Wave Formation

Video Transcription:

Hello, traders. Welcome to the Elliott Wave Theory course, and the third module, Advanced Elliott Wave Analysis. In this lesson, we’re going to talk about wave formation. What we’re going to discuss here in this lesson is not how a wave should look like, or how a pattern should look like, but more importantly, where does the pattern start, and where does the pattern end? How to determine these tops and bottoms, and how orthodox these tops and bottoms have to be in order for it to be a complete pattern?

Wave formation

Now, let’s start by defining what a wave formation is. A successful Elliott Wave count or analysis depends fully on a proper labeling of the patterns, and sub-waves inside the pattern, of course. We always have to assume that a price extreme is the correct starting point for wave labeling. This means that no matter where price is at the moment, we must always start our analysis at the previous extreme price action. This means that if we are whether in a bullish or bearish market, we need to go back and look for the previous extreme. This means that we are always going to try to find, for example, if we are in an up move, we are always going to try to find the previous high or the previous, well, the previous extreme high, if we are in a corrective move. Because from that extreme high, we are going to start labeling back and forth, for us to have a correct Elliott Wave count.

After determining the start point of the pattern, we must determine the right ending point for each wave, whether we are in a basic 5-wave pattern, or a 3-wave corrective structure. And of course, if we are just trying to trade a corrective move or a corrective structure, like a combination, a zigzag is just the same idea. We need to know where the pattern is going to start, and where the pattern is going to end, because it’s very easy just to grab a chart, and start throwing 1s, and 2s, and 3s, and 4s, and As, and Bs, and Cs, on the chart and have a wave count that really will not give you an exact entry on the market. Because remember, after all, counting waves and analyzing price action with Elliott Wave is all about perfectly timing your entry and your exit in the market. If you don’t have a correct count, you’re not going to be able to do it.

Up until now, we have started and learn what a pattern looks like, and how to correctly spot them and label them, but it’s important, too, to determine the possible length of a wave inside a pattern, and the end of each one, to correctly label them. Elliott Wave theory is all about perfectly timing the markets and it wouldn’t be possible without all of this. Some corrective patterns are different in their angle of trend, meaning that some have a sharper angle than others. Whether we are talking about zigzags or combinations, our goal is the same, letting us know when the corrective move will end, and where, and when we can look for entries to follow the trend.

Now, we’re going to go to a chart right now and I’m going to show you how to correctly look for the end of each wave, and how to look for the correct entries in the market. Here we are on the AUS/US dollar daily chart and as you can see, we are in a very steep down move. Of course, this is 2013 price action.

But let’s imagine that we are just right here. What we want to do here is we want to find the extreme in price action. Remember, we are in a very strong down move, so we are looking to go short. That’s the main idea. Where’s the extreme in this chart? The extreme is right here. The lowest point of the entire move is our extreme. This means that this is the end of this down move. How do we know this is the end of the down move? Because as you can see right here, we have made a higher low, which means that the down structure that we were in has been compromised and completely broken when we made a new high. We have made a new high because we broke with the previous highs right here. This is what we call finding an extreme.

Here, we have the lowest point of the trend, then we have a higher low, then a break of the previous highs, which means that this is going to be our extreme, and the starting point of the wave count that we are going to be making. Right now, we don’t know where we stand. We don’t know if we are looking at a 5-wave basic pattern or a sideways combination. We are going to start labeling price action. Right here, we have the first wave to the upside, so we can label it 1. Even though we have a double-top right here, it is the same wave. This is the same impulse to the upside. Then we have a corrective move to the downside. Remember, we did not correct more than 100%, so we can label this wave 2 of this move to the upside. Remember that this is a very strong down move, so what you need to know or understand is that we might have kind of a deep correction.

Remember that from August 2012 to April 2013, we were trapped inside a 500 pip range. Then the range broke, and we had a 1,500 pip move to the downside, so we might be looking at a very strong or very deep corrective move to the upside. Let’s forward in price action and let’s find the next wave. We already know that this is the extreme in the market, and this is the first wave. The first wave ends here, because you can see that the up move or the movement to the upside, or the structure that price was in when it was correcting to the upside and made this high, was broken when price made the second low.

Then, again, we made a second low right here, which is the end of wave 2, and it’s the end of wave 2 because we broke with this high right here, meaning that this corrective wave to the downside, let’s call it corrective because I think we are in a 5-wave basic pattern. This second corrective move is a very deep corrective move to the downside because of the depthness of the movement, or the depthness and the strength of this move from April 2013 until August 2013.

Wave formation

We are going to have a lot of bear pressure when we make new highs, and you can see it right here. This correction is a deep correction but, then again, we find bulls that break with this down structure and make a new wave. Now, here’s when this becomes very interesting. We are going to start labeling. Well, this is the end of wave 3. Let’s call it the end of wave 3, we don’t know yet, remember. We don’t know yet if this is the end of wave 3 because actually price might just make a new low, a new high or low, and then continue to the upside, which would mean that we’re no longer in a 5-wave passive pattern, but, we are looking at a complete corrective move to the upside. That doesn’t matter. What we need to know and what we need to understand is where to find the end of these waves.

You can see right here that we have always on our Fibonacci tool, the 161.8, and from the end of wave 2 until the end of wave 3, we can always look for a 161.8% retracement of the previous wave. This means that price is going to retrace 100%, and then an extra 61.8% to make it the largest wave of the pattern. We know that this is going to be the area where wave 3 is likely to end. This is important. Wave 3, this is the area where wave 3 is likely to end, around this 161.8. This is why we’re going to label this the end of wave 3, because you can see that we spiked above the 161.8 but then we retraced back and broke with the previous low.

Now, let me just get rid of this Fibonacci tool, and of course, let me just arrange these squares on the chart. This is the end of wave 4. When price hits our Fibonacci levels and then retraces, we already know that we are in a 5-wave basic pattern. This is wave 4, and we are going to look for the end of wave 5, to start our short position. Where are we going to find the end of wave 5? That’s easy. Again, we are going to grab our Fibonacci tool, and we are going to put on a retracement from the high of wave 4 to the low of wave 4. This means that we are looking again at around a 161.8 retracement of wave 5.

I know that this sounds a little complicated, but it’s not. We are always going to be looking for a 161 as our entry point. We are going to help ourselves with previous levels. Right here we have a very strong level of support. Let me just put on a diagonal line right here on the charts, and let me change it to another color right here, we have red, which is nice. We have this level, and of course we have the high of the level. This is going to be the area where we are going to look for short opportunities. Why? Because we are going to look for wave 5 to be a 161 retracement of wave 4.

As you can see, we pinpoint the entry by putting our entry or our pending orders right here, right around this area, and we are going to put our stop-losses, let me just grab another tool, right here, above these highs. Why? Because not only we need the price to hit the 161.8 and hold, but we don’t need it to break the previous highs. If we break the previous highs, it would mean that this count is no longer, well, this is not an exact 5-wave pattern, and we must not trade it short. Basically, we are going to be risking around 140 pips to make around 780 pips. Why we are going to make 780 pips because, we know this 1, 2, 3, 4, 5 wave count is only a corrective move to the upside for a continuation of the move to the downside. This is what happens. This is how you’re going to pinpoint and perfectly time, and perfectly understand the wave formations inside of a pattern.

Adam

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