Under the Elliott Waves Theory, there is a thin line between an impulsive and a corrective wave. The whole theory is based on a trader’s ability to correctly identify a wave, to properly count it and interpret it.
Corrective and impulsive moves are extremely different and the rules one needs to follow vary based on the type of the corrective or impulsive move the market makes. However, there are some simple things that traders use for not wasting too much time to interpret a move under the Elliott Waves Theory.
Overlapping is such a thing. Overlapping means that two waves have a common territory.
Even this simple explanation is misunderstood many times as most of the traders are using the overlapping rule in an incorrect fashion. The confusion comes from the fact that everyone is looking for the last wave to end into the territory of the previous one.
This is totally wrong, as overlapping, again, refers to the territory of two waves of the same type. Elliott found that the two corrective waves in an impulsive move MUST avoid overlapping.
As a reminder, an impulsive move is a five-wave structure that is labeled with numbers 1-2-3-4-5, with the second and the fourth waves being the corrective waves. Therefore, the overlapping rule refers to these two waves, the second and the fourth one.
The second wave in an impulsive move is the most difficult one to assess. Luckily, overlapping can/should be applied well after the second wave is completed.
The reason why the second wave is difficult to interpret comes from the fact that traders have no idea about its structure. It can be a simple or a complex correction, it can take less or more than the time taken for the first wave, it can be a classical correction or a running one. Literally, there’s no clue.
However, because overlapping refers to the second and the fourth wave, by the time the fourth wave is in progress, traders know what to expect. This is extremely useful in positioning for the fifth wave to follow.
According to the principle of alternation that we already spoke about here on ForexGator.com, the second and the fourth waves in an impulsive move MUST be different, they must alternate. Because the second wave is already known, traders have an idea about what the fourth wave should look like.
For example, if the second wave is taking a little time, the fourth wave is most likely to take more, and so on. Moreover, by the time one is comparing the fourth with the second wave, overlapping must be taken into consideration.
The way to avoid overlapping is to effectively measure the territory of the second wave. This is NOT the territory from the end of the fourth wave until the end of the second wave, but the territory within the highest and lowest point in the second wave.
Therefore, the correct approach is to look at the highest and lowest point in the second wave from the moment the second wave started and to draw two horizontal lines. That is the territory of the second wave.
The fourth wave MUST not enter that territory by any means. If it does, the move is not an impulsive move, as ALL impulsive moves must respect this rule.
The picture above shows you how to correctly interpret and mark the second wave territory. This is vital when it comes to using the overlapping principle.
As you can see, parts of the second wave go beyond its beginning, even though the second wave is a corrective wave. That is still considered to be second wave territory.
Moving forward, we know that the third wave is most likely to be the one that is extending, so we should expect a move that is bigger than 161.8% when compared with the length of the first wave. That is the minimum distance to be traveled, as the market can go to 261.8% and even more in a strong impulsive move.
The image above is correctly showing an impulsive move, or a five-wave structure that is respecting the overlapping principle. As you can see, no parts of the fourth wave enter the territory of the second wave.
In this case, the fourth wave is a triangle. The first swing lower in the triangular formation, or the a-wave, is not going into the second wave territory.
There is some controversy as some traders say that Elliott is looking for more than 10% distance to be respected for the two waves to be considered as not overlapping. While this may be true for some other markets, for the currency one is not.
This simple overlapping rule is enough for experienced traders to know in a blink of an eye if a move is a five-wave structure or not. Therefore, understanding the overlapping principle is important to knowing how to label impulsive waves.