. These would have all been rather useful insights.
Using Elliot to inform what sort of market conditions we were in (And having the right read on waves as they appear, which is easier said than done) this is the approximate expectations we’d have had over this move.
Showing this is best done on a big timeframe (Because at least the chart will still look similar even if you’re reading this a while after it was written) but by just taking the most recent action from the SPX one hour chart we can see how we could have applied the same general theory to the recently rally.
Here we have steady trends with pullbacks where they “Should be” and then we have the strong no pullback trend into the high. We’re then into a PRZ and it’s time to switch gears on the types of strategies we’re using. This gives us a really good way to try to gauge the expected mood of the market, from here we can plan how we’re going to engage.
When we are able to correctly identify which wave we’re in, this gives us a massive edge by knowing what direction of bet we should be taking, what style of bet and when we want to stop making that bet. Elliot waves are not happening all the time, and we can easily misread them in real time, but when we have clear expressions of them a lot of the hard work is done for us.
A great thing about Elliot is it can disprove itself. Since it’s a trend formation theory, we can easily spot when one of the critical rules for Elliot has been broken. This tells us we need to get out of our positions, take a step back and then take a fresh look at the market (Maybe check higher time frames to see if you’ve missed something bigger).
Basic rules that must not be broken:
1. Wave 2 Must Not Retrace Beyond the Start of Wave 1: In an impulsive wave structure, Wave 2 should not retrace beyond the starting point of Wave 1. If Wave 2 retraces beyond this level, it suggests that the wave count may be incorrect.
2. Wave 3 Must Be the Longest Wave: In a five-wave impulsive structure, Wave 3 should be the longest wave compared to Waves 1 and 5. It should demonstrate the strongest price momentum and often has the highest trading volume. If Wave 3 is shorter than Wave 1 or 5, it may indicate a different wave pattern.
3. Wave 4 Must Not Overlap Wave 1: Wave 4 should not retrace beyond the price territory of Wave 1 in an impulsive structure. This rule ensures that the impulsive nature of the trend remains intact. If Wave 4 overlaps with Wave 1, it suggests an alternative wave count.
4. Wave 3 Must Not Be the Shortest Wave: Wave 3 should not be the shortest wave among Waves 1, 3, and 5 in an impulsive structure. While Wave 3 is typically the longest wave, it should also not be the shortest. If Wave 3 is the shortest, it may invalidate the wave count or indicate a different wave pattern.
5. Wave 5 Must Not Fall Short of the Trendline Drawn from Wave 1 to Wave 3: When drawing a trendline from the start of Wave 1 to the end of Wave 3, Wave 5 should not fall short of this trendline. If Wave 5 fails to reach or surpass the trendline, it may suggest a truncated or incomplete wave structure.
6. Corrective Waves Must Exhibit Different Characteristics: Corrective waves, such as Waves A, B, and C, should display distinct price patterns, such as zigzags, flats, or triangles. Each corrective wave should have its unique structure and not overlap or exhibit impulsive characteristics.
When it’s possible to do so, using Elliot to determine the expected market conditions is optimal. It’s the first thing we should be doing. We need to determine what type of market we expect to have, where we’re going to engage and how we’ll know if we’re wrong. The first and latter of these can be covered with basic Elliot wave analysis (In correct conditions).
When it comes to specifically how we’re going to engage, that’s where we need to dial into our repeatable market conditions and strategies to trade in them.
Failed Counts
In Elliot wave when we think we’ve determined we’ve in a certain wave and we’re wrong, this is a “Failed count”. Elliot wave can be highly subjective and it’s very easy to have the wrong count and think you’re in a swing you’re not. This is a big criticism of Elliot. Even people highly proficient with it make mistakes they can only spot later.
When Elliot works, it can give you a really good read on the direction of the market, how far it will go and the style of move it will be. During these times, a lot of profit can be made. However, you also have to accept that even when you get good at Elliot it’s possible to misread counts. Which will lead to you having the wrong trading bias at the wrong time.
The reason this is not a huge issue is Elliot has some definitive rules that can not be broken. So we can pinpoint exactly where our idea that we’re in a certain wave would fail. We can say, “If we’re in the move I think we should see this and that and we should not see that and this”. When the reading is correct you can make a lot, when it’s wrong you can get out quickly.
We’ll cover more about how to simply Elliot wave to reduce the number of misreads and also how we can protect ourselves from being wrong on the counts by knowing the failure points of our theory. Knowing when to get out and how to reassess the market (For example, usually checking a higher timeframe will help add more context).
For now, just know it’s not essential to be an expert in Elliot wave. We’re really just borrowing from a few of it’s most useful and easy to use aspects to help give us some sort of initial idea of what sort of market conditions we may have. It’s not about being highly proficient in the wave counts, it’s about understanding the characteristics of different waves.