Hello Forex Traders,
The ECB rate cut on Thursday sent the Euro spiraling down and the markets reacted with lots of volatility. On Friday – again – a big news event is on its way: NFP and unemployment rate for the US. The numbers could be an important indication whether a hint of tapering might be in sight on the horizon.
Last 2 weeks we introduced the article Elliott Wave (EW) Explained Easy. Wave analysis looks at whether legs/swing high and swing lows are impulse or corrections and connects those to each other. By doing this, a Forex trader can assess whether there is a higher probability of the next move being up or down and impulse or correction. This is not an easy task, as understanding impulse/momentum versus correction itself has it challenges. First we will explain what wave analysis is before explaining why it is crucial to use other tools such as trend lines.
WHAT IS WAVE ANALYSIS?
Wave analysis is both a tool for making trading decisions and a method of understanding price movements. Or in other words it has a practical and theoretical side to it.
From a theoretical point of view, the wave analysis provides guidance why and how price could move and react as it does and explains market/crowd/group psychology.
From a practical point of view, in certain cases wave analysis provides a guidance of price expectations and potential support and resistance. In other cases the wave count is unclear and then the value of the analysis becomes less relevant.
If a Forex trader wants to use wave analysis for practical reasons and actual trading decisions, then they should always use other tools when applying wave analysis to a.) judge whether their wave count is correct and b.) use for entry and exit purposes. Never ever use wave analysis as a standalone tool for decisions.
TOOLS TRADERS USE WITH EW
1) Fibonacci – explained in last week’s article.
2) Trend channels – explained in last week’s article.
3) Trend lines – trend lines allow a Forex trader to understand whether the currency is in a trend, when it could be breaking out of a trend, and whether the currency is back into the direction of the trend. Primarily the later has it great benefits.
Waiting for trend lines to break or bounce is a method of the Forex trader to be objective in their analysis. By using trend lines, the Forex trader is using the chart as a map and not as a crystal ball. Therefore trend lines are a very useful method of understanding market structure.
4) Moving averages – use moving averages, for example a 50 ema and/or 200 ema, to see the angle of price and whether price is above it or not to judge the count. The basic premise is that currency’s price extends away from its moving average during an impulse and then returns back to that average during a correction. Currencies eventually return to their average but the impulse can last long.
Once the impulse has been completed, the currency will either:
- a. make a reversal;
- b. make a correction.
i. “Passive correction” – it can do so passively as price goes sideways and the moving averages catch up with price.
ii. “Active correction” – it can do so actively as prices moves towards to the moving averages.
5) Angles – when price is in an impulse price then it should be proceeding at a steep angle (60 degrees). If price is in a correction price then it should be proceeding at a shallow angle (20 degrees). The subsequent channel connecting impulse and correction then makes an average (+/- 40 degrees).
6) Time factor – in wave 3 price should move many pips in a short time frame – hence the steep angle of price action. In corrective waves price should move less in more time – hence the shallow angle or price action. If price does not break a candle high or low within a certain number of candles (read this article on time factor), then we can conclude that the impulsive is over the move and a reversal or correction.
As mentioned above, not all scenarios and situations are equally clear. The clarity can also vary from time frame to time frame, and obviously from pair to pair.
Most Forex traders who use wave analysis tend to focus on the following situations:
1) There are 5 waves made on a smaller time frame – this could be either a 1 or A
- This means that after an ABC correction it is a good moment to enter in the direction of the previous move for a wave 3 or C at a Fib such as 50% or 61.8% with stop loss below the origin of wave 1/A.
2) If price extends very far and to a deep Fibonacci target – likelihood of a wave 3 is high
- This means that after a bull or bear flag, wait for a break out for a wave 5 trade
3) An impulse of wave 1 or 3, sometimes even wave 5 (riskier) – zoom into a lower time frame and attempt to trade the break out and pullbacks of the smaller waves within bigger wave
- This method allows for scaling in and out of smaller waves within the bigger wave
4) Multiple divergence on higher time frames (4 hr/day) – reversal potential
- Look for a clear wave A impulse that has a good thrust, then wait for corrective wave B to correct wave A
- Trade a deeper Fib and/or wait for break out of trend line when wave C starts
Wave counts provide benefit for understanding the market and are in some cases useful as a supportive reason for trading decisions. However, always use other tools, indicators, and patterns to make actual trading decisions and use confluence of various tools to enhance probabilities. This way a Forex trader allows the market to decide its own path and price movement.
A Forex trader never wants to “beat the market” by “out thinking” it. Forex traders are map readers and they want to find the quickest and safest route from A to B. Their map is the chart with their chosen tool or 2 plus occasional chart pattern (avoid overcrowding of the chart which causes paralysis of analysis). For Forex traders this means finding best entries and exits and keeping the charts simple and objective to read. The market speaks, traders just need to listen to it – not decide for it.
Thank you for reading this article and sharing it. Wish you a great weekend!
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