Archive for the ‘Faces of Waves Illustrated’ Category

Faces of Waves Illustrated [5] - Impulse wave (2)

This is the second article on impulse wave. Today I describe…

2. When does it appear? How to anticipate the next impulse wave?
3. What is the trading strategy over impulse waves?

2. When does it appear? How to anticipate the next impulse wave?

If you recall the previous article, one of the rules of impulse wave says,

  • Wave 3 must be an impulse wave

So, it is obvious, you should look for 3rd wave of impulse to locate smaller impulse wave.

Other places you could anticipate impulse waves are:

  • 1 and 5 waves in motive waves except for ending diagonal (I will explain what the ending diagonal is in coming article)
    int removeId = j;
  • A and C waves in zigzag
  • C wave in flat

I have not explained details of waves other than impulse, and you will understand better about whereabouts of impulse wave after you will learn every wave patterns. For now, this figure may help you:

locating-impulse

The bold green lines indicates the sub-waves in each wave pattern where you can anticipate an impulse wave.

Example: Suppose you have just seen a beautiful upward impulse wave followed by a corrective wave of any type downwards, and we want to guess what is the type of the wave of one greater degree. Looking from above picture, we know it is either impulse, diagonal, or zigzag. Conveniently, in either scenario, the wave that comes next is motive and it is often impulse because:

  • In case of impulse the next wave is either Wave 3 or 5. If it is Wave 3, it will be an impulse. If it is Wave 5, it is any of motive.
  • In case of (leading) diagonal the next wave is either Wave 3 or 5, and both are to be motive and potentially impulse. (I will explain what “leading diagonal” is in the coming article.)
  • In case of zigzag, the next wave is Wave C that is to be motive and potentially impulse.

The example above is very simple scenario, and it takes the understandings of the substructures of other wave patterns (so far we only studied impulse) in order to make our prediction more accurate. We also should zoom up and down to the waves of one greater or lesser degree to grasp the whole picture and check there is not a contradiction. It’s just like we start looking at whole mountain first, then to zoom up to woods, then to a single tree, or vice versa.

Our study so far gave a vague idea when to anticipate an impulse wave, which may or may not come. But it gave much clearer idea when NOT to expect an impulse wave. The number of sub-waves in the six wave patterns (impulse=5, zigzag=3, …) in the figure is 32. The sub-waves marked with the green lines are only 9. So, if those six wave patterns are present in the chart, we know that we should not be trading at all for 62% of the time. Some novice traders buy and sell restlessly with no discipline only to lose money. But with the help of Elliott wave principle, we know when we should refrain from trading and just stay back to see where the market goes.

3. What is the trading strategy over impulse waves?

While knowing exactly where we are on the wave patterns takes further study and practice on the real charts, it is still true that you could anticipate the appearance of an impulse after you have just seen a impulse-corrective sequence. So, I think it is exciting and beneficial to introduce a trading strategy on impulse wave.

impulse-trading-idea

Phase (a) Suppose we think there are a chance for an impulse wave to appear next. The sub-wave 1 (black 1 in the above figure) of coming impulse is a motive wave followed by sub-wave 2 (black 2) that must be a corrective wave and it is often a zigzag. So we wait to see if those two sub-wave sequence will appear as we anticipate…and they did! We are even more convinced that we are at the beginning of the impulse wave. We also anticipate the next sub-wave to be Wave 3 that is also an impulse wave of the lesser degree.

Phase (b) We wait again to observe sub-sub-wave i and ii. The next one is sub-sub-wave iii, and once sub-sub-wave iii  takes off, it should not come back down lower than the end of ii. We buy as sub-sub-wave iii overcomes the peak of sub-sub-wave i (the first green star in the figure).

Phase (c) and (d) Now we have two scenarios:

  • Success scenario. We can exit the market at the end of sub-sub-wave iii, or we can go all the way to the end of sub-wave 5 (blue circles in the figure).
  • Failure scenario. What we thought to be sub-sub-wave iii goes below the end of sub-sub-wave ii before extending the gain. This means this was not an impulse wave, and we pay for what we judged wrong.

Yes, we may fail. We always have a chance to fail and take a loss.

The most important thing in this strategy is that we know the exact cost of the failing scenario by the time we establish the position: The loss is about the difference of the entry price level and the price at the end of sub-sub-wave ii (shown as potential loss in the figure). It is crucial in trade, especially when you use leverage, that we are disciplined enough to exit the market as soon as the price action breaks the rules of Elliott wave.

It would be also helpful if we can estimate the potential profit (reward) besides the potential loss (risk). A clear risk:reward ratio would help us to decide how much of the capital we expose to the risk. One way to estimate the potential profit is to use golden ratio or traders often call Fibonacci, and it is the topic that I am going to write in the next article.

Faces of Waves Illustrated [4] - Impulse wave (1)

If you are new, check the introduction and table of contents first.

The first wave pattern I describe in details is impulse wave. Fortunately, this is the most important wave pattern we learn. It also have the most distinct shape, so we can easily identify.

I will describe impulse wave focusing on the following points:

  1. Anatomy: How does it look like? What is the subwave structures.
  2. When does it appear? How to anticipate the next impulse wave?
  3. What is the trading strategy over impulse waves?
  4. Using Fibonacci (golden ratio) to estimate the potential profit.
  5. Variation in the impulse structure: extension & truncation.

Probably, it would take three articles to finish presenting all the materials above.

1. Anatomy: How does it look like? What is the subwave structures.

The image below shows how impulse waves look like:

impulse-wave

Impulse wave is in the motive wave group. So an impulse wave must follow the rules of motive wave that I already described in the previous article. I list them again for your reference:

  1. Wave 2’s end point must not go beyond Wave 1’s start point
  2. Wave 3’s end point must go beyond the Wave 1’s end point
  3. Wave 4’s end point must not go beyond Wave 2’s end point

There are additional rules a wave must follow to be qualified as an impulse wave. They are:

  1. Wave 3 must be an impulse wave
  2. Wave 3 must not be the shortest among 1, 3 and 5 waves.
  3. Wave 4′s end point must not cross Wave 1′s end point. In other words, Waves 1 and 4 never overlaps in the price range.

That is it. These three additional rules make impulse wave look clearly pointing up or down, and it is easy for us to recognize the wave. As long as a impulse wave meets those rules, it can have variations in the shape as I illustrated on the right side of the image above. (I will describe the variations of impulse wave in coming articles.)

Now let’s look deeper into the substructure of the impulse wave. The next image shows the subwave sequence within an impulse wave:

impulse-substructure

As you can see,

  • Wave 1 must be a motive wave, and it can be diagonal or impulse. Appearance of a diagonal wave is rather rare here.
  • Wave 2 must be a corrective wave. A zigzag wave frequently appears in Wave 2, but it could be other corrective wave.
  • Wave 3 must be an impulse wave.
  • Wave 4 must be a corrective wave. We often observe a complex wave.
  • Wave 5 must be a motive wave. Either impulse or diagonal. Often we see a diagonal wave here.

And here is an example from real market:

20090922_eurusd_15min_impulse

It is very important to remember the subwave sequence in impulse wave, for a few years to a decade boom in the market often follows this impulse wave pattern. The market psychology at each wave is often described like this:

  • Wave 1: The bull market is emerging under the surface, but most people are still skeptical of the economy and desperate.
  • Wave 2: A zigzag but deep pull back falsely convince people of the continuation of the bear market. But it is actually the phase that the market charges energy for the strong bull market.
  • Wave 3: All of a sudden, the market gains upward momentum, and it only accelerates. The emergence of the bull market is now obvious to everybody.
  • Wave 4: Profit taking. The fortunate people who entered the market early enough start to cash out (sell). But there are still plenty of buyers, and the market goes sideways as a result of the tug of war between buyers and sellers.
  • Wave 5: Sellers at Wave 4 failed to change the course of market as the late participants rush to the market. The buying momentum overcomes the selling, sending the price even higher. Almost everybody is bullish about the market, and it becomes a mania. Only a few notice that the bull market is actually ending. (and the careless people lose their fortune in the bear market that follows)

I think I covered plenty in this article, so I will leave the remaining materials in the late articles. But before concluding, let’s go back to Wave 3 rules of impulse wave:

  1. Wave 3 must be an impulse wave
  2. Wave 3 must not be the shortest among 1, 3 and 5 waves.

So when we count the waves, we have to be careful not to break those rules. In the example below, the wave count on the left is incorrect because Wave 3 is the shortest. The right one is the same wave as the left, but with the correct wave count. Notice the use of subwave counts that makes Wave 3 itself an impulse. This agrees well with the rule No.2.

wave3-must-be-longest

Faces of Waves Illustrated [3] - Motive wave

(Previous article is here)

So far, we memorized the basic six patterns of the waves. We also learned the basic labeling rules. We observed that wave has fractal structures, and we learned how to count sub-waves in a wave. I also hinted that there are rules and guidelines in which wave patterns comes after which. From this article, we focus on the detailed observation of each wave pattern, and I will present practical trading ideas.

Anatomy of motive wave

First, let’s take a look at motive waves. A motive wave has a clear direction. For an upward (bullish) wave, it always starts from lower and end higher as in this picture.

motive

As I mentioned before, motive waves has 5 waves. For upward waves, Waves 1, 3, and 5 are upwards, and Waves 2 and 4 are downwards. For downward waves, 1, 3, and 5 are downwards, and 2 and 4 are upwards. (I will not explicitly explain downward counter parts from now. Just flip the picture 180 degree in your mind.) Not all 5 waves sequence are qualified as motive waves, and it has to follow these rules to be qualified as motive:

  • Wave 2′s end point must not go beyond Wave 1′s start point
  • Wave 3′s end point must go beyond the Wave 1′s end point
  • Wave 4′s end point must not go beyond Wave 2′s end point

In other words, there are always gap between start point of the motive wave and Label 2, between Labels 1 and 3, and between Labels 2 and 4. And the Labels 2, 3, and 4 must be higher than its counter part. (see the chart indicated as “critical gap”.

Trading ideas in motive wave:

Because of the directionality of motive waves, it is easier to determine whether you want to buy or sell, and the trading success rate will simply go up if you trade on this wave. In fact, I never trade in corrective wave unless I find a motive wave within the corrective wave (Remember the fractal structures?). My trading plan is always focused around the motive wave. It’s a very important point to become a profitable trader using Elliott wave principle!

To present a concrete trading idea, I need to go into the details of two motive wave patterns: impulse and diagonal, so the readers have to be patient for now. But here is one thing worth remembering:

Now imagine you draw two straight lines for a motive wave. The first line passes Labels 1 and 3. The second line passes Labels 2 and 4. Those are called trend lines, and once defined they act as resistance and support. It requires more buyers for the price to go above the resistance line, and it requires more sellers for the price to go below the support line. So, the buying or selling energy are often not higher enough, and we see the price is bouncing against the narrow corridors defined by those two trend lines. So here come the ideas:

  • If you want to buy at dips, look for support line.
  • If you want to sell at rally, look for the resistance line.
  • If you want to set a loss cut line on your existing long position, look for a clear break of the support
  • If you want to set a loss cut line on your existing short position, look for a clear break of the resistance

Just one note for downward trend. No matter whether you are looking at upward or downward motive wave, a resistance line is always the trend line above the price level, and opposite for a support line.

In the next article, we will look at the first kind of motive wave: impulse wave.

Real time trading tweets

The plan in the article may get rejected any time, so please check out my tweets on Twitter.

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