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. His theory of pattern recognition argues that market trends unfold in five waves when traveling in the direction of a primary impulse and 3 waves when opposing that impulse. This theory further stipulates that each wave will subdivide into three waves towards the trend and two against it. Finally, it explains a fractal market in which each wave churns out similar patterns within progressively lower and higher time frames. (For further explanation, see: ​Elliot Wave Theory.) 

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.

Luckily, we don’t need to join a secret society or spend a decade memorizing a thousand rules and exceptions to take advantage of EWT’s great power. In fact, we can apply three easily understood wave principles to a popular breakout strategy right now and watch how they improve market timing and profit production. We’ll look for specific Elliott Wave criteria after a major low appears and a financial instrument tests a key breakout level. (Fore more, see: The Anatomy of Trading Breakouts.)

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.

A. 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 October 27. After a quick slide to 76, the stock zoomed into resistance just above 85. It stalled at that level, carving out a potential 4^th wave that found support near 82. So far at least, there is plenty of space between the two blue lines designating the top of the 1^st wave and bottom of the 4^th wave. This raises odds that we’re looking at a 4^th wave consolidation that will yield a 5^th wave breakout and uptrend.

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

When rising price prints a big gap and keeps on moving, doubling the length of the wave prior to its appearance, it’s called a continuation gap, as defined by Edwards and Magee in the 1948 book Technical Analysis of Stock Trends. Aetna gapped up on October 31^st (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 odds even further that sideways price action at resistance will yield a breakout and even higher prices.

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

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

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, which added 7.84 points, or the third wave which added 8.81 points. Applying the third principle, we split the difference and add 8.30 to the bottom of the 4^th wave at 81.93, establishing a minimum reward target just above 90.

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 advancing price has reached a hypothetical ending point. In fact, many Elliott wave rallies subdivide higher and higher, especially during 5^th waves, as buy signals go off and momentum traders pour into positions. (For more, see: Calculating Risk and Reward.)