Elliott Waves Theory – Trading 5th Wave Extensions
Besides 1st and 3rd wave extensions, Elliot found that there is another type of extension suitable for an impulsive wave: the 5th wave extension. Such an impulsive move, while rare, it is being characterized by a sharp move in the 5th wave, taking everyone by surprise. This impulsive wave is a tricky one in the sense that it starts like a corrective wave. Many traders will look at it as a flat pattern, mistaken the first three waves of the impulsive move with an a-b-c of a flat. Because of that, by the time the 5th wave starts in the opposite direction, stop losses are being triggered as traders are being taken by surprise. There are some important things to consider when dealing with a 5th wave extension, and they are referring mostly to the post impulsive wave activity.
Things to Consider in a 5th Wave Extension Impulsive Move
Even though this impulsive move looks unfamiliar and strange, all the basic rules of an impulsive wave, as described here in our Forex Trading Academy previous articles, must be respected, namely:
– In a five-waves structure, the 1st, 3rd and 5th waves are impulsive waves on their own;
– The 2nd and the 4th waves are corrective;
– At least one wave is extended;
– The 3rd wave cannot be the shortest one when compared with the 1st and the 5th.
Because of the confusion created by the first three waves in the impulsive move, traders rarely manage to trade such a pattern, and they will most of the times be caught on the wrong side of the market. However, even after the fact, a 5th wave extension can provide a very good setup for profitable trades.
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Alternation Between the Non-Extended Waves
Like it was the case in the 3rd and 1st wave extensions, the key for the whole move stays with the non-extended waves. They need to alternate in such a way so they respect the rules stated above, while price and time should vary based on a Fibonacci internal ratio. This is what gives the whole impulsive move validity. Based on the rules mentioned above and the fact that in this case the fifth wave is the longest and the third wave is not the shortest, it means that the first wave is the shortest out of all the motive waves. Having said that, look for the 3rd wave to be only slightly longer than the 1st one. This is a common arrangement in a 5th wave extension impulsive move.
Mind the Overlapping
Overlapping is an important aspect often overlooked by traders. First, few people understand what overlapping is standing for when it comes to impulsive waves. Second, the overlapping concept is so important that it can invalidate a count no matter if other measurements are correct or not. No parts of the 4th wave should go into the territory of the 2nd wave. In doing that, overlapping is avoided and traders have a green light for counting an impulsive move. Overlapping is specifically important in 5th wave extensions because the 4th wave has the tendency to retrace quite a lot into the territory of the previous third wave. Often, this retracement level is even more than 50%. However, the price may retrace, but overlapping should not occur.
Fade the 5th Wave
A 5th wave extension impulsive move, while aggressive, is destined to be faded. How to fade such a powerful move? The answer is quite simple. Even though the 5th wave is so strong, post impulsive wave activity is even stronger, but this time in the opposite direction. This means that we can fade the 5th wave and a nice place to trade in the opposite direction is being given by the following setup:
– Draw a trend line from the end of the 1st wave, until the end of the 3rd wave and project it further on the right side of the chart.
– By the time the 5th wave breaks this trend line (such a break is mandatory), it represents a good opportunity to take a trade in the opposite direction. That is, if the impulsive wave is a bullish one, then the trade should be a short one, and if the impulsive wave is a bearish one, then the trade should be a long one.
The target for the trade should be the start of the overall impulsive move, so we’re looking for a one hundred percent retracement of the whole move. As for the stop loss, this one can be calculated by measuring the whole distance from the start of the impulsive wave until the end of the 3rd wave, multiply it by two, and add it on the top of the 3rd wave.
Places where 5th Wave Extensions Appear
As mentioned at the start of this article, such impulsive waves are not common, and this limits the places where it is possible to find a 5th wave extension. As a matter of fact, it appears almost always as the c-wave of a flat pattern. Remember, the c-wave of a flat pattern is always an impulsive wave, and it can be a 5th wave extension. If this is the case, look for it to be completely retraced by the move that follows. This means that the flat will be either the end of a complex correction (like a double or triple flat, or a double combination that ends with a flat) or a simple corrective wave. Out of these two possibilities, most likely the flat will be a simple correction and the full retracement of the c-wave will result in the flat being confirmed. With this article, the Elliott Waves part of our Forex Trading Academy is completed and we must say that it is the most comprehensive one in our educational project. The reason for this comes from the fact that Elliott Waves is based on so many rules that one cannot simply count waves correctly without knowing them all. Even though all those rules make the theory looking like a complicated one (which, to some extent, it is), Elliott Waves theory is one of the most powerful, if not the most powerful trading theory that exists. Not only that traders will consider price when making a forecast, but also time. There is no other trading theory that uses the time element like the Elliott Waves theory and this is important when making a forecast. One may have an idea regarding a specific price target but if that idea is not backed up by a time horizon, the whole forecast is useless. The articles in this project dedicated to Elliott Waves theory are offering a clear guidance for counting waves and reaching profitable trade setups. Other factors are needed, though, for successful trading, factors like money management, understanding market psychology, etc. All these aspects will be covered in future articles here on Forex Trading Academy.
Other educational materials
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Bollinger Bands – Profit from One of the Best Trend Indicators
- Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
- Dow Jones Industrial Average
- FTSE 100 Index
Recommended further readings
- “International trade and financial integration: a weighted network analysis.” Schiavo, Stefano, Javier Reyes, and Giorgio Fagiolo. Quantitative Finance 10, no. 4 (2010): 389-399.
- “Evolving neural networks for static single-position automated trading.” Azzini, Antonia, and Andrea GB Tettamanzi. Journal of Artificial Evolution and Applications 2008 (2008): 1.