Cryptocurrency trading strategy based on the Elliott wave studies by Bill Williams and Robert Prechter
I have given a detailed description of the Elliot Wave principle in the interpretation of Bill Williams and Robert Prechter. If you haven’t read those articles or have forgotten theory, I recommend you get familiar with the following materials:
This post starts a series of articles devoted to my own trading strategy that I developed based on the three tools offered by the two authors I mentioned above. I want to note at the beginning that I write this material for solely educational purposes. Trading with this strategy doesn’t guarantee a profit. If you decide to trade with this strategy, you should understand that this is your responsibility.
Going back to the previous articles, my own experience proves that Williams developed a highly efficient tool to identify the trend pivot point, he called it Five Bullets; he also gave detailed instructions on the trading algorithm and money management. Prechter went deep into studying the wave structures that should be taken into account when interpreting the price charts.
So, I extracted the most important information from these two approaches and decided to develop a cryptocurrency trading strategy based on this material. I will describe it in the process of analyzing a few impulse waves and corrections used as an example. I will also describe the tools I chose for the analysis. Well, let’s get down to business.
Identify a zero point
Williams and Prechter agree that the analysis of any wave or wave-pattern starts with the identification of their starting or zero points. To do this, we need to learn how to determine the end of corrections.
At the first stage, you need to at least approximately identify the structure of previous impulse waves and corrections.
The hourly BTCUSD price chart displays a probable zero-point marked with a blue oval. Having analyzed visually the previous bars, we see that the last bearish trend looks like a correction in the form of a plain zigzag. The preceding bullish trend is a normal five-wave sequence with the extended third wave.
Next, to accurately determine the zero point, we will use the five bullets described by Williams. I will briefly remind you:
- The candlestick that makes an extreme is in the target zone.
- There is a divergence between the MFI indicator and the price (as an additional signal, it may enter the overbought/oversold zone).
- There is a fractal at the extreme point.
- There is a squat bar in the place of one of the three up or down bars (displayed by the Market Facilitation Index MFI
- There is a momentum change on the MACD indicator, the up momentum reverses down in the bullish market, and a down momentum reverses up in the bearish market.
As there is a three-wave formation, not the five-wave one that shows the divergence right after the third wave and through the beginning of the fifth wave, we shall focus on the overbought or oversold zones. It will signal that the price is too low, and the bearish trend is exhausting.
The next signal is a fractal at the lowest point, marked with the blue up arrow. However, this signal is only indirect evidence that the interpretation is right because fractals emerge quite often in the chart.
One of the three bars of the assumed extreme is squatting. It corresponds to the pink bar of the Market Facilitation Index. It is followed by the withering bar (brown bar on the indicator, the second from the bottom line), which signals that the current price stops meeting expectations of most trader. It can also emerge at the Elliott waves’ peaks.
And, finally, the MAs of the MACD are meeting, and the indicator moves from the red zone to the green one, which signals that the bullish trend will soon start.
Now, let’s check if the bars are in the target zone. According to theories developed by Williams and Prechter, in a simple correction, the C wave should be 100%-161.8% of the A wave’s length. Sometimes it retraces the A wave of 61.8%. As you see from the chart, the length of the C wave is a little more than 161.8%, that maybe because it is extended.
To check the accuracy of the price chart interpretation, we should calculate the relations between the corrections described by Robert Prechter. If you see a five-wave sequence as a single motive wave, the following sharp correction, a simple zigzag in our example, should be 50%-61.8% of the motive waves’ length. The presumed endpoint of the correction is between the retracement levels of 50% and 61.8%.
Therefore, we can conclude that the suggested point is the endpoint of the corrective zigzag.
It is rather risky to enter the market in the new trend at the first wave. It is most commonly very volatile, and it can be canceled, and the old trend may continue.
In this strategy, the first wave is used to confirm that there is a new five-wave sequence at its inception rather than the continuation of a complex correction. You can enter a trade only within a five-wave formation of a smaller degree, I will write about this a little later.
As you remember, any impulse is a five-wave sequence. We will use this feature to verify our assumptions. Wave (1), marked by the green line in the chart, can be easily divided into five waves of a smaller degree (marked by blue lines).
Besides, a sharp correction in the position of the sub-wave 2 may confuse, as you may think that the previous correction hasn’t finished yet. However, it is higher than the starting point, so it doesn’t break the principle of the impulse wave formation. There is a five-wave structure of wave 1 one degree lower, it is marked by turquoise lines. There is also a sideways correction in the positions of wave 4, following the correction in the place of wave 2. This meets the alternation principle (a sharp wave is followed by a flat). In total, this suggests that this is a normal five-wave sequence that corresponds to wave 1 one degree higher.
The next step is to identify the endpoint of wave one. We again use Williams’s five bullets. We also calculate the wave relations according to Prechter.
Well, there is a fractal in the chart, and the Market Facilitation Index displays a squatting bar close to the assumed extreme point. It is followed by a withering bar. The common MFI shows a divergence close to the fifth wave marked by pink lines.
The indicator is in the middle, around level 57.2. It can be explained by the too intensive step rise that can’t create the overbought condition. The MACD histogram goes from the green zone into the red one, but this signal is a little later. The MAs are also rounded, tending to cross the long-period one downside. All these signals together indicate that the bullish trend has exhausted.
To calculate the target zone, we use a five-wave sequence of a lower degree, it is marked by blue lines in the chart. Williams thinks that the fifth wave’s length should be 61.8–100% of the total length of wave 3. However, as the structure is irregular in this case, a potential pivot point is at 50%. On rare occasions, it can be a resistance level where the trend reverses.
As an additional verification, we shall use the principle of wave relationships described by Robert Prechter. It says that that the end of wave four divides the formation according to the Golden Section. It means the distance from the start of the first wave to the termination point of wave 4 is 61.8% of the entire impulse.
You see from the BTCUSD chart that the projected pivot point is a little higher than the point of 1.618 relations. So, it is the peak of the fifth wave and the first wave of the primary formation.
Wave 2 is an expected correction that is inevitable after wave one finishes. It is rarely forming on big volume, as the selling pressure usually exhausts by this time. Sharp correction most commonly emerges in the position of the second wave.
At the stage of the second wave emerging, you may enter short positions if you have the experience of margin trading, as it is the safest approach at this point, according to risk management.
This is because if the formation will be broken and the second wave will continue the previous bearish trend, you will benefit. Otherwise, if the second wave really starts a new bullish movement, you will exit based on the signals suggesting the second wave’s end; I will describe these signals later.
As I already noted, when the correction starts, that is right after the peak of wave (1), based on Bill Williams’s trading plan, we enter our first trade. According to the trading strategy, it is a margin sell, so we enter a short trade. If you can’t track the opened position all the time, you should set a take profit in the range of 50% – 61.8% of the first wave’s retracement. The second wave most commonly has such length in practice. If you won’t trade even safer, the target profit can be set in the range of 38,2% -50% of the first wave’s length. However, the profit will be much less in this case. A stop-loss, in case the interpretation has been wrong, will be set a little higher than the presumed peak of the first wave.
If you can, you need to switch to a shorter timeframe and define the correction type during the development of the wave. We will define the pivot point by analyzing the last corrective wave and the signals of five bullets.
The BTCUSD price chart displays the second wave that, upon closer examination, has a five-wave structure. Blue circle highlights the expected point of its end, the green arrow marks the relevant take-profit zone (50%–61.8% of the first wave’s length). As you see, the last bar has only a little exceeded the level of 0.618. Let’s look at the indicators.
There is a down…