Welcome to the second part of our Elliott Wave series. In this part, we’ll be talking practically on how to pick out waves and ride to the Wave City of Financial Freedom (WCFF).
In the previous blog, we covered the basics of the Elliott Wave principle, which included the types of waves and the rules for marking waves. For convenience, let’s see the rules again.
For impulse waves:
- Wave 2 never retraces more than a 100% of wave 1
- Wave 4 never retraces more than a 100% of wave 3 and never overlaps wave 1
- Wave 3 always travels beyond the end of wave 1
- Wave 3 cannot be the shortest of the three impulse waves
- Wave 2 and wave 4 must display alternation in as many ways as possible
Any wave that does not obey the above rules is classed as a corrective wave.
Where should I look out for the start of an Elliott Wave?
The most logical place to look out for wave beginnings is at a swing high or low. The low of a buying wave would usually be the beginning of that wave. So an impulse wave begins with a first wave, after which a correction takes place.
Then we have another leg up, followed by a correction, then a final wave up. After this we then have a correction for the entire five wave sequence, which would be larger than the previous two corrections in the preceding wave. Let’s give a clear picture.
A 4hr chart on EURNZD showing a first wave followed by a correction. Source: Tradingview.com
A 4hr chart on EURJPY showing a five wave sequence followed by a correction. Source : Tradingview.com
From the above you can get an important clue: after a five wave sequence, expect a correction larger than the previous two seen in the five wave sequence. In both pictures depicted above, the wave after a beginning five wave sequence usually retraces at least 50% of the entire distance moved by the first wave.
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What do I need to know about Fibonacci ratios - and how should I use them?
Put simply, Fibonacci ratios are obtained from the Fibonacci sequence of numbers developed by an Italian mathematician after whom the sequence is named. These ratios play a key role in determining the extent of each wave, be it impulse or correction.
There are two Fibonacci tools available usually used on charting platforms: Fibonacci retracements and Fibonacci extensions. The retracements are used in estimating the likely extent of corrective waves, while the extensions are used in estimating how far an impulse leg is likely to move.
The common Fibonacci retracement ratios observed are 0.236, 0.382, 0.5, 0.68, 0.79 and 1.
Wave 2 is most likely to terminate at the 0.5 or 0.68 retracement of wave 1. This is not a law however, but a regular occurrence to keep a trader alert and have them watch out for it.
For the extensions, we often find these on charts: 1.38, 1.5, 1.68, 2, 2.23, 2.38. In practice, a common target for wave 3 is usually the 1.68 extension of wave 1, with the end of wave 2 as it’s beginning.
Going beyond this extension is possible and in that case we have an extended wave 3. Extended waves are also a common occurrence in Elliott Wave counts and usually occurs in the third impulse wave.
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Where should I start an Elliott Wave count?
The easiest point from which to kick off a wave count would be at a swing low or at the end of a correction. As a clue, corrections usually end in diagonals. At this point, divergences can be found on momentum indicators.
A 4hr chart showing a correction ending in a five wave contracting triangle. Source: Tradingview.com
How can I use timeframes to look for waves?
Another clue is to look for the end of a wave that occurs in three legs, as this would be a corrective wave, then anticipate the beginning of an impulse wave. Also note that the timeframe matters. So, while looking for a five-wave sequence on a five minute chart, it would be most beneficial to study the hourly chart to know which wave the market is currently in and what to expect.
A common saying in the market is THE TREND IS YOUR FRIEND. It would be much easier for you to go with the flow of the river than to swim against the current. Sounds like a no-brainer, right? However, an examination of many trades taken by retail traders would reveal a violation of this seemingly obvious rule. The trend is like the free Town Bus calling on people to jump in. But some would rather ignore the bus and walk. Don’t be that person.
So, the trend has been identified to be going upward, you see a three-wave correction coming to an end, forming a swing low, and you notice a divergence on the momentum indicators. The more reasons you have to jump on a trade, the better. Now you wait to see a five wave move up that breaks the last swing low from the just ended correction on the time frame you are considering.
After this, you expect a correction to at least the 0.5 or 50% mark of wave 1. Another common target for wave 2 is the 0.68 retracement. However, pay more attention to the wave form than to the Fibonacci ratio. This is an important point to take note of. Price could also retrace 100% of wave 1, but not more than that as this would be a violation of a cardinal rule in the Elliott Wave principle.
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Spotting a wave: a step by step guide
A 5 minute chart of the AUDUSD Source: Tradingview.com
In the above chart, we first check to see that the trend is bullish on the AUDUSD pair. Then we look for a swing low. After a correction, the market moves up in five waves, breaking the previous swing high by barely a pip, then begins to make a correction. A correction is basically made up of three waves, and we see the three waves terminating at the 0.618 ratio of wave 1.
Now we can get in, and place a stop loss at 0.7262 which is 2 pips below the low of wave 1, because wave 2 should not go beyond a 100% retracement of wave 1.
Wave 3 picks off, and we see another five waves up, with each wave respecting all the rules of an impulse wave. This should boost the confidence of the trader to stay in the trade and anticipate a fifth wave. The trader can then lock in some profits by moving their stop loss above the high of wave 1, as wave 4 should not overlap into wave 1. Closing some part of the position can be done at this point. But if the Trader’s profit target is met at any point in the wave count, then they can take all profits and be content.
Wave 4 is a running flat corrective wave and retraces about half of wave 3 and then the final wave commences. Now here’s another key guide. Wave 3 cannot be the shortest impulse wave and in many cases, if wave 3 is greater than wave 1, wave 5 would likely have the same length as wave 1.
Another likely target for wave 5 is the 50% of the distance from wave 1 to the top of wave 3. As wave 5 ends, a huge correction comes in that retraces about 90% of the first 5 wave move upwards.
So our five wave move up to the 0.7303 price mark becomes wave one of a higher degree, and so we anticipate an entry after the correction, for another impulse wave upwards on the higher degree.