In my opinion, waves are probably the most reliable as well as most risky technical analysis tools. If you get it right, you may be able to tell where the market is heading, where it stops to retrace and where it's heading next. Prices move in the form of waves so that we can predict where prices go next by counting those waves. Again, it's a statistical result. I have seen some price movements in the real world and they fall into the definitions of waves theory nicely.
Some waves followers try to explain every price movement of a security by waves theory. If it turns out to be wrong, they recount from the very beginning and try to find a count that can best explain the current price movement. I consider this is the major flaw of this theory as it tries to explain the whole price movement in an infinite time line by a limited price data.
However, some price patterns do fulfill classical waves pattern. Trader shouldn't focus too much on details of waves in a consolidation pattern. Waves seem to work better in a market that has trend rather than range.
The followings are characteristics of waves theory.
- The basis waves count that contain three impulse waves, 1,3 and 5, and two corrective waves, 2 and 4. Once the price has completed the entire sequence 1,2,3,4,5. It's then corrected by a sequence a,b,c.
- Each of the impulse waves and corrective waves can then have their own impulse waves and corrective waves. It'll look like this.
- Extension of impulse waves. Usually, only one of the three impulse waves will extend. It's a very bullish or bearish signal. It's very risky if you trade against the trend. You should buy on any retracement or sell on any rebounds instead. The extension of the fifth wave sometimes comes as a wedge. It's likely that the price will retrace back to the beginning of the the wedge and hit back the top of the wedge.
- Also, the fifth wave might fail to go over the peak of the third wave. It then forms the typical double tops chart pattern. Usually, wave 1 should have the same magnitude of wave 5 if wave 3 is the extended wave. The extended wave 3 should be 1.618 or 2.618 times as long as wave 1. Wave 5 can also be 61.8% of the magnitude of wave 3.
These are the major characteristics of waves theory. Now, you need to grab some nice graph of securities that have high volume of transaction and practice counting. You may be amazed by this theory. Don't forget to get your calculator or go to our Fibonacci calculator to check the magnitude of waves.
- Wave 2 and Wave 4 are corrective waves of the impulse waves. Either one of them is usually very complex or the other is simple. Please note that bottom of wave 4 should never go below the the peak of wave 1.
- There are various type of corrective waves. They are in the form of 3 legs, a,b,c. However, wave a and wave c can contain 5 legs and wave b has 3 legs.
- Wave 2 or wave 4 can be the 38.2%, 50%, 60% and 100% retracement of wave 1 and wave 3 respectively.