(03/21/12) Video: How I Trade with Elliott Wave

Trader Juan Sarmiento highlights a potentially costly misconception about Elliott Wave analysis and goes on to teach a simple, easy-to-apply method any trader can use to spot and trade trend changes in any market.

What I view as the greatest misconception about Elliott Wave theory is that there are two types of waves: the trending waves called "impulses" and the non-trending waves called "corrections." I would agree that non-trending patterns are always corrective, but it is not true that trending patterns are always impulses.

Further, impulses can be parts of corrective patterns such as a zigzag. So far this is all semantical, oriented to dedicated Elliotticians, but how do we make all this information practical to traders?

I find it more useful to characterize wave patterns as trending and non-trending. Glenn Neely describes a host of corrective patterns, some of which are quite strongly trending. The most common of these patterns are the zigzag and the double zigzag. In fact, some software programs that claim to find Elliott Wave patterns in charts often mislabel double zigzags as impulses. Since I find that double zigzags are far more common than impulses, I believe that software programs may often mislead us.

So how do we avoid the catastrophic error of expecting a fifth wave that might never come, or take advantage of a trending pattern like the zigzags and double zigzags?

I use the “Rule of Three.” Every time I see a strong move, I don’t have to trade immediately. Rather, I place the stock on a bearish or bullish watch list, and wait until a proper correction takes place.

A correction may retrace 61.8% to 80% of the first move. Inevitably, the third wave will occur after that correction. I estimate the third wave to extend 100%-127% from the end of the second wave, and to approach or reach a trending channel (more below). If the overall pattern is an impulse, then the third wave is very likely to exceed the limit and go to 161.8% of the first, but I don’t have to count on that. I am interested in reaching the 100%-127% extension. If I happen to be lucky and get an impulse, then the third wave will be very aggressive, and I will notice it as it moves, raising my expectation that the top of my channel is going to be reached.

Since I find double zigzags to be far more common than impulses these days, I can use my channel methodology to project a target, and a time by which it would be reached. Using my time and price targets, I can use the right option strategy and expiration to take advantage of the move. The channeling methodology is brilliant in its simplicity, and can be applied to single stocks and indices.

Here is how I apply it. For upward-trending charts, first, locate a recent low. Connect this low point to the first higher low by a lower line. This low is the end of the second wave.

The top of the first wave is the highest point to touch a parallel line to lower line. The channel formed is extended to the right of the chart. Using a Fibonacci extension tool, calculate the target for the third wave to be 100%-127% of the first, from the bottom of the second wave. My target in time and price is the crossover of the Fibonacci extension and the upper line of my channel. For downward-trending charts, I do the opposite.

This methodology is simple, practical, and oriented for use by the trader, rather than the Elliott Wave enthusiast.

Here is a video tutorial that will give you additional information: