A remarkable number of traders the world over use Elliott Wave (EW) theory as at least a part of their trading plans. But, how many of them are able to trade in a way that controls risk and is, therefore, profitable over the long-term? All professional traders know that, without strict risk control, a trader’s longevity will be limited…

One of the (many) criticisms leveled at EW theory is that its basis is subjective. You have to judge where a market is in an EW sequence (typically, a 5-wave trend or a 3-wave correction to a trend). You may be “right,” you may be “wrong” or you may start off looking “right,” only to find price moving away from the assumed market pattern -- that feels distinctly “wrong”!

If this is the case, how can a trader have any control over his trade risk or know in advance the profit levels to be used in any formal risk-reward calculation? For a risk-reward assessment to be made, the two sides of the equation need to be both simple and known. To achieve that with standard EW analysis is at best difficult, at worst impossible…

One way for a trader to address these inherent difficulties is to strip down EW principles to form a lean, tradable approach to the markets. This may deter the purists, but the survivors in the trading world know perfectly well that trading is about understanding risk, not about forecasting or “getting it right.”

Probability risk can be reduced… The practical meaning of risk in trading involves two elements: probability risk (the risk that a trade may not turn out as anticipated) and money risk (the amount lost if a trade does not turn out as anticipated). Probability risk is usually the more difficult of the two to pin down. If we accept trading with the trend as a basic premise, in EW terms, this means trading off the end of a correction-to-a-trend, back into the trend itself.

Ideally, this can be in only 3 places: Off a corrective Wave 2 into a trend Wave 3, off a corrective Wave 4 into an end-of-trend Wave 5 and off a corrective Wave B into a trend Wave C. Again, the ideal is to see the Wave 2, Wave 4 or Wave B unfold as a simple 3-wave correction-to-trend -- an ABC correction, the easiest-to-identify correction in the EW world.

The probability of this trade set-up actually working is enhanced if there is no confusion over its identification (it is a clean zig-zag pattern), if it clearly follows an unambiguous trend (so could be correcting it) and if it is at a critical price level. We may disagree over what is “critical,” but the use of Fibonacci numbers and ratios to guage when the correction is ideally over provides a constant framework.
For instance, if the length of Wave C of the ABC correction equals 0.618x or 1.00x the length of Wave A, this may indicate that, say, selling power is now becoming exhausted in a correction down against an uptrend. To further improve the probability risk, it is wise to wait for the market to show signs of price reversal itself, rather than jump the gun. So, the many variants of reversal bars, indecisive price movement (inside bar, etc.), traditional Japanese candlestick patterns, channel / moving average breaks or oscillator reversals can be used to narrow the odds of a market returning to trend.

Money risk can be controlled…
This leads us to a discussion of money risk. To know this type of risk, you must know the entry price and initial stop loss price in advance of any trade. It follows that, the closer the entry trigger to the initial stop, the smaller the initial (money) risk.
If you are trading off one of the 3 best market junctures in EW terms (as previously described), the initial stop can always be the extreme price reached in the ABC correction. Logically, this makes sense in that, if this price is reached, the trader’s initial analysis is incorrect, and there is no business in this trade for now. If you are trading any other part of an EW sequence, appropriate stop loss placement is much less clear.

Risk-reward can be assessed…

For the other side of the risk-reward equation, reward levels have to be clear and constant. If a trader is specializing in entering trades off these “isolated” ABC corrections, the obvious profit targets are the EW price levels that would be reached if the market does indeed return to its previous trend direction.
For instance, if you are trading off an ABC correction that forms a Wave B, the trend wave to follow would be the Wave C -- here, the minimum, typical and maximum Wave C price targets using the widely accepted Fibonacci ratios would form the profit targets. They can be calculated in advance of entering the trade, so you can also know and evaluate the risk-reward outlook before you commit any capital.
Trades should be treated in isolation...

Furthermore, the standard pitfalls of conventional EW analysis must be prevented from interfering with this risk-reward trading framework. If you treat these trade set-ups in complete isolation, you can avoid having to fit the corrective pattern into a larger EW pattern or squeeze a smaller-degree pattern inside it. Similarly, you can also avoid having to link the corrective pattern and its prior trend to previous market movement.

This Isolation Approach also means that any trades resulting from these set-ups can be managed on the same timeframe as that on which the set-ups occurred. No interference with the trader’s mindset from conflicting timeframes (there are 9 in traditional EW analysis…) is allowed. Elliott wave labeling or “counts” do not change mid-trade and the profit targets are unmovable. This all makes for highly decisive and consistent trading.

Overcoming R. N. Elliott’s own problems...
As Frost and Prechter state in Elliott Wave Principle “for all his (Elliott’s) meticulous study and profound discovery, he displayed a typical investor’s weakness in (at least once) allowing a prior opinion adversely to affect his objectivity in analyzing the market.” To be able to use some of his basic principles for consistent and objective risk-reward trading really is something for traders to celebrate.

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