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Elliott Waves theory is based on the concept that the market is moving in a five-wave structure before correcting with a three-wave one. This concept is so popular and makes the theory widely known among Forex traders.
Out of the five waves, three of them are moving in the same direction of the general trend. These are called impulsive waves.
The other two are corrective waves within the five-wave structure. In this five-wave sequence, the third one is the longest.
Because of that, everyone is trying to ride this longest wave. Heavy buying or selling starts when the second wave is considered completed.
A general belief is that the second wave in an impulsive move should end around 50%-61.8% retracement. What traders do is to use a Fibonacci retracement tool to find these levels, and place pending orders to buy (if the five-wave structure is bullish) or sell (if the main trend is bearish).
The take profit is set at 161.8% distance when compared with the length of the first wave, while the stop loss is at the start of the first wave. This is a classical approach and the standard Elliott Wave trade.
It is so popular that it rarely works, of course. There’s one reason for it: people are not aware of running corrections.
A running correction, is, firstly, a correction. It means it refers to the two corrective waves in an impulsive move. These are the second and the fourth waves. Between the two possibilities, trading the fourth wave as a running correction should be avoided at all costs.
The reason for this is that this instance is so rare that if you reach such a conclusion, you’re probably wrong with your analysis in the first place. Using the logic above, we’re ending up with one real possibility for a running correction to appear: as a second wave in an impulsive move.
Before moving forward, it is important to lay the rules that define a running correction. This word, running, refers to the fact that the correction ends higher (in a bullish impulsive move) or lower (in a bearish impulsive move) than its starting point.
In plain English, it means that the second wave ends above the end of the first wave in a bullish impulsive move, or below the end of the first wave in a bearish impulsive move. As such, the third wave’s length should be projected from that point!
The image above shows the EURUSD pair and the center of attention is the drop from the 1.40 level that started a few years back. This drop is impulsive, but if you use the classical interpretation, the standard Elliott Waves approach, you won’t catch it.
There is no pullback into the 50%-61.8% levels, but this doesn’t mean the move is not impulsive. The solution comes from interpreting the second correction as a running one.
In this case, the impulsive move is bearish. As explained earlier, in this case, the second wave should end below the end of the 1st wave.
Such an interpretation is considered revolutionary, but it works like a charm, especially on the Forex market, where large swings are the name of the game. All this, while respecting the general Elliott Waves rules.
One must think of the times the theory has been invented. The Forex market simply didn’t exist back then and was not available to retail traders.
In other words, today’s retail traders are handling a different market with a trading instrument that was not intended for it. As the trading world changed, traders need to adapt their approaching point.
After a running correction, at least a 161.8% extension for the third wave comes. This is the minimum distance to be traveled, but the price could easily go to 261.8% or more.
At the first glance, it doesn’t seem to be any problem. If anything, this is a win-win situation, as both traders, the ones that trade the classical pullback and the ones aware of running corrections were right about the general market direction: to the downside.
The problem comes from the interpretation of the overall impulsive move. When doing that, traders that fit into the first category will try to buy at the end of the projected fifth wave.
Such a strategy is deadly for a trading account. The buying is simply too early and these traders are often caught buying an aggressively bearish market.
I mentioned that running corrections are appearing as the second waves in an impulsive move, but there are other places to be found too. Triangles, for example, can be running ones.
Triangles represent the most common way for the market to range or consolidate. Considering that ranges are dominating, triangles are everywhere.
A running triangle should, therefore, end above its starting point, if the triangle is part of a bullish trend or part of an ending bearish complex correction. When labeling, such a triangle is either the b-wave of a zigzag or the 4th wave in an impulsive move.
A bit earlier it was stated that 4th waves are to be avoided as running corrections, so what’s really left on the table is a b-wave.
In fact, any running correction that is valid as a second wave can be a b-wave in a zigzag. To explain, the key in a zigzag is for the pullback in the b-wave not to be more than 61.8% of the previous a-wave.
But no-one is saying that it MUST end in the territory of the previous a-wave. Therefore, running corrections are possible here.
Between the two situations, for a running correction to appear as a second wave in an impulsive move or a b-wave in a zigzag, the first instance is more common. Elliott Waves traders will gain a great deal of experience if they are to incorporate the concept of a running correction with their analysis.
After all, a different approach is needed to gain a competitive advantage from the crowd. If the crowd would be right, everyone would make money when trading. This is simply not the case.