(04/28/10) Understanding Elliott Wave (Part 3)

Continuing our Elliott Wave series, I am going to be writing about the basics of Elliott Wave (EW). I want to keep this as simple as possible, because it is simple. The other objective I have for this series is to make it relevant to trading. This is not for the academician…this is for the trader.

I will examine how EW analysis can be used to project turning points in the market.

I am going to cover wave three and wave C separately, although they have many similarities and could be covered together. Wave 3 belongs to a five-wave impulsive structure. It is usually the longest and strongest (most momentum) of the impulsive waves (1, 3 & 5). If it is not the longest, it cannot be the shortest.

Our goal in trading a wave three is to capture as much of it as possible. Ideally, we want to get in at the beginning of wave three and get out before wave four begins. Wave four is often a prolonged correction. We covered trading a W2, which would get us into W3 at its beginning, in yesterday’s lesson. Assuming we are in a wave three trade, what are the typical price targets? In order to calculate the price target for wave three, we need to first identify waves one and two. Then, using our Fibonacci extension tool, we click the beginning of wave one, then click the end of wave one, and finally click the end of wave two. A typical wave three will be equal to the 161.8% projection of wave one from the end of wave two.

A maximum typical wave three is the 261.8% projection of wave one. It is said that the minimal W3 projection of wave one is 100%, but I find it rare that this is a wave three with ES. If the wave ends at 100%, I find that it is usually a wave C, and what we thought were W1 and W2 are relabeled wave A and B. This often happens when we think a five-wave impulsive move has completed and we enter a trade thinking we have bought the beginning of a new trend, only to find that we entered into the W4 of the impulsive move. That is why I always take some profits at the 100% level, whether I am in a corrective or impulsive wave.

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Structure of Wave Three

A wave three always subdivides into five waves. That is what we call the fractal nature of waves, or waves within waves. This does not help us differentiate a W3 from a wave C though, because wave C also subdivides into five waves. Occasionally, wave C will take the pattern of an ending diagonal (ED), but wave three never will.

Wave Three Tips

Because wave three is the strongest wave in a trend, you won't know when it will extend beyond your expectation. It is a good rule to always leave at least a runner to capture an extended move. The first significant correction in a W3 is usually W4 of W3. If you are trading a one- to five-minute chart, you may want to ride through that correction, if it's only going to amount to a few points. Remember what happens when you try a countertrend trade in the face of a W3, and just ended up stepping in front of a freight train. Ride that train! Let your profits run. It's always best to let the market take you out of a W3 trade, in my opinion. To let the market take me out, I usually go to a one-minute chart and set a stop loss one tick below the last little swing low or high, depending on which way the trend is going.

W3 in Actual Market Action

I am including this chart as an example of a W3, not because it is a classic-looking impulsive wave, but to show a real-life example of what an impulsive wave might look like. When you are trading one- to five-minute charts, you will see more of these impulsive moves with wide swings and extreme moves. Also, note how the W4 of W3 probably fooled most EW traders into thinking that the W3 high was the W5 high, and end of the impulsive move. How many times have we seen this scenario in longer time frames, when it looked like the top was in, but it was only the end of W3?

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