Elliott Wave theory is widely used by large institutions and speculative traders as a reliable indicator of current trading sentiment and future price movement. Elliott Wave theory determines that market action (in a free market) is predictable and recurring, as group psychology can be seen to occur in waves.
The theory identifies two forms of wave patterns, impulse waves and corrective waves. Impulse waves are formed using a five-wave pattern and determine the current longer-term trend, corrective waves follow a complete impulse wave and retrace a portion of the impulse wave.
Being able to interpret price action and identify where it sits within a longer-term wave pattern is fundamental to being able to predict price movement using Elliott Wave.
This article discusses how to count impulse waves to gain an understanding of longer terms price action.
In This Article:
- What Does An Impulse Wave Look Like
- Rules To Counting Impulse Waves
- Market Sentiment During An Impulse Wave
- Summary
What Does An Impulse Wave Look Like
A traditional Elliott Way Impulse Wave is made up of a five-wave structure as shown below.
The first thing that a trader using Elliott Wave Theory as the basis for their trading strategy should understand is that an impulse wave can occur in either an uptrend or a downtrend. It is a common mistake that the term impulse means "bullish". Impulse waves are simply movements in the direction of a larger trend and can occur within either a bull or bear market.
For the purposes of clarity, we will assume that the impulse wave is bullish and trading in an upward direction. We see therefor that the structure of the five-wave pattern consists of three impulse waves in an upward direction (1, 3 & 5) and two corrective waves moving downwards (2 & 4).
The wave structure is fractal in nature, this means that impulse wave 1, will also be made up of the same structure, as will the corrective waves. This fractal nature means that wave counting can be verified by zooming into smaller time frame charts to assist with identifying the full duration of a wave on a longer-term technical chart.
It is essential that correct wave counting is mastered, only then can Elliott Wave theory be reliable upon for predicting future price action. Let's have a look at an extract from an actual trading chart showing the count for a bullish impulse wave:
Looking at the above chart we can see that a 5-stage impulse wave has been completed and that there is a corrective 3-stage wave due to follow. Now that a trader has identified the end of the impulse wave, it is possible to track the correction and find the entry point for the next impulse wave. The is the very basis of Elliot Wave Theory, patterns are destined to repeat themselves, allowing the trader to reliably predict market behaviour and enter early positions, capitalising on potentially profitable opportunities.
Rules To Counting Impulse Waves
When counting impulse waves, there are two rules that cannot be broken. If the rules cannot be met, an impulse wave is not in play, or the count needs correcting to suit the rules:
1) Wave 3 in any impulse wave can NEVER be the shortest wave and will generally be the longest.
2) Waves 1 & 4 should never overlap i.e., in a bullish impulse move, the bottom of the correction wave 4 cannot fall to a lower price than the peak of wave 1.
Sentiment During Impulse Waves
Elliott Wave Theory is all about understanding group behaviour and how market prices are consequently affected. It is important when counting impulse waves to understand the market sentiment that is creating the wave, as being able to correlate price action to sentiment, allows a trader to develop an instinct and feel for the market. Let's explore the group psychology behind that is the basis for each wave formation.
Wave 1
The beginning of wave 1 is very rarely correctly identified as the start of a new trend. At this point, traders will remain positive that the previous bear trend is still in place and that what is being seen is a simple market correction. Traders who have been following Elliott Wave closely on a particular currency pair may start accumulating long positions knowing that the fifth leg of a bear market has just completed.
The first leg of an impulse wave should ideally see slow upward price movement, indicating that traders are slowly beginning to exit their short positions and acknowledge the trend reversal.
Wave 2
The second leg is a corrective move of the initial price increase and traders still holding onto their short positions reassure themselves that they were right to hold on. However, they are destined to be disappointed as price will not return to the previous lows seen in the prior leg and will generally only retrace around 38% to 62% before rising in the direction of the newly formed trend.
Wave 3
Identifying the retracement limit of wave 2 will provide an entry point to take a long position early in wave 3. Getting in early on wave 3 is the big-ticket ride. During this period prices rise rapidly, and volume of trading is extremely high. Wave 3 is where much of the public concede that the previous bear trend is well and truly over and exit their short positions and instead buy long. Wave 3 generally extends around 1.618 times the size of wave 1.
Wave 4
This is a period of consolidation. Traders are exiting and taking their gains from wave 3 while others are buying into the new trend taking long positions. Generally trading volume is low and price action remains pretty stagnant. Wave 4 can take some time to complete, and they can be difficult to count.
Wave 5
This is the fifth and final move of the five-leg impulse wave. Volume is generally lower than in wave 3. During this period everybody is feeling bullish and feeling confident the good times will continue for some time yet. However, the experienced Elliott Wave Trader will be preparing to exit their position and begin trading the imminent corrective wave.
Summary
Counting impulse waves successfully is the foundation of an Elliott Wave trading strategy. This can be difficult for new traders but following two key rules will help identify when an impulse wave is in play, and where price action currently stands within it. Using technical tools to assist in calculating retracement and expansion levels leads to being able to predict future price movements.
