Use Elliott wave theory to give your trading an edge

One of the major themes in my MoneyWeek Trader posts is the advantage of using basic Elliott wave theory. Every trader needs an edge that most others do not possess. If you are using a common method, then it is impossible for you to have an advantage over others. And to succeed in trading, you must be prepared to do things that most others will not do.

It is one of the many seemingly irrational aspects of trading that must be understood before you can graduate into the ranks of the serious trader.

It boils down to the way markets work. What actually moves prices? For example, in the gold market, is it the supply/demand balance of the actual metal? Or is it the manipulations of the Fed (this is one of the more colourful conspiracy theories floating around)? Or is it perhaps the news flow?

For every market, there is one central marketplace that dominates trading. In the case of gold, it is the Comex in New York. The global price of gold is set there (and on the electronic platform in out-of-hours trading). In Comex, it is futures that are traded, not the actual metal.

So what drives the price of the futures? It is simply the ever-changing flow of buy and sell orders and the fluctuating balance of these competing forces that produce the swings up and down in the charts. And because these swings are patterned, the Elliott wave theory describes how these swings are related to each other.

This allows for forecasts to be made based on previous price action, provided the correct wave labels are applied to the current chart. That is always the challenge!

Monday’s trade was right on the money

On Monday, I illustrated how Elliot wave theory works by identifying a major top in the GBP/USD – specifically, the key reversal at the 1.70 top. I was then able to place wave labels on the subsequent decline in this chart:

GBP/USD spread betting chart

Wave 3 was instantly identified because it was ‘long and strong’. On Monday morning, the market was rallying in wave 4, which I forecast would very likely terminate at either the Fibonacci 38% or 50% levels. These are the retracement levels of the wave down off the 1.70 top.

My forecast then was for the market to complete wave 4 and then head back down below the wave 3 low in wave 5. When wave 5 terminated, the market would embark on a corrective rally – hopefully in an A-B-C form.

But the key point is that if this scenario panned out, the five minor waves down would be the signal that the top was in and the next big trend for GBP/USD would be down.

The power of Elliot wave analysis

Let’s see how this idea is working out so far. Here is the current chart as I write:

GBP/USD spread betting chart

Monday’s rally did turn around at the Fibonacci 38% level and the market then declined below the wave 3 low. As expected, there was a strong positive-momentum divergence there signalling a weakening of the selling strength.

This morning, the market is rallying in wave a, and I expect a decline in wave b and then another rally in wave c.

In a nutshell, the scenario that I painted on Monday was right on the money. And excellent trades could have been made along the way. Isn’t that pretty?

Monday’s trade demonstrated the power of Elliott wave analysis, and why it would pay all traders to get to know at least the basics of this most useful method.

How to choose the correct pivot points

If we are indeed in an A-B-C up, then where is wave c likely to terminate, and where could we look for a new short trade? For this, we apply the Fibonacci levels once again to the move off the high. But this time, I am using as a pivot point the second high off the top, and the chart will reveal the reason I have chosen this point and not the absolute top:

GBP/USD spread betting chart

If I had chosen the absolute top as my high pivot point, then I would not get such good hits on the minor highs marked by purple arrows. These hit the precise 50% and 38% levels on the nose.

This is a way I use to check to see if I have chosen the correct pivot points.

The levels marked are the most likely turning points for wave c. If there is also a negative-momentum divergence (NMD) at the c wave high, that is my signal to start looking for a new short entry.

If this scenario pans out, then I expect new lows to be made. This would then be the larger Elliott wave picture:

GBP/USD spread betting chart

If my five down on the hourly chart is my larger wave 1, the current rally is wave 2. My wave 3 down would then be a new low. I have marked the Fibonacci 50% and 62% levels of the big rally off the March major low, which are natural terminating points for wave 3.

This ride promises to be exciting!