Elliott Waves Theory is extremely popular among traders since it is one of the few trading theories that offers traders concrete levels for stop loss and take profit orders. Moreover, entry can be made under specific conditions, with the use of pending orders being highly recommended.
According to Elliott, the market moves in impulsive and corrective waves, with corrective waves being more common due to the fact that consolidation areas form more often.
Having said that, it means impulsive waves are hunted by traders looking to ride a trend that started or is about to start. What Elliott found is that any impulsive wave needs to have an extension, or an extended wave of a lower degree.
Out of the five wave structure that represents an impulsive wave, waves one, three and five are impulsive on their own, while waves two and four are corrective.
Out of those three impulsive waves, at least one needs to be extended, and extension refers to it being at least 161.8% bigger than the other ones. In other words, the way to find out which wave is a candidate for being the extended wave, a trader should follow this logical process:
– which one of the three impulsive waves of a lower degree is the longest one
– take a Fibonacci retracement or extension and measure it, in order to find out the 161.8% level
– compare the outcome with the other two remaining impulsive waves
If they are smaller than your outcome, it means the wave is extended and this extension rule is respected.
Depending on which wave is extended (wave one, three or five), we can talk about a first wave extension, third wave extension or fifth wave extension impulsive wave. It is very important to know what kind of an extension market is forming because it leads to forecasting the price action to come after the whole impulsive wave is completed.
It is worth mentioning here that out of the three possibilities; the most common one is for the market to develop a third wave extension impulsive move. Also, fifth wave extensions are really rare, so I would be reluctant in interpreting a move as a fifth wave extension. If you see one, it is most likely a double extended impulsive wave rather than a fifth wave extension.
How can the extension be traded? The 161.8% is only the minimum distance to be traveled by an extended wave, and in many cases, especially when the second wave is small and insignificant, extension can easily exceed 161.8% and even more when compared with the length of the first wave.
There is no rule to know where the extension will end, so the best way to trade the extended wave is to stay on the trade until the 161.8% level comes, then book half of the initial position while trailing the stop or moving the stop loss at break-even. This way, even if market turns, there’s still a profit to be made and in the case that it is going well beyond the 161.8%, profits are running still.
Extension can be used the other way around, for traders that want to fade a trade, but it should be mentioned here that this is quite a risky adventure.
When the analysis is being made on the bigger time frames, for example; a trader is looking for the c wave of a zigzag to end (c wave of a zigzag is always an impulsive wave) then the best way to enter a trade in the other direction is by the time 161.8% extension came.
If there is no extended wave in any five wave structure, then according to Elliott that is not an impulsive move and it must be corrective, as there is no other possibility.
Therefore, a clear understanding of how to find out the extended wave and its implications is vital when it comes to applying the theory to any financial product. This is the beauty of Elliott Waves theory, after all, it can be used and applied to any financial product; be it a currency pair, or stock, bond, index, etc.
The rules are the same and can be easily mastered if there’s enough passion for trading.
The next article dedicated to the beginner’s series here at www.forexgator.com will deal with the importance of swaps when it comes to choosing a trading direction for a currency pair. You may think swaps are meaningless, but only because you’re looking from a retail trader point of view. In reality, they are showing us the future direction of the market as well as the quality of a forex broker. When the analysis is being made on the bigger time frames, for example; a trader is looking for the c wave of a zigzag to end (c wave of a zigzag is always an impulsive wave) then the best way to enter a trade in the other direction is by the time 161.8% extension came.