Hello Forex Traders,
Last week we introduced the article Elliott Wave Explain Easy. It was my way of showing how Elliott Wave (EW) analysis is nothing more and nothing less than connecting the various impulses and correction with each other to gain an understanding what the next wave / leg / move / swing high, swing low could be. Wave analysis allows for a grand understanding of market structure and the patterns which price can make. The core principle of price movement is the fact that price moves from level to level in sequels of impulses and corrections and in this article I focus on why wave analysis can increase the ability to understand the latter.
You can find the link to read the first part here.
BASIC RULES & GUIDELINES EW
The intent of this article is not to sum up and repeat all of the EW guidelines. It shouldn’t be a problem to find those by yourself via searching online or buying a book. However, at the very minimum I do want to add the 3 rules which accompany wave analysis and the basic explanation.
The Elliott Wave Principle explains that “collective investor / group / crowd psychology moves between optimism and pessimism in natural sequences / waves – which create patterns evidenced in the price movements of markets at every degree of trend or time scale.”
Prices alternate between an impulsive and a corrective phase on all time scales, as the illustration shows. Impulsive waves always move with the trend, whereas corrective waves move against it (valid for bull & bear markets).
From R.N. Elliott’s essay, “The Basis of the Wave Principle,” October 1940.
Rule 1) Wave 2 never retraces more than 100% of wave 1.
Rule 2) Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.
Rule 3) Wave 4 does not overlap with the price territory of wave 1, except in the rare case of a diagonal triangle.
Basically wave 3 must be impulsive and cannot be corrective. Other than that all waves (1/2/4/5/a/b/c/d/e) can be either impulsive or corrective, and it depends on the structure/pattern/sequence of the price pattern to tell which one is more likely.
If waves 1 & 5 are moving correctively – corrective impulse
If waves 1 & 5 are moving impulsively – impulsive impulse
If waves A & C are moving impulsively – impulsive correction
If waves A & C are moving correctively – corrective correction
In general, waves 1 and 5 tend often to be impulses. Wave 2, A and C can be either impulses or corrections. Wave 4 and B are more often corrective. Wave D and E only occur in triangles.
I must also emphasize though that there are many (more) guidelines which are very important to know and help determine the likelihood of impulse or correction (write a comment down below if you are interested in a separate article on this), but this is not the goal of today’s article.
S&R / INVALIDATION LEVELS WITHIN EW
With the above rules in mind we can conclude that the logical support and resistance (S&R) are places where the wave count is invalidated as well. Placing a stop loss at (below/above) those invalidation levels is an equally justified concept as the trade is only exited when the analysis has been proven invalid.
Logical places are the following:
1) Origin of wave 1 – price in wave 2 cannot break bottom wave 1
2) Top/bottom of wave 2 – price in wave 3 cannot break bottom wave 2
3) End of wave 1 – price in wave 4 should not go into wave 1
4) Top/bottom of wave 4 – could act as a S&R for continuation of wave 5
5) Origin of wave A- only in case wave A is impulsive, then wave B will not break it
6) End of wave A – wave B and C could use bottom of wave A as S&R
7) End of wave A – once bottom of wave A is broken, bigger correction or reversal will occur
The extreme (top/bottom) of wave 5 is not as decisive as the other levels mentioned above because it’s possible for an ABC correction to break the top of wave 5 – the exception being point 5.
Fibonacci (Fibs) and wave analysis are highly interconnected. Both analyses can certainly be implemented separately, but there is syn-energy when combining the 2 concepts. Here is the basic understanding:
Wave 2 is often a deep retracement (EW guideline) – most common 61.8% / 78.6% / 88.6% Fibs // sometimes 50% Fib
Wave 4 is often a deep retracement (EW guideline) – most common 38.2% Fib // sometimes 23.6% / 50% Fibs
Wave B is deep when A is corrective – most common 88.6% / 138.2% (break S&R)
Wave B is shallower when A is impulsive – most common 38.2% / 50% / 61.8% Fibs
Wave 3 Fibonacci targets – often -1.618 / -2.618 of wave 1
Wave 5 Fibonacci targets – often -0.272 / -0.618 of wave 3
Wave A Fibonacci targets – top / bottom in correction
Wave A Fibonacci targets – the -0.272 / -0.618 of wave A in impulse
In theory trend channels can be placed on the chart, which connect the bottoms and tops of the waves, to predict the end point of future waves.
1) Connecting wave 1 and 3 with each other and then placing the opposite channel trend line on wave 2 should provide the bouncing spot for 4.
2) Connecting wave 2 and 4 with each other and then placing the opposite channel trend line on wave 3 should provide the ending spot for 5.
In practice I hardly ever use the above method because price is usually not that neat in its movements. Yes there will be occasions that it is useful and predicts where the waves 4 and 5 end but in many cases the trend channel end up looking differently. So I do not use this concept actively in my own trading and rather focus on Fibonacci levels which provide more guidance for me. With that said, I do want to emphasize that I do use trend channels and trend lines often! I just don’t emphasize using trend channels in combination with wave counts.
What I find more useful is the following:
There can be 2 different types of channels:
a) The base channel – is often the start of the impulse with many waves 1 and deep wave 2 retracements which means that the channel has a shallow angle
b) The acceleration channel – when price is in an impulsive move (wave 3 must be impulsive), it will be in an impulsive channel on a lower time frame
A good tip though is to keep an eye on the base channel and see which trend line breaks. If in an up channel and the top line breaks then a wave 3 acceleration might be taking place. If in an up channel and the bottom line breaks then a break of a bear flag is more likely. The opposite holds true for the down channel.
Next week we will continue with EW part 3 – taking it one step further. Here I will discuss:
– how to use wave counts
– what tools are most important of all
– how to assess probablities of waves
Thank you and wish you a great November trading!
Part 3 is here: http://winnersedgetrading.com/forex-wave-trading-part-3/
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