How to Trade Breakouts Using Elliott Wave Theory

Professional accountant Ralph Nelson Elliott fired the opening shot in a decades-long debate when he released The Wave Principle in 1938. 

Elliott’s theory of pattern recognition argues that market trends unfold in five waves when they’re traveling in the direction of a primary impulse and three waves when opposing that impulse. This theory further stipulates that each wave will subdivide into three waves toward the trend and two against the trend. It explains a fractal market in which each wave churns out similar patterns within progressively lower and higher time frames.

Key Takeaways

• Ralph Nelson Elliott was an accountant and management consultant who is credited with discovering that the stock market moves in repetitive patterns.
• Elliott published his theory in The Wave Principle in 1938.
• Three wave principles can work in tandem to guide decisions based on market exposure.
• They should be considered together with risk management techniques.

Elliott Wave Theory and Market Lore

Elliott Wave Theory (EWT) occupies an odd position in market lore with adherents taking years to master its secrets and skeptical observers dismissing it as voodoo, favoring a more traditional approach to price prediction. Wall Street has been particularly dismissive of the practice over the years but conspiracy theories persist such as unconfirmed reports that major players often consult with wave theorists to make key decisions on market exposure.

Three Wave Principles

We don’t have to join a secret society or spend a decade memorizing a thousand rules and exceptions to take advantage of EWT’s great power. We can apply three easily understood wave principles to a popular breakout strategy and watch how they improve market timing and profit production. We can look for specific Elliott Wave criteria after a major low appears and a financial instrument tests a key breakout level.

Aetna (AET) topped out near 86 in July 2014 following a long rally. It corrected in a typical ABC pattern that ended at 72 in October. The stock jumped back to resistance at the summer high in early November, carving out two rally waves and stalling out into mid-month. Three EWT principles helped us predict what happened next because the buying spike into resistance showed the outline of waves 1 through 4 of an Elliott 5-wave rally set.

We’ll test this thesis by applying the first two of our three principles.

#1: The Bottom of the 4th

The bottom of the 4^th (2^nd selloff) wave cannot exceed the top of the 1^st wave.

The first wave completed at 79.64 on Oct. 27. The stock zoomed into resistance just above 85 after a quick slide to 76. It stalled at that level, carving out a potential 4^th wave that found support near 82.

There’s plenty of space between the two blue lines so far, designating the top of the 1^st wave and the bottom of the 4^th wave. This raises the odds that we’re looking at a 4^th wave consolidation that will yield a 5^th wave breakout and uptrend.

#2: A Continuation Gap

A continuation gap often aligns perfectly with the center of the 3^rd (2^nd rally) wave.

It’s called a continuation gap when a rising price prints a big gap and keeps on moving, doubling the length of the wave before its appearance. This was defined by Edwards and Magee in the 1948 book Technical Analysis of Stock Trends.

Aetna gapped up on Oct. 31 (the red circle) and kept on going with that level marking the halfway point of the 3^rd wave. This is vital information in our trade analysis because it raises the odds even further that sideways price action at resistance will yield a breakout and even higher prices.

We can buy the instrument within the 4^th wave in anticipation of the breakout with this information in hand. We can also place a stop under the trading range to minimize our loss if we’re proven wrong. This brings us to our third and final principle.

Important

Two of the three primary waves are likely to be identical in price gain.

#3: Two of Three Primary Waves

We’ve identified and entered a 4^th wave trade setup that’s likely to produce an uptrend equal in length to the first wave that added 7.84 points or the third wave that added 8.81 points.

We split the difference by applying the third principle and adding 8.30 to the bottom of the 4^th wave at 81.93. This establishes a minimum reward target just above 90.

What Is a Breakout in Trading?

A breakout is said to occur when a stock gathers momentum and moves rapidly outside recognized existence or support levels. Traders can take short or long positions early on in the trend based on these levels.

What Are Examples of Risk Management Strategies in Trading?

Risk management strategies can be aggressive or simply a matter of discipline and behavioral modification. One strategy is to leave the emotion out of it. Some traders impose trading limits on themselves and routinely exit positions when an asset plunges. They often use stop-loss orders, automatically exiting positions at a certain point regardless of gossip or personal hunches.

Why Is Wall Street Dismissive of the Elliott Wave Theory?

Detractors take the position that the Elliott Wave Theory is too subjective to be reliable. The theory itself may have merit but it can be open to interpretation that doesn’t follow specific and definable rules.

The Bottom Line

The stock broke out into a 5^th wave rally in mid-November and posted a swing high of 91.25, even higher than our Elliott target. Solid risk management then comes into play because it’s unnecessary to sell just because the advancing price has reached a hypothetical ending point. Many Elliott wave rallies subdivide higher and higher, especially during 5^th waves as buy signals go off and momentum traders pour into positions.