Although the Elliott Waves Theory appears to be simple, it is precisely this simplicity which makes it complex. While it seems to be straight forward i.e. 5 waves up should be corrected by 3 waves down, the problem is that all of those waves are formed from another 5 waves up and 3 waves down of lower degree and this subdivision continues. This means a trader has to know where to start their count in order to profit.
Impulsive waves are the most desirable as this means that the price is moving rapidly and making a fast profit appeals to every trader regardless of which product is being traded. It is important therefore to know how to trade with impulsive moves, as even they they are not supposed to be channelling as this is actually a corrective waves characteristic, in fact they do and channelling is one of the best tools to use to find a place to buy call or put options.
Identifying the Extended Wave and Analysing the Impulsive Wave
This first step is to identify which is the extended wave, as channelling is based on this, giving a reasonably clear idea about the ending point of the fifth wave. An impulsive move cannot be channelling, and this is the essential factor in any Elliott Waves Theory analysis. However when the extended wave of an impulsive move is identified correctly, specific actions are able to be taken.
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Once the second wave has been completed the impulsive wave should be analysed. This signifies that both the first and second waves have been completed and the third wave is expected, and this is the most likely one to be extended.
The Importance of Trend Lines
Trend lines are very helpful in this case, and connecting the start of the impulsive wave with a trend line to the end of the 2nd wave is essential for finding the future channel. Once this has been done, the resulting trend line can be copied and pasted to the project out from the ending point of the 1st wave. This builds the channel. The future price action of the third wave will therefore either break the projected 0-2 trend line or it will not be able to reach it. If the line is broken, the 3rd wave can be expected to be extended and to reach more than 161.8% – up to 261.8% or above. This is a third wave extension and can be traded by applying the 161.8% of the first wave by the time the second one has been completed. If and when the channel’s upper trend line has been broken, however the 161.8% extension is not yet reached, a trader should buy call options in the case of a bullish impulsive move or put options for a bearish impulsive move. Of course, the expiry date should also be adjusted to match the timeframe on which the move is forming.
Conversely, if the price cannot break the projected 0-2 trend line, this means the market will channel and it is not an impulsive move but a corrective one. In this instance, the trader should trade put options by the time the market reaches the level in the case of a bullish trend or call options for a bearish trend.
If the price ends anywhere between the channel’s uppser side and the lower side in the case of a bullish trend, this means that the impulsive move has been completed as long as there is an extension. In this case, the channel should be split into 2 parts and put options should be bought by the time the retracement level of 50% has been reached in the case of a rising channel or call options in the case of a falling channel. The 50% retracement level is useful for identifying the potential end of the fifth wave, and the place where the striking price is likely to be found is the 50% retracement level of the channel. This means that the trader should buy put options by the time that the 50% retracement level has been reached by the fifth wave in the case of a bullish impulsive move, or buy call options for a bearish impulsive move.
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- Determining The End Of The Trend. Target, 3, 5 Samuels, J. (2008)
- “Wall Street Voodoo Economics: Investment Strategy Backtesting.” Davidsson, Marcus (2006)