Tuesday, August 23, 2011

ABC Correction

The 5-wave trends are then corrected and reversed by 3-wave countertrends. Letters are used instead of numbers to track the correction. Check out this example of a smokin' hot corrective 3-wave pattern!
ABC corrective wave pattern

Just because we've been using a bull market as my primary example doesn't mean the Elliott Wave Theory doesn't work on bear markets. The same 5-3 wave pattern can look like this:
Reverse ABC corrective wave pattern

Types of Corrective Wave Patterns

According to Elliott, there are 21 corrective ABC patterns ranging from simple to complex.
"Uh 21? I can't memorize all of that! The basics of the Elliott Wave Theory are already mind-blowing!"
Take it easy, young padawan. The great thing about Elliott Wave is you don't have to be above the legal drinking age to trade it! You don't have to get a fake ID or memorize all 21 types of corrective ABC patterns because they are just made up of three very simple easy-to-understand formations.

Let's take a look at these three formations. The examples below apply to uptrends, but you can just invert them if you're dealing with a downtrend.

The Zig-Zag Formation

Zig-zag formations are very steep moves in price that goes against the predominant trend. Wave B is typically shortest in length compared to Waves A and C. These zig-zag patterns can happen twice or even thrice in a correction (2 to 3 zig-zag patterns linked together). Like with all waves, each of the waves in zig-zag patterns could be broken up into 5-wave patterns.

The Flat Formation

Flat formations are simple sideways corrective waves. In flats, the lengths of the waves are GENERALLY equal in length, with wave B reversing wave A's move and wave C undoing wave B's move. We say generally because wave B can sometimes go beyond the beginning of wave A.

The Triangle Formation

Triangle formations are corrective patterns that are bound by either converging or diverging trend lines. Triangles are made up of 5-waves that move against the trend in a sideways fashion. These triangles can be symmetrical, descending, ascending, or expanding.
Drop by our forums if you want to see the bullish and bearish versions of these Elliott Wave patterns.

The 5 - 3 Wave Patterns

Mr. Elliott showed that a trending market moves in what he calls a 5-3 wave pattern.
The first 5-wave pattern is called impulse waves.
The last 3-wave pattern is called corrective waves.
In this pattern, Waves 1, 3, 5 are motive, meaning they go along with the overall trend, while Waves 2 and 4 are corrective.
Do not confuse Waves 2 and 4 with the ABC corrective pattern (discussed in the next section) though!
Let's first take a look at the 5-wave impulse pattern. It's easier if you see it as a picture:
Elliott wave black and white

That still looks kind of confusing. Let's splash some color on this bad boy.
Elliott wave colored

Ah magnifico! It's so pretty! We like colors, so we've color-coded each wave along with its wave count.

Here is a short description of what happens during each wave.
We're going to use stocks for our example since stocks are what Mr. Elliott used but it really doesn't matter what it is. It can easily be currencies, bonds, gold, oil, or Tickle Me Elmo dolls. The important thing is the Elliott Wave Theory can also be applied to the foreign exchange market.

Wave 1

The stock makes its initial move upwards. This is usually caused by a relatively small number of people that all of the sudden (for a variety of reasons, real or imagined) feel that the price of the stock is cheap so it's a perfect time to buy. This causes the price to rise.

Wave 2

At this point, enough people who were in the original wave consider the stock overvalued and take profits. This causes the stock to go down. However, the stock will not make it to its previous lows before the stock is considered a bargain again.

Wave 3

This is usually the longest and strongest wave. The stock has caught the attention of the mass public. More people find out about the stock and want to buy it. This causes the stock's price to go higher and higher. This wave usually exceeds the high created at the end of wave 1.

Wave 4

Traders take profits because the stock is considered expensive again. This wave tends to be weak because there are usually more people that are still bullish on the stock and are waiting to "buy on the dips."

Wave 5

This is the point that most people get on the stock and is most driven by hysteria. You usually start seeing the CEO of the company on the front page of major magazines as the Person of the Year. Traders and investors start coming up with ridiculous reasons to buy the stock and try to choke you when you disagree with them. This is when the stock becomes the most overpriced. Contrarians start shorting the stock which starts the ABC pattern.

Extended Impulse Waves

One thing that you also need to know about the Elliott Wave Theory is that one of the three impulse waves (1, 3, or 5) will always be "extended". Simply put, there will always be one wave that is longer than the other two, regardless of degree.
According to Elliott, it is usually the fifth wave which is extended. As time went by, this old school style of wave labeling has changed because more and more people started labeling the third wave as the extended one.
Check out this forum thread for more Elliott Wave diagrams.

Back in the old school days of the 1920-30s, there was this mad genius and professional accountant named Ralph Nelson Elliott.
By analyzing closely 75 years worth of stock data, Elliott discovered that stock markets, thought to behave in a somewhat chaotic manner, actually didn't.
When he hit 66 years old, he finally gathered enough evidence (and confidence) to share his discovery with the world.
He published his theory in the book entitled The Wave Principle.
According to him, the market traded in repetitive cycles, which he pointed out were the emotions of investors caused by outside influences (ahem, CNBC, Bloomberg, ESPN) or the predominant psychology of the masses at the time.
Elliott explained that the upward and downward swings in price caused by the collective psychology always showed up in the same repetitive patterns.
He called these upward and downward swings "waves".
He believes that, if you can correctly identify the repeating patterns in prices, you can predict where price will go (or not go) next.
This is what makes Elliott waves so appealing to traders. It gives them a way to identify precise points where price is most likely to reverse. In other words, Elliott came up with a system that enables traders to catch tops and bottoms.
So, amidst all the chaos in prices, Elliott found order. Awesome, huh?
Of course, like all mad geniuses, he needed to claim this observation and so he came up with a super original name: The Elliott Wave Theory.
But before we delve into the Elliott waves, you need to first understand what fractals are.

Graduation 0%

Elliott Wave Theory

Fractals

Basically, fractals are structures that can be split into parts, each of which is a very similar copy of the whole. Mathematicians like to call this property "self-similarity".
You don't need to go far to find examples of fractals. They can found all over nature!
$Examples of fractals$
A sea shell is a fractal. A snow flake is a fractal. A cloud is a fractal. Heck, a lightning bolt is a fractal.
So why are fractals important?
One important quality of Elliott waves is that they are fractals. Much like sea shells and snow flakes, Elliott waves could be further subdivided into smaller Elliot waves.

Here are some easy-to memorize tips that will help you to make smart pivot point trading decisions:

Pivot points are a technique used by traders to help determine potential support and resistance areas.
There are four main ways to calculate for pivot points: Standard, Woodie, Camarilla, and Fibonacci.
Pivots can be extremely useful in forex since many currency pairs usually fluctuate between these levels. Most of the time, price ranges between R1 and S1.
Pivot points can be used by range, breakout, and trend traders.
Range-bound traders will enter a buy order near identified levels of support and a sell order when the pair nears resistance.
Pivot points also allow breakout traders to identify key levels that need to be broken for a move to qualify as a strong momentum move.

Sentiment (or trend) traders use pivot points to help determine the bullishness or bearishness of a currency pair.

The simplicity of pivot points definitely makes them a useful tool to add to your trading toolbox. It allows you to see possible areas that are likely to cause price movement. You'll become more in sync to market movements and make better trading decisions.

Using pivot point analysis alone is not always enough. Learn to use pivot points along with other technical analysis tools such as candlestick patterns, MACD crossover, moving averages crossovers, the stochastic, RSI, etc. The greater the confirmation, the greater your probability of a successful trade!

Using Pivot Points to Determine Market Sentiment

There is one other way to incorporate pivot points into your trading strategy, and that's to use it to gauge market sentiment.
What this means is that you can tell whether traders are more inclined to buy or sell the pair. All you would need to do is to keep an eye on the pivot point. You could treat it like the 50 yard line of a football field. Depending on which side the ball (in this case, price) is on, you can tell whether buyers or sellers have the upper hand.
If the price breaks through the pivot point to the top, it's a sign that traders are bullish on the pair and you should start buying the pair like it's a Krispy Kreme donut. Here's an example of what happened when the price stayed above the pivot point.

In this example, we see that EUR/USD gapped up and opened above the pivot point. The price then rose higher and higher, breaking through all the resistance levels.
Now, if price breaks through the pivot point to the bottom, then you should start selling the pair like it's Enron stock. The price being below the pivot point would signal bearish sentiment and that sellers could have the upper hand for the trading session.
Let's take a look at a chart of GBP/USD.

In the chart above, we see that the price tested the pivot point, which held as a resistance level. Next thing you know, the pair keeps going lower and lower. If you had taken the clue that price remained below the pivot point and sold the pair, you would have made some nice moolah. GBP/USD dropped almost 300 pips!

Of course, it doesn't always work out like this. There are times when you think that traders are bearish on a pair, only to see that the pair reverses and breaks through to the top!

In this example, if you saw price breaking lower from the pivot point and sold, you would have had a sad, sad day. Later on during the European session, EUR/USD popped higher, eventually breaking through the pivot point. What's more, the pair stayed above the pivot point, showing how buyers were rockin' away.
The lesson here?
Traders are fickle!
How traders feel about a currency can shift dramatically day to day, even session to session. This is why you cannot simply buy when price is above the pivot point or sell when it is below it.
Instead, if you choose to use pivot point analysis in this way, you should combine it with other indicators to help you determine overall market sentiment.

Playing the Breaks with Pivot Points

Just like your normal support and resistance levels, pivot point levels won't hold forever.
Using pivot points for range trading will work, but not all the time. In those times that these levels fail to hold, you should have some tools ready to take advantage of the situation!
As we showed you earlier, there are two main ways to trade breakouts: the aggressive way or the safe way.
Either method will work just fine. Just always remember that if you take the safe way, which means waiting for a retest of support or resistance, you may miss out on the initial move.
Let's take a look at a chart to see potential breakout trades using pivot points. Below is a 15-minute chart of EUR/USD.

Here we see EUR/USD made a strong rally throughout the day. We see that EUR/USD opened by gapping up above the pivot point. Price made a strong move up, before pausing slightly at R1.
Eventually, resistance broke and the pair jumped up by 50 pips!
If you had taken the aggressive method, you would have caught the initial move and been celebrating like you just won the Super Bowl.
On the other hand, if you had taken the safe way and waited for a retest, you would have been one sad little trader. The price did not retest after breaking R1. In fact, the same thing happened for both R1 and R2!
Notice how EUR/USD bulls tried to make a run for R3 as well.
However, if you had taken the aggressive method, you would have gotten caught up in a fake out as the price failed to sustain the initial break. If your stop was too tight, then you would have gotten stopped out.
Later on though, you'll see that the price eventually broke through. Notice how there was also a retest of the broken resistance line.
Also, observe how when the pair reversed later in the day and broke down past R3. There was an opportunity to take a short on the retest of resistance-turned support - turned resistance (read that again if you have to!).
Remember that, when support levels break, they usually turn into resistance levels.
This concept of "role reversal" also applies for broken resistance levels which become support levels. These would have been good opportunities to take the "I think I'll play it safe" method.

Placing stops and targets with breakouts

One of the difficult things about taking breakout trades is picking a spot to place your stop. Unlike range trading where you are looking for breaks of pivot point support and resistance levels, you are looking for strong fast moves.
Once a level breaks, in theory, that level will likely become "support-turned-resistance" or "resistance-turned-support."
If you were going long and price broke R1, you could place your stop just below R1.
Let's go back to that EUR/USD chart to see where you could place your stops.
As for setting targets, you would typically aim for the next pivot point support or resistance level as your take profit point. It's very rare that price will break past all the pivot point levels, unless a big economic event or surprise news comes out.
Let's go back to that EUR/USD chart to see where you would put those stops and take profit points.

Placing stops and profit targets using pivot points

In this example, once you saw price break R1, you would have set your stop just below R1. If you believed that price would continue to rise, you could keep your position and move your stop manually to see if move would continue. You'd have to watch carefully and adjust accordingly. You'll learn more about this in later lessons.
As with any method or indicator, you have to be aware of the risks with taking breakout trades.
First of all, you have no idea whether or not the move will continue. You might enter thinking that price will continue to rise, but instead you catch a top or bottom, which means that you've been faked out!
Second, you won't be sure if it's a true breakout, or just wild moves caused by the release of important news. Spikes in volatility are a common occurrence during news events, so be sure to keep up with breaking news and be aware of what's on the forex calendar for the day or week.
Lastly, just like in range trading, it would be best to pop on other key support and resistance levels. You might be thinking that R1 is breaking, but you failed to notice a strong resistance level just past R1. Price may break past R1, test the resistance and just fall back down.
You should make use of your knowledge of support and resistance, candlestick patterns, and momentum indicators to help you give stronger signals as to whether the break is for real or not.

How to Calculate Pivot Points

The first thing you're going to learn is how to calculate pivot point levels.
The pivot point and associated support and resistance levels are calculated by using the last trading session's open, high, low, and close. Since forex is a 24-hour market, most traders use the New York closing time of 4:00pm EST as the previous day's close.
The calculation for a pivot point is shown below:
Pivot point (PP) = (High + Low + Close) / 3
Support and resistance levels are then calculated off the pivot point like so:
First level support and resistance:
First resistance (R1) = (2 x PP) - Low
First support (S1) = (2 x PP) - High
Second level of support and resistance:
Second resistance (R2) = PP + (High - Low)
Second support (S2) = PP - (High - Low)
Third level of support and resistance:
Third resistance (R3) = High + 2(PP - Low)
Third support (S3) = Low - 2(High - PP)
Keep in mind that some charting software plot intermediate levels or mid-point levels. These are basically mini levels between the main pivot point and support and resistance levels.

If you hated algebra, have no fear because you don't have to perform these calculations yourself. Most charting softwares will automatically do this for you. Just make sure you configure your settings so that it uses the correct closing time and price.

We here at BabyPips.com also have our very own Pivot Point Calculator!
The awesome part is, just like everything on the website, it's FREE!
The calculator can come in handy, especially if you want to do a little back testing to see how pivot point levels have held up in the past. Remember, one of the advantages of using pivot points is that it is objective, so it's very easy to test how price reacted to them.
Next up, we'll teach you the various ways in which you can incorporate pivot points into your trading strategy.

Forex Pivot Points

Are you all excited? It's your last year in junior high before you head off to high school!
Professional traders and market makers use pivot points to identify potential support and resistance levels. Simply put, a pivot point and its support/resistance levels are areas at which the direction of price movement can possibly change.
The reason why pivot points are so enticing?
It's because they are OBJECTIVE.
Unlike some of the other indicators that we've taught you about already, there's no discretion involved.
In many ways, pivot points are very similar to Fibonacci levels. Because so many people are looking at those levels, they almost become self-fulfilling.
The major difference between the two is that with Fibonacci, there is still some subjectivity involved in picking Swing Highs and Swing Lows. With pivot points, traders typically use the same method for calculating them.
Many traders keep an eye on these levels and you should too.
Pivot points are especially useful to short-term traders who are looking to take advantage of small price movements. Just like normal support and resistance levels, traders can choose to trade the bounce or the break of these levels.
Range-bound traders use pivot points to identify reversal points. They see pivot points as areas where they can place their buy or sell orders.
Breakout traders use pivot points to recognize key levels that need to be broken for a move to be classified as a real deal breakout.
Here is an example of pivot points plotted on a 1-hour EUR/USD chart:

As you can see here, horizontal support and resistance levels are placed on your chart. And look - they're marked out nicely for you! How convenient is that?!

Here's quick rundown on what those acronyms mean:
PP stands for Pivot Point.
S stands for Support.
R stands for Resistance.
But don't get too caught up in thinking "S1 has to be support" or "R1 has to be resistance." We'll explain why later.
In the following lessons, you will learn how to calculate pivot points, the different types of pivot points and most importantly, how you can add pivot points to your trading toolbox!

Like we promised, here's a neat little cheat sheet to help you remember all those chart patterns and what they signal.
We've listed most of the chart patterns, when they are formed, what type of signal they give, and what the next price move will be. Check it out!

Chart Pattern	Forms During	Type of Signal	Next Move
Double Top	Uptrend	Reversal	Down
Double Bottom	Downtrend	Reversal	Up
Head and Shoulders	Uptrend	Reversal	Down
Inverse Head and Shoulders	Downtrend	Reversal	Up
Rising Wedge	Downtrend	Continuation	Down
Rising Wedge	Uptrend	Reversal	Down
Falling Wedge	Uptrend	Continuation	Up
Falling Wedge	Downtrend	Reversal	Up
Bearish Rectangle	Downtrend	Continuation	Down
Bullish Rectangle	Uptrend	Continuation	Up
Bearish Pennant	Downtrend	Continuation	Down
Bullish Pennant	Uptrend	Continuation	Up

You also might want to add this page to your bookmarks in case you need to double-check those chart patterns' signals before you risk your hard-earned cash on a trade.
You never know when you're gonna need to cheat, hah! Bookmark this thing yo!

As you probably noticed, we didn't include the triangle formations (symmetrical, ascending, and descending) in this cheat sheet.
That's because these patterns can form either on an uptrend or downtrend and can signal either a continuation or reversal.
Like we mentioned, it's tough to tell where the price will breakout.
What's important is that you have your entry orders ready so that you can be part of the action either way!

How to Trade Chart Patterns

That's a whole lot of chart patterns we just taught you right there. We're pretty tired so it's time for us to take off and leave it to you from here...
Just playin'! We ain't leaving you till you're ready!
In this section, we'll discuss a bit more how to use these chart patterns to your advantage.
It's not enough to just know how the tools work, we've got to learn how to use them. And with all these new weapons in your arsenal, we'd better get those profits fired up!
Let's summarize the chart patterns we just learned and categorize them according to the signals they give.

Reversal

Reversal patterns are those chart formations that signal that the ongoing trend is about to change course.
If a reversal chart pattern forms during an uptrend, it hints that the trend will reverse and that the price will head down soon. Conversely, if a reversal chart pattern is seen during a downtrend, it suggests that the price will move up later on.
In this lesson, we covered six chart patterns that give reversal signals. Can you name all six of them?

Double Top
Double Bottom
Head and Shoulders
Inverse Head and Shoulders
Rising Wedge
Falling Wedge

If you got all six right, brownie points for you!
Double top

To trade these chart patterns, simply place an order beyond the neckline and in the direction of the new trend. Then go for a target that's almost the same as the height of the formation.
For instance, if you see a double bottom, place a long order at the top of the formation's neckline and go for a target that's just as high as the distance from the bottoms to the neckline.
In the interest of proper risk management, don't forget to place your stops! A reasonable stop loss can be set around the middle of the chart formation.
For example, you can measure the distance of the double bottoms from the neckline, divide that by two, and use that as the size of your stop.

Continuation

Continuation patterns are those chart formations that signal that the ongoing trend will resume.
Usually, these are also known as consolidation patterns because they show how buyers or sellers take a quick break before moving further in the same direction as the prior trend.
We've covered several continuation patterns, namely the wedges, rectangles, and pennants. Note that wedges can be considered either reversal or continuation patterns depending on the trend on which they form.
Falling wedge

To trade these patterns, simply place an order above or below the formation (following the direction of the ongoing trend, of course). Then go for a target that's at least the size of the chart pattern for wedges and rectangles.
For pennants, you can aim higher and target the height of the pennant's mast.
For continuation patterns, stops are usually placed above or below the actual chart formation.
For example, when trading a bearish rectangle, place your stop a few pips above the top or resistance of the rectangle.

Bilateral

Bilateral chart patterns are a bit more tricky because these signal that the price can move either way.
Huh, what kind of a signal is that?!
This is where triangle formations fall in. Remember when we discussed that the price could break either to the topside or downside with triangles?
Ascending triangle

To play these patterns, you should consider both scenarios (upside or downside breakout) and place one order on top of the formation and another at the bottom of the formation.
If one order gets triggered, you can cancel the other one. Either way, you'd be part of the action.
Double the possibilities, double the fun!
The only problem is that you could catch a false break if you set your entry orders too close to the top or bottom of the formation.
So be careful and don't forget to place your stops too!

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