### Wave Counting - Looking at the Bigger Picture

I've taken more to watching the bigger trend when trading. It helps me psychologically to know that I am trading in the direction of the larger trend, and so therefore I'm developing some techniques in watching patterns unfold in the larger trend.

One of the best ways to watch a trend, in my opinion, is to actually count the waves, using Elliott Wave theory. For those of you who are not familiar with this, let me attempt to simplify it for you.

A basic wave primer:

There are only 2 types of waves - impulsive and corrective. Impulsive waves are waves moving in the direction of the trend. Corrective waves correct the impulsive waves; also known as retracements or pullbacks.

The nature of waves:

a. An impulsive wave is always made up of 5 sub-waves, labelled 1, 2, 3, 4, 5. Three (3) of those sub-waves are impulsive (waves 1, 3 and 5); two (2) sub-waves are corrective (waves 2 and 4). It looks like this.

b. A corrective wave is generally made up of 3 sub-waves, labelled a, b, c. Two (2) of thos sub-waves are impulsive (yes, impulsive within a corrective). That's because Wave-a can behave like Wave 1 and Wave-c can behave like a Wave 3. Corrective waves can move sideways, or it can move in a zigzag fashion, but the main concern is that it still unfolds in 3 sub-waves.

c. An impulsive wave is always followed by a corrective wave, which is followed by another impulsive wave, and so on and so forth.

d. Waves are fractal in nature. That means each wave can be broken down into smaller waves and the same pattern exists, i.e., 5 impulsive waves, followed by 3 corrective waves. This would explain why a sub-wave of a corrective wave can be impulsive. Fractal also means each wave is part of a larger degree wave, and in that larger degree wave, the same pattern still exists. This is what looks like.

Anyway, we digress. Just bear in mind the basic strucure: 1-2-3-4-5 impulsive and a-b-c corrective wave, let us go now to the basic rules for wave counting.

There are only a few general rules to remember when wave counting:

1) Wave 3 is NEVER the shortest wave. In fact, most of the time, it is the longest and the strongest. NOTE that I said most of the time, not all of the time. It doesn't have to be the longest, but it definitely cannot be the shortest wave.

2) Wave 4 can never overlap the peak of Wave 1, otherwise the entire wave is a corrective wave rather than an impulsive one.

3) Waves 2 and 4 alternate in form. Waves 2 and 4 are corrective waves. I mentioned above that corrective waves either move sideways or in a zigzag fashion. What this rule (we call it the alternating rule) means is that if Wave 2 unfolded in a zigzag fashion, Wave 4 will most likely move sideways. If Wave 2 moves sideways, then Wave 4 will be a zigzag.

Remember these are general rules. It's about assessing the probabilities of what path the market will take. So when the waves you are counting violates one of these rules, the next most likely scenario is that what you thought was an impulsive wave is actually a corrective wave. For example, if you are in what you think is an impulsive wave, and there are only 3 waves formed, then that was a corrective wave. The next wave will be an impulsive one, and will probably be the general direction of the market until 5 waves are formed.

Let's look at an example chart to see an actual wave formation:

Notice that Wave 3 is the longest and strongest. Wave 4 never violated the peak of Wave 1. And, Wave 2 and 4 alternate in form: Wave 2 is zigzag, Wave 4 moved more sideways.

And now, to add my own personal observations:

1. Wave 2 is the first HL (higher low) after a downtrend. This means the direction has changed and was are now in an uptrend. (Wave 2 is also the first LH (lower high) in a downtrend.)

2. Wave 1 can look like a retracement in a downtrend; it's hard to tell when a Wave 1 has taken place. Only after Wave 2 has happened can we distinguish a Wave 1. (NOTE: In my system however, Wave 1 oftentimes coincide with price breaking through TSF - the blue-grey line above, thus making it easier for me to see.)

3. Wave 3 coincides with extremes in momentum indicators. This also explains why Wave 3 is moft often the longest and strongest, because that's when momentum is strong.

4. Wave 5 coincides with divergences in momentum indicators. This supports the fact that Wave 5 is the last impulsive wave of the trend. Momentum is fading, and the market is getting ready to turn.

It's interesting that no matter what type of analysis you apply to the market, it all means the same thing. For those who are not familiar with Elliott waves, or who condemn its usefulness, for me it has helped tremendously in reading where we are in the market structure.

This is how I use the Elliott Wave Principle in my own trading:

1. I try to enter the market on Wave 3, the longest and strongest of all waves. I wait for Waves 1 and 2 to finish. I can either enter 1 tick above the peak of Wave 1 or 1 tick above the peak of Wave 2 (the former is an less risky). I will ride this until Wave 3 ends or I get stopped out on the retracement (Wave 4). This technique is also known as MOF (Money-On-the-Floor) in some trading circles, as taught by Buffy. It is nothing more than a pure Wave-3 trade.

2. When I don't see a divergence yet, I try to enter on a continuation, which is a Wave 5 (after Wave 4 has completed).

3. Less often, I will enter when price breaks through TSF, which most often coincides with Wave 1, wait it out and just ride the trend until Wave 3 ends.

For those who are interested in learning more about the Elliott Wave Principle and how you can use it in your trading, visit www.elliottwave.com, or click on one of the links on the sidebar for more up-to-date analysis of the markets using Elliott Wave.

## 2 Comments:

Hi! If you have something interesting to say about Fibonacci retracements, join us.

http://motls.blogspot.com/2005/01/fibonacci-traders.html

By Lumo, at January 8, 2005 at 1:56 PM

Hi, great blog, I'm interested in trading and actually have a site about it at...http://trading--online.blogspot.com/

By Len, at February 20, 2006 at 1:25 PM

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