As mentioned in the previous articles dedicated to Elliott Waves trading here on ForexGator.com; markets spend most of the time in corrective waves or consolidation and therefore understanding how these waves are forming is crucial for successful trading.
Diving further into corrections, they can be either simple or complex ones, with complex corrections forming more often than the simple ones.
If a correction is a simple one, it can only be a flat, zigzag or a triangle, as these are the three simple corrections Elliott identified.
In order for a correction to be considered to be a complex one, there is the need for a wave that makes the connection between two or three simple corrections. This is the X wave.
As a rule of thumb, the X wave is always a corrective wave on its own, and therefore it should be labeled with letters, and not numbers. Of a lower degree, it can be either a simple correction (triangle, flat or zigzag), or a complex one.
Based on the above, it is not possible for the X wave to connect more than three simple corrections, and this means that any complex correction cannot have more than two X waves.
How to trade this X wave though? The thing to do or the key comes from the first simple correction that is forming before the X wave. This one cannot be a triangle, as a complex correction is never ending with a triangle, so the only other two possibilities are a zigzag or a flat.
Let’s assume the first correction is a zigzag; by the time the wave C of the zigzag is completed (and we can find out exactly when the termination point is because wave C in a zigzag is always an impulsive wave and it means the extension rule will give us its ending) one should place pending orders to trade in the direction of the zigzag but only after a meaningful retracement is coming.
The idea is to measure the whole length of the zigzag, basically from the start of wave A until the end of wave C. If the zigzag was a move to the downside, then pending sell orders should be placed at 23.6% retracement, 38.2% and 50%, with stop loss being at 61.8% retracement.
The reason for the stop loss to be at the golden ratio level comes from the fact that complex corrections that have an X wave to retrace more than 61.8% are pretty rare so chances are that the market is going to have a smaller one.
In the case the stop loss is being hit, any further dip should be bought as those corrections have almost equal legs and it means longs should be taken until the complex correction is over and a new trend starts.
The nature of the X wave is most of the time a simple one, and therefore the rules of a zigzag, triangle or flat should tell us more about the future price action to come. For example, if the X wave is a triangle, by the time it is completed, namely price is breaking the B-D trend line, it means the X wave is completed as well and the new simple correction starts.
Another way to trade a complex correction that involves an X wave is to wait for price to break below or above (depending on the direction of the correction) the termination point of the first simple correction and then simply trade the break. In this case, it is mandatory that the stop loss should be at the end of the X wave.
Corrective waves being that common, it is no wonder Elliott identified a lot of them and there are plenty of rules and conditions to be fulfilled before fully understanding where a complex correction ends.
Markets are full with fake moves, especially the forex market, and most of the times one has the impression that the market is breaking only to find out later that after the so-called break it is returning to the original point. This means the correction was not completed and, most likely, the spike or dip was an intervening X wave.
Next article here at ForexGator.com is going to deal with one concept that offers a great value when it comes to trading: a double or a triple top/bottom. These are powerful patterns as they signal a trend reversal, so identifying one provides a great competitive advantage; more on this in our next article.