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When it comes to Elliott Wave Theory, you either understand it, or you don’t, there is no in between.
In the same way, those who understand it either find value in it or they don’t.
Having been a student of the financial markets since , I can tell you I don’t subscribe to Elliott Wave principles, at least not in the full meaning of the term. It’s far too convoluted and ambiguous for my taste.
Don’t get me wrong; I’m not saying it doesn’t work. I’ve been around the markets long enough to know better than to speak in absolutes about what does or doesn’t work.
After all, achieving consistent profits as a trader isn’t about finding the best trading strategy, it’s about finding the strategy that works best for you.
But the truth is, as price action traders we use a portion of Elliott Wave every single day. You may not even know it exists, but its present in everything we do.
I’m referring to the notion of impulsive and corrective moves.
If you aren’t entirely sure what those are or how they can aid you in your trading, it’s okay. By the time you finish reading this lesson, you’ll know three simple yet effective ways to use these moves in combination with price action strategies to help stack the odds in your favor.
Lets get to it!
First things first, to fully understand the meaning of impulsive and corrective waves, you need to know that every market ebbs and flows in harmony with daily events.
Those events include everything from the interest rates that are set by central banks to natural disasters.
The ebb and flow as its often called, is the visual representation of how markets respond to and sometimes counteract those daily events.
Why does this matter?
It matters because it’s what allows us as technical traders to buy at support and sell at resistance.
Think of the ebb and flow as the regular and often repeatable manner in which every financial instrument moves.
The more in tune you are with it, the more money you stand to make.
As much as I’d like to say it’s something that can come from a textbook, I can’t do that. Every profession, whether it be trading, medicine, law or any other desirable career has certain limitations as to the skills that can be acquired through written words alone.
The rest has to come from experience. In your case, screen time.
At the risk of sounding cliche, if you want to become a great trader you have to become one with the market’s ebb and flow. You need to eat, sleep and breathe price action until spotting trends, drawing critical levels and identifying favorable patterns becomes second nature.
Only then will you have the “x factor” necessary to achieve consistent profits.
The good news is that I can help. I can show you what to pay particular attention to while you rack up said screen time, and it all starts with a markets ebb and flow.
Keep these points in mind as you navigate through the following sections. The material below is the foundation for every profitable trade ever taken, regardless of the strategy that was applied.
These are the moves or waves that best represent the direction of the current trend. During an uptrend, the impulsive moves are those that push prices higher. The opposite applies to a downtrend where the impulsive waves are those that drive prices lower.
These impulse movements are often made up of large candlestick bodies and are typically quite aggressive, especially compared to corrective moves.
Heres an example of three impulsive bearish moves on the AUDUSD daily chart.
As you can see, these impulse movements are swift and aggressive. As such, these areas offer the greatest profit potential in the least amount of time.
But things arent always as neat and tidy as the AUDUSD chart above. In fact, more often than not these movements vary in size as well as angle.
Take the USDJPY weekly chart below as an example.
During an uptrend, these impulsive waves push prices higher in a relatively short period.
However, notice how the second rally above is much smaller than the other two. You could even argue that the entire middle section of the chart was corrective.
But as is the case with most topics in the Forex market, its somewhat open to interpretation.
In summary, impulsive moves within a downtrend are comprised of mostly bearish candles. Alternatively, impulsive bull moves, like the USDJPY chart above, are made up of mostly bullish candles.
On the opposite end of the spectrum, we have corrective moves or waves that work against the prevailing trend. These counter-trend moves represent a period of consolidation and are typically weaker and less aggressive than the impulsive waves we just covered.
A corrective move during an uptrend is characterized by a move lower or even sideways. Unlike impulse movements, corrections are formed by a mixture of bullish and bearish candlesticks where the bodies are relatively small.
Here is the same AUDUSD daily chart as above, only, this time, were focusing on the corrections.
Notice how the two areas above include a mixture of both bullish and bearish candles, a common trait of most corrective movements.
They also developed against the prevailing trend and at a less severe angle. These are telltale signs of corrective moves that have the potential to be continuation patterns. More on this later.
Next up is the USDJPY weekly chart we studied previously.
Just like the impulsive moves above, we can see that these corrections arent always uniform. They can take on various shapes and sizes, but whats important is the meaning behind them.
Each area highlighted above occurred following extended rallies and moved at a less steep angle than that of the impulsive waves.
These characteristics signal that buyers were taking profit during these periods, thus creating a level of indecision that formed a pause in the uptrend.
In summary, corrective moves are typically comprised of a mixture of bullish and bearish candles. The same goes for both uptrends and downtrends.
What is it about the pin bar that makes it such a profitable candlestick pattern?
Is it how the candle forms or its location in context to the surrounding price action?
An argument can be made for both as the most profitable pin bars are distinct and also occur at key support or resistance.
But here’s the deal
A perfectly formed pin bar in the middle of nowhere is useless. Sure, it may trigger a move, but it doesn’t have what we need for it to be tradable.
On the flip side, a decently formed pin bar at an obvious level of support or resistance can be extremely profitable.
Therefore, we can say that the location of a pin bar is more important than how the candlestick forms.
Here’s an excellent example of two well-formed pin bars that occurred at prominent levels in the market.
What made these two patterns work as sell and buy signals respectively are the levels at which they formed.
Sure, the pin bars are also perfect, but those same candles at arbitrary prices wouldnt trigger the same favorable follow through.
While these were no doubt profitable setups, a ranging market isnt always the best when looking for price action signals.
Why is that, you ask?
The lack of a directional bias creates uncertainty. For this reason, trade setups that occur within a strong trending market are almost always the better option.
With this in mind, its best to identify the trend first and then watch for bullish or bearish price action at key levels. By doing this, youre able to leverage the momentum of the market to help ensure follow through once youve taken a position.
We can, therefore, say that the very best pin bars are the ones that occur at the end of a corrective move and form at support or resistance. The idea is to position ourselves to catch the next impulsive wave as soon as it begins.
Here’s an excellent example of one such pin bar that occurred on the EURUSD weekly chart.
Four factors contributed to the success of this bullish pin bar:
In summary, the ability to determine where a trend is in its lifecycle will allow you discover price action signals that provide follow through.
Using corrective moves to identify breakout opportunities has become my favorite method of identifying setups over the last few years.
Why is that?
It’s because a corrective move is nothing more than a market hitting the pause button.
This pause in the price action allows me to reassess the situation and determine whether any favorable patterns exist.
But there are a few choice technical patterns that work the best.
These include the bullish or bearish flag along with the wedge. And the great thing about using these formations, especially the bull and bear flag, is that they occur more often than you might think.
Again, it takes practice, but a Forex trader can easily make a living from trading nothing but flag patterns. In fact, Ive met a few who do just that.
So why are these continuation patterns so lucrative?
Because joining an established trend takes half of the guesswork out of what we do as traders. You know the momentum is there which means all you have to do is find a favorable entry and profit target.
The momentum takes care of the rest.
Okay, lets dig into a couple of examples to see how these corrections can offer a chance to join an established trend.
Do you remember the USDJPY weekly chart from earlier? Well, here is the first corrective move as it appeared on the daily time frame at the time.
The wedge pattern you see above offered an exceptional opportunity to get long following an extended corrective move.
Everything between support and resistance is considered consolidation and is, therefore, labeled as corrective within the broader uptrend.
And here is the second period of consolidation as it appeared on the daily chart.
Again, another wedge pattern that ultimately triggered a massive rally.
Note that in this case, the pair not only carved out a wedge pattern but also formed a bullish pin bar following the break from consolidation.
As such, we can call the chart above a blend of the first two strategies in this lesson.
You now know that the study of impulsive and corrective movements can lend itself to help you find favorable momentum plays.
But all trends, regardless of how healthy they appear, must eventually come to an end. Its during these transitional periods that we can use the same concepts to discover reversal plays.
A reversal pattern such as a head and shoulders and its inverse are indications that a trend is tiring. In other words, they signal a potential change in sentiment and momentum.
Here’s an example of a topping pattern on NZDJPY that we recently traded.
After several weeks, the structure above provided us with a 1,pip profit.
But chances are youre familiar with how to trade the head and shoulders pattern. What you may not know are the forces at work that make the formation profitable, namely how impulsive and corrective moves play a role.
So lets view the same NZDJPY weekly chart from a different perspective.
What makes this pattern so lucrative are the forces at work behind the head of the structure.
Within this one swing high was the last impulsive bullish move as well as the first impulsive bearish move in over two years.
This first bear move gave rise to the first bearish corrective move, which is designated by the larger red area in the chart above. You can then see the steep decline that transpired immediately following the break below neckline support.
Now, because were studying the ebb and flow of a market rather than technical patterns, its important to keep in mind that reversals come in all shapes and sizes. They arent always a clear head and shoulders, double bottom, etc.
Take the USDCAD daily chart below. Here we have a bullish pin bar/rejection bar that formed at new support. This formation came after the pair carved out its first impulsive bullish move in several months.
This particular setup was one that was covered here at Daily Price Action and also traded by several members.
So what made me think this level would hold?
The fact that it had already played a significant role over the previous twelve months was a good starting point.
But it didnt end there. The recent rally from a multi-month low looked impulsive, at least compared to the other corrective moves of late.
Notice how the rally in blue occurred at a much steeper angle and for a longer period than the other corrections shown. This led me to believe that USDCAD was on the cusp of a rebound.
Combine that with the bullish candle at key support and we had a favorable opportunity to trade a reversal.
What were studying here is the relationship between price and time. Said another way, were reading the angles of the market to help determine whether buyers or sellers are in control.
So there you have it. The study of impulsive and corrective price action extends beyond the realm of identifying favorable trend continuation signals. The same movements can also be used to discover exhaustion patterns that lead to an extended move in the opposite direction.
Will you start looking for impulsive and corrective waves when trading?
Leave your comment or question below and Ill get back to you as soon as possible.
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If you’ve decided to work on your forex trading strategy in using new technical analysis methods, the Elliot Wave theory is a good place to start. Despite being a hundred years old, many forex traders today use it to keep track of price patterns and predict trends. This, in turn, allows them to take advantage of both short and long-term trends. Because the Elliot Wave Theory is a prevalent concept in the world of stock and forex trading, it’s worth understanding to make better sense of different charts and spot favorable trading opportunities.
Let’s explore what Elliott Wave Theory is, the different types of waves involved, and how it can be used for forex trading.
Download the free Elliott Wave book: Free eBook.
In the s, Ralph Nelson Elliott came up with a technique to analyze stock price movements. After looking at many decades of stock market data across different indices, the American accountant and author managed to predict the stock market nadir. At the time, many investors believed that stock markets behaved in an unpredictable and random fashion. On the other hand, he believed that markets follow recurring cycles or waves. He was able to identify specific fractal patterns, which he referred to as ‘waves.’
His theory is that you can predict stock and forex price movement by looking at the price history. But how? He explained that markets move in wave-like patterns that occur as a result of investor psychology. Traders who find a favorable opportunity and make a profit from a market trend are referred to as ‘riding the wave.’
Perhaps the most important part of the theory is that they’re fractal. That means you can notice repetitions of the wave pattern across any timeframe. If you pull up a one-year chart for any forex pair, you’ll be able to spot the signature wave pattern. And if you zoom in to look at a single tick chart, you can still see the basic wave pattern.
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Speaking of which, the Elliott wave theory is based on a specific wave pattern. Its the set of movements that Elliott noted as the fundamental aspect of stock market price action. The entire pattern is made up of eight waves, and each one moves in the opposite direction of the last wave. So, if one wave moves upwards, the subsequent wave will move downwards.
The movement of the waves is dependent on the current trend, so it requires understanding whether the current trend is bullish or bearish. The first five waves in the pattern, which is called the motive phase, will always move in the direction of the overall current trend, whether its bullish or bearish. The last three waves make up the corrective phase, and they move against the overall current trend.
Once these eight waves are completed, the motive phase will become the first wave of a much wider pattern. The corrective phase will form the second wave, and so on, allowing the pattern to continue infinitely. This is what gives the Elliott wave pattern its fractal nature.
In any Elliott wave pattern, you’ll see two types of phases: motive and corrective.
These are then made up of 5 waves that make a net movement in the same direction. It includes the most common motive wave, wave 5, making it easier to spot. Besides showing the highest possible price level, it indicates the lowest price level, allowing forex traders to take on favorable positions.
Among the five waves that make up this phase, three are motive waves, which means they follow the general market trend, while the other two are corrective trends. Therefore, they retrace the preceding waves and move in the opposite direction.
For a wave formation to be called a motive phase, it must meet three conditions:
This phase is made up of three waves that move against the existing market trend. Typically, the first and third waves, A and C, move downwards, while wave B retraces A. If the market was showing bullish sentiment, it signals that the market is now correcting itself from the last trend. It also distinguishes the highest price level in the market, which is important for traders to sell their positions or take on short positions.
For a wave formation to be a corrective phase, it must follow three conditions:
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Let’s take a look at the different wave patterns that these formations make:
If the market is currently showing an uptrend, a flat wave pattern shows a downward market momentum. This is usually a signal for traders to exit the market. And if the market is showing a downtrend, the flat wave pattern shows upward momentum and signals traders to enter the market.
This is a corrective wave pattern that indicates a strong upward or downward price movement. Waves A and C are motive waves that move in the direction of the market, while B moves against the market. During a continued uptrend, the zig-zag wave pattern brings down the price of a currency pair, signaling traders to sell. But if it’s a continued downtrend, it signals traders to buy.
The diagonal pattern has several waves that move in the direction of the market. It comprises multiple sub-waves with no specific count, and it shows traders that the existing momentum is strong. It also signals appropriate entry or exit levels depending on whether the market is bullish or bearish.
This is a corrective pattern comprising five waves that balance the existing market direction. It includes three corrective waves and two motive waves. In a contraction, the waves become smaller in length, while expansions show the waves increasing in length. In simple terms, this pattern indicates that the market is moving back to its previous position.
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According to Ralph Nelson Elliott, the signature wave pattern follows specific rules.
Keep in mind that within each phase, certain waves move against the phase. So, in the motive phase, which moves upward in a bull market, wave 2 and 4 move downward. And in the corrective phase, which goes downward, wave B moves upward as it retraces from A. It’s important that these waves aren’t bigger than the preceding waves. Therefore,
Heres how you can interpret the Elliott wave theory: The first five waves of the pattern follow the overall market trend. So, if the market is showing a bullish or bearish trend, waves 1, 2, 3, 4, and 5 will follow this trend, even though waves 2 and 4 are retracements.
This is followed by three more waves, A, B, and C, which make up the corrective phase. The last three aren’t numbered because they move in a different direction from the first phase. So, if the first phase moves up, the corrective phase will go downward and vice versa in the event of a bear market. Then, the motive and corrective phase become the first and second waves of the next bigger wave pattern. Although the pattern continues, the timespan of each wave varies.
All this talk about the Elliott wave theory begs the question, Does it work for forex trading? Yes, its possible to use Elliott waves in Forex trading, as investors who apply it are able to take advantage of favorable opportunities.
If you’re still a beginner, you may struggle to implement the theory as part of your strategy. At this stage, a strategy with more objective rules is much easier to track. That’s why many forex traders combine it with other theories for a well-rounded strategy. That’s where the Fibonacci theory comes in.
Since Elliott wave formations are highly subjective and fractal in nature, you can apply the Fibonacci theory for a comprehensive strategy. Using Fibonacci retracement levels, you can predict when the corrective waves 2, 4, and B will end. Similarly, you can use Fibonacci extensions to predict when impulse waves 1, 3, 5, A, and C will end.
According to the Fibonacci system, wave 2 can be 50, , , or percent of wave 1 since these percentages are classic retracement levels over 50 percent. Since wave 3 is an extension of wave 1, it can reach percent of the first motive wave. While it sounds a little complicated, rest assured that you won’t need to do this manually. Most trading platforms come with a Fibonacci drawing tool as part of their charting software. With this tool, you’ll be able to plot Fibonacci levels on an Elliott wave.
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In case you weren’t aware of what Fibonacci retracements are, here’s a quick rundown. These levels are horizontal lines on your chart that show the possible locations for support and resistance levels of a forex pair, stock price, etc. It indicates the extent to which the prior movement will be retraced while the direction of the overall trend continues.
Although Fibonacci retracements help predict support levels, extensions can narrow down possible price targets in the overall trend. They go beyond the usual retracement levels, and you can use these extensions to set stop-loss or take-profit orders.
If you plan on using the Elliott wave theory for forex trading strategy in , start by finding out if the current market is facing a bullish or bearish trend. Then, you must determine if it’s currently in the motive or corrective phase of the pattern. Of course, finding out the current phase also depends on the timeframe. It’s possible that a day chart shows a motive phase while a one-year chart shows a corrective phase.
That’s why the theory has gained traction among swing traders, who try to capitalize on price movements in wider trends. They do so by finding out which wave the market is currently in and where it will move next. Let’s suppose the overall trend of the market is moving upward. One example is that they may buy while it’s in the motive phase and sell once the corrective phase begins.
That being said, it’s complicated to implement an Elliott wave strategy because it takes time to master the skill of identifying different waves and phases. Before you start trying your hand at using Elliott waves in forex trading, it’s recommended to read pricing charts for different forex pairs across different time frames. It’s an effective practice exercise that improves your ability to spot wave patterns and builds confidence in using the theory for forex trading.
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