The Elliott wave principle is considered to be one of the best forecasting tools in technical analysis since the post-Great Depression area, however, it is practiced and understood only by a small fraction of the trading community. In the words of Frost & Prechter, the EWP "is not primary a forecasting tool; it is a detailed description of how markets work."
Ralph N. Elliott discovered that crowd psychology tended to shift between optimism to pessimism in natural sequences and formed common patterns, unique, however present at every market degree or time scale.
This is not going to be an in-depth review of the EWP, instead we will focus only on the main chart patterns that markets establish quite frequently and present a few guidelines for each of the patterns.
The following 5 chart patterns will paint a clear picture on where the specific market/asset is trading, either in a trend-mode or in a consolidation mode.
In this part #1, we will focus only on the first core EW pattern. As you probably know by now, markets tend to develop their swings in two modes:
trends,
corrections.
What are trends and how to identify a market that is in a trend mode?
In Elliott parlance, a trend is called a motive wave, which is categorized as follows:
Motive waves are 5-wave structures going in the direction of the trend and are distinguished by the speed of price changes. Markets are highly volatile and in price discovery during their motive phase. The most common pattern that determines a trend is the impulsive wave:
Rules & guidelines of the Impulsive Wave
Waves (1), (3) & (5) have 5 sub-waves each;
Waves (2) & (4) have 3 sub-waves each labelled as A-B-C;
Wave (2) cannot retrace all of wave (1);
Wave (3) is never the shortest;
Wave (4) cannot overlap with wave (1);
Wave (3) is usually the longest & the steepest, except in commodities (Gold), where wave (5) tends to be extended and elongated.
Wave (5) tends to equal wave (1) if wave (3) has been elongated & stretched quite far;
Wave (2) is usually a deep correction where traders think the previous decline is about to resume again;
Wave (4) is usually a shallow side-ways correction proceeding wave (3) explosive move.
Every time a 5-wave move has been completed, the market will enter a corrective phase which may be a dramatic (sharp) reversal depending on the degree of the previous trend termination.
Sharp reversals are usually spotted at the termination of wave 1 and 5 while wave 3 top is proceeded by a shallower and side-ways correction.
An Example of the Impulsive Wave in the NFLX stock chart
In this example, we can see that:
wave (3) is the the longest and has been extended;
wave (4) never went into the price territory of wave (1) and it was a shallow pullback;
wave (2) never retraced 100% of wave (1);
wave (5) is at equal length with wave (1) due to the extension that happened in wave (3);
waves (1), (3), (5) are developing in the direction of the trend;
waves (2) and (4) are counter-trend moves.
What are some key Fibonacci-Elliott wave relationships?
Wave (2) usually retraces 50%-78.8% of wave (1);
Wave (4) usually retraces 23.6%-38.4% of wave (3);
Wave (3) usually extends 161.8% and in larger trends 261.8%, 361.8% and 423.6% of wave (1).
Wave (5) usually equals wave (1) if wave (3) is extended more than 161.8%.
How can I trade in an impulsive wave?
Tracking wave development in real-time is one of the most challenging things a trader/investor/analyst can do, that is why other tools are needed to give light to the best wave count. The best tools that are used extensively with Elliott Wave are the Fibonacci retracement & extension levels.
During the real-time development of an impulsive pattern, we can trade the following parts of the trend:
Wave (3) start once wave (1)-(2) is in proper place;
Wave (5) once wave (4) has hit target area.
After a previous decline, market tends to stabilize and consolidate. If that consolidation rebounds and forms a 5-wave pattern then we have the 1st sign of a bottom. The 2nd clue we look for to confirm a bottom is a pullback in a 3-wave fashion. A cycle of 5-3 is the basic premise of a completed cycle. A 5-3 pattern signals the start of a bigger move in the direction of the previous 5. Let's us take an example in USDJPY 15minute timeframe:
The above is one of the most common formations to trade and position yourself ahead of a bigger move towards higher price. A risk-reward pattern of at least 1-3, where stop loss is the low of wave (c) and target is at least 3x your stop loss. Let us see what happened to USDJPY in the next few hours:
Apparently, the initial 5 sub-wave structure we identified ended up being wave i of a larger degree trend. Positioning in a 5-3 structure, both for a bull trend and bear trend, tends to give us larger rewards for a very small amount of risk. After having identified a 5-3 structure or a i-ii setup, we take profits at 100% extension and 161.8% extension levels respectively.
To conclude on the first core Elliott wave pattern, the impulsive structure, keep in mind that any 5-wave moves against the prior direction might signal the start of a stronger reversal and new trend. Practice the Fib-wave relationship and make sure to position ahead for the start of wave (3).
In the next part, we will discuss about the second EW core pattern - the Diagonals.
You might want to read up on the following concepts as well:
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