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

US dollar strength: Mid and long terms outlook

Once in a while, it’s a good idea to step back and look at the chart in a greater scale. Now that we made a killing in selling EURUSD, it’s good time to stop trading, and check where we are.

The first chart we are looking is performance of 8 cross-usd currency from November 26, 2009. In other words how much each currency appreciated (depreciated) against US dollar.  Click on the chart for an enlarged image.

The reason why I took November 26, 2009 as the origin in this chart is that it is the bottom of US dollar index so far.

20100124_cross_usd_2month

As of January 20th, performance from the top is CADUSD, AUDUSD, GBPUSD, JPYUSD, NOKUSD, CHFUSD, SEKUSD, EURUSD, but they are all depreciating against US dollar in past 2 months. And as you could have well expected, Euro is sold badly, nearing 7% decline in 2 months.

My trading plan is focused around the US dollar strength this year, and especially I will focus on Euro weakness against US dollar.

Among the 8 cross-USD currencies in the first chart, all of them except AUD and NOK are used to calculate US Dollar Index. It is a weighted geometric mean of the six currencies, and in fact EURUSD is weighted 57.6 percent.

So it is very natural, US Dollar Index and EURUSD charts look almost symmetric:

20100124-dx-vs-eur-daily

It is good to have these images in mind when we construct trading plans even for the short term trading.

From the next chart, I will focus on EURUSD. First I show you the very long term: monthly chart.

20100124-eurusd-monthly

In this time span, it is very difficult to count Elliott waves because we have very few waves in the past that we can use as the reference. So, I am not sure at all whether my purple .1 and .2 or even black labels are correct. But I can be more confident about the blue underlined labels. So, if you look around the black 1, you will see blue underlined 1 to 5 is complete. It is likely, from this count, we are in some kind of corrective wave. And because the blue underlined a was so severe downtrend (2008 financial crisis), I would expect the current wave to be blue underlined c in a a-b-c- zigzag wave. In zigzag wave, the initial descent (blue underlined a) can be used as a reference to estimate how far c wave would go (blue arrow in the chart). The end of the arrow is pointing around 1.1380.

EURUSD went down badly since November 26 of last year, but it looks like we have just started out journey.

Lastly, let’s look at daily chart. (I changed the label notation slightly to be sync with my Elliott wave count of US dollar index)

20100124-eurusd-daily

While I won’t be surprised to see another push down towards 1.4000, I think the initial 5 waves descent of the EURUSD has ended. I often see 61.8% or even 78.6% retracement after any Wave 1, so EURUSD may rebound towards 1.4720 in February.

So my plan is not to trade until EURUSD will break the gray trend line resistance, and count the wave in shorter time span, and probably we have time to long EURUSD once or twice to make some money before the purple II finishes.

$EURUSD Expect rebound to 1.4376 but hold on to the position.

Update: I completely closed this position at 1.4200.

It’s always good when the first news in the morning is the realized profit of 240 pips in a single trade.
The limit order to take the profit from my first half of the position entered at 1.4545 was filed at 1.4305. It gave me 3.6% return.

Now I am left with the other half of the position, entered at 1.4489. (The new US regulation requires first-in first-out transaction.)

If my count is correct, we have just finished the black 3 wave at 1.4250. I would expect a rebound towards 1.4376. A 130pips rebound might give shorter term traders a good reason to get out. There is nothing wrong with that, but it’s just not my case in this market condition.

For now, I will keep my 1.4430 stop loss. If anticipated black 4 shows enough 4th wave characteristic (i.e. complex wave within a range), I may consider selling more before the final descent towards 1.4171 level.

Also notice how well Fibonacci support levels worked, and they agree well with the support levels from trend lines and previous lows & highs.

20100119-eurusd-60min

Real time trading tweets

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

Current risk exposure:

"","","","","$29,058.30","","","","","","","","","","","","","","","","","","","","41.95%","","","2.00%","","","","","","","","","","","","","","","","","","","","","","","","","","","",""
Rational Move always use stop loss orders, and this is the worse case potential loss over the capital for the currently open positions. This is unrealized loss is less or equal to the risk exposure.

Capital growth

From recent 100 trades (%) The growth right before the 1st trade is set to 0%.
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Drawdowns

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Total returns

Since inception
(Aug 10, 2009)
Year-to-date Quarter-to-date
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This is a normalized value: the return on each trade is normalized against the capital just before the trade execution. This way, it is eliminating the effect by the capital change from deposits and withdrawals. The calculation thus reflects the trading performance of each trade. The value does not contain unrealized profits and losses. RM's trading strategy never risks more than 5% of the present capital. Not including subtraction by tax.

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