Impulse Waves
Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern.
The first 5-wave pattern is called impulse waves.
The last 3-wave pattern is called corrective waves.
In this pattern, Waves 1, 3, 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.
Do not confuse Waves 2 and 4 with the ABC corrective pattern (discussed in the next section) though!
Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
The first 5-wave pattern is called impulse waves.
The last 3-wave pattern is called corrective waves.
In this pattern, Waves 1, 3, 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.
Do not confuse Waves 2 and 4 with the ABC corrective pattern (discussed in the next section) though!
Let’s first take a look at the 5-wave impulse pattern. It’s easier if you see it as a picture:
That still looks kind of confusing. Let’s splash some color on this bad boy.
Ah magnifico! It’s so pretty! We like colors, so we’ve color-coded each wave along with its wave count.
Here is a short description of what happens during each wave.
We’re going to use stocks for our example since stocks are what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.
Here is a short description of what happens during each wave.
We’re going to use stocks for our example since stocks are what Mr. Elliott used but it really doesn’t matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.
Wave 1
The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons, real or imagined) feel that the price of the stock is cheap so it’s a perfect time to buy. This causes the price to rise.
Wave 2
At this point, enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.
Wave 3
This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock’s price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.
Wave 4
Traders take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to “buy on the dips.”
Wave 5
This is the point that most people get on the stock and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. Traders and investors start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.
Extended Impulse Waves
One thing that you also need to know about the Elliott Wave Theory is that one of the three impulse waves (1, 3, or 5) will always be “extended”. Simply put, there will always be one wave that is longer than the other two, regardless of degree.
According to Elliott, it is usually the fifth wave which is extended. As time went by, this old school style of wave labeling has changed because more and more people started labeling the third wave as the extended one.
According to Elliott, it is usually the fifth wave which is extended. As time went by, this old school style of wave labeling has changed because more and more people started labeling the third wave as the extended one.
Corrective Waves
The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are used instead of numbers to track the correction. Check out this example of a smokin’ hot corrective 3-wave pattern!
Just because we’ve been using a bull market as my primary example doesn’t mean the Elliott Wave Theory doesn’t work on bear markets. The same 5-3 wave pattern can look like this:
Types of Corrective Wave Patterns
According to Elliott, there are 21 corrective ABC patterns ranging from simple to complex.
“Uh 21? I can’t memorize all of that! The basics of the Elliott Wave Theory are already mind-blowing!”
Take it easy, young padawan. The great thing about Elliott Wave is you don’t have to be above the legal drinking age to trade it! You don’t have to get a fake ID or memorize all 21 types of corrective ABC patterns because they are just made up of three very simple easy-to-understand formations.
Let’s take a look at these three formations. The examples below apply to uptrends, but you can just invert them if you’re dealing with a downtrend.
“Uh 21? I can’t memorize all of that! The basics of the Elliott Wave Theory are already mind-blowing!”
Take it easy, young padawan. The great thing about Elliott Wave is you don’t have to be above the legal drinking age to trade it! You don’t have to get a fake ID or memorize all 21 types of corrective ABC patterns because they are just made up of three very simple easy-to-understand formations.
Let’s take a look at these three formations. The examples below apply to uptrends, but you can just invert them if you’re dealing with a downtrend.
The Zig-Zag Formation
Zig-zag formations are very steep moves in price that goes against the predominant trend. Wave B is typically shortest in length compared to Waves A and C. These zig-zag patterns can happen twice or even thrice in a correction (2 to 3 zig-zag patterns linked together). Like with all waves, each of the waves in zig-zag patterns could be broken up into 5-wave patterns.
The Flat Formation
Flat formations are simple sideways corrective waves. In flats, the lengths of the waves are GENERALLY equal in length, with wave B reversing wave A’s move and wave C undoing wave B’s move. We say generally because wave B can sometimes go beyond the beginning of wave A.
The Triangle Formation
Triangle formations are corrective patterns that are bound by either converging or diverging trend lines. Triangles are made up of 5-waves that move against the trend in a sideways fashion. These triangles can be symmetrical, descending, ascending, or expanding.
Elliott Waves Within an Elliott Wave
Like we mentioned earlier, Elliott waves are fractals. Each wave is made of sub-waves.
Do you see how Waves 1, 3, and 5 are made up of a smaller 5-wave impulse pattern while Waves 2 and 4 are made up of smaller 3-wave corrective pattern?
Always remember that each wave is comprised of smaller wave patterns. This pattern repeats itself…
FOREVER!
To make it easy to label these waves, the Elliott Wave Theory has assigned a series of categories to the waves in order of the largest to the smallest. They are:
Okay, to make things much clearer, let’s see how an Elliott Wave looks in real life.
Always remember that each wave is comprised of smaller wave patterns. This pattern repeats itself…
FOREVER!
To make it easy to label these waves, the Elliott Wave Theory has assigned a series of categories to the waves in order of the largest to the smallest. They are:
- Grand Supercycle (multi-century)
- Supercycle (about 40–70 years)
- Cycle (one year to several years)
- Primary (a few months to a couple of years)
- Intermediate (weeks to months)
- Minor (weeks)
- Minute (days)
- Minuette (hours)
- Sub-Minuette (minutes)
Okay, to make things much clearer, let’s see how an Elliott Wave looks in real life.
As you can see, waves aren’t shaped perfectly in real life. You’ll also learn it’s sometimes difficult to label waves. But the more you stare at charts the better you’ll get.
Besides, we’re not going to let you go at it alone! In the following sections, we’ll give you some tips on how to correctly and easily identify waves as well as teach you how to trade using Elliott Waves. Surf’s up
Besides, we’re not going to let you go at it alone! In the following sections, we’ll give you some tips on how to correctly and easily identify waves as well as teach you how to trade using Elliott Waves. Surf’s up
3 Cardinal Rules of the Elliott Wave Theory
3 Cardinal Rules of the Elliott Wave Theory
- Rule Number 1: Wave 3 can NEVER be the shortest impulse wave
- Rule Number 2: Wave 2 can NEVER go beyond the start of Wave 1
- Rule Number 3: Wave 4 can NEVER cross in the same price area as Wave 1
- Conversely, sometimes, Wave 5 does not move beyond the end of wave 3. This is called truncation.
- Wave 5, more often than not, goes beyond or “breaks through” the trend line drawn off Wave 3 parallel to a trend line connecting the start of Waves 3 and 5.
- Wave 3 tends to be very long, sharp, and extended.
- Waves 2 and 4 frequently bounce off Fibonacci retracement levels.
How to Trade Forex Using Elliott Waves
Hypothetical, will-most-probably-be-right scenario:Let’s say you wanted to begin your wave count. You see that price seems to have bottomed out and has began a new move upwards. Using your knowledge of Elliott Wave, you label this move up as Wave 1 and the retracement as Wave 2.
In order to find a good entry point, you head back to the School of Pipsology to find out which of the three cardinal rules and guidelines you could apply. Here’s what you found out:
- Rule Number 2: Wave 2 can NEVER go beyond the start of Wave 1
- Waves 2 and 4 frequently bounce off Fibonacci retracement levels
Since you’re a smart forex trader, you also take your stop into consideration.
Cardinal rule number 2 states that Wave 2 can never go beyond the start of Wave 1 so you set your stop below the former lows.
If price retraces more than 100% of Wave 1, then your wave count is wrong.
Let’s see what happens next…
Cardinal rule number 2 states that Wave 2 can never go beyond the start of Wave 1 so you set your stop below the former lows.
If price retraces more than 100% of Wave 1, then your wave count is wrong.
Let’s see what happens next…
Your Elliott Wave analysis paid off and you caught a huge upward move! You go to Vegas (or Macau), blow all your forex profits on roulette, and end right back where you started. Lucky for you we have another hypothetical scenario where you can earn imaginary money again…