Elliott Wave Basics: Trading Impulsive and Corrective Waves

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Impulsive and corrective waves occur in all markets, on all time frames, and create the price structure we see on our charts. They help us establish the trend direction, spot reversals, and can be used on a micro scale to see when the trend may be tiring out (prior to reversal) or to see when a pullback is stalling out and the price is about to start moving in the larger trending direction again.

Impulsive and corrective are terms borrowed from Elliott Wave Theory. Don’t worry if you think Elliott Wave is confusing, or if you don’t know what it is. You don’t need to understand Elliott Wave to use these concepts.

Elliott Wave Basics: Impulse and Corrective Waves

Even if you never delve further into Elliott Wave theory, the concept of impulsive and corrective waves will aid your trading. These two types of waves create the overall market structure, and therefore being able to tell the difference between them is the difference between taking high probability trades or low probability trades.

An impulsive wave is what allows trends to exists. It is a sustained move in one direction. While each bar may move up or down, overall, the price is biased in one direction.

A correction is a smaller move which occurs in the opposite direction of the impulse.

In Figure 1 the price and time scales have been deleted since our focus is on comparing one wave to another. There is an upward impulse followed by several corrective waves (all which compose one larger corrective wave). The corrective waves (individually and cumulatively) are smaller than the impulse.

Impulsive and corrective waves are fractal. That means they also occur within each other. The corrective wave highlights this well. If you were to zoom in on only that corrective wave, what would you see? You would see an impulse down, a corrective wave up, impulse down, and then impulse wave up.

This fractal nature is where these very simple concepts become powerful. For example, it is easy to spot the big impulse up in Figure 1. Since we know the price moves in an impulse-correction pattern, we may decide to wait for a pullback and then buy, hoping another impulse wave to the upside follows. That is a pretty vague plan. To fine-tune our entry during the pullback, we can watch for clues in the size of the waves during the pullback.

In the case of a corrective wave during an uptrend, a very strong drop tells us to stay away. As do very small moves to the upside (relative to moves to the downside). But what if we start to see the downward waves shrink and/or the upward waves get bigger? That indicates the buyers are starting to gain some control again, and the uptrend could resume.

You still need a strategy and trade trigger–a precise event that tells you to get into a trade–but this sort of analysis can greatly aid in trade selection and timing of trades.

While these are very simple concepts, it takes many months of practice to get good at assessing all these big and small waves. Likely you will look through the charts and see so many waves you will be overwhelmed. Spend some time tracing out the waves and trying to get a feel for how the structure of waves can help anticipate whether the corrective wave will continue, or whether another impulse is about to kick off.

Elliott Wave Basics: Trading with Waves

I am primarily a trend trader. I prefer to trade in the direction of the impulse waves.

If the last impulse is to the upside, this is the direction to trade in. The impulse shows the direction of current momentum. Impulses create trends, therefore, we want to enter on corrective waves and ride impulsive waves.

Since figure 1 shows a strong impulse wave to the upside, the correction provides an entry into hopefully another impulse wave higher.

Trends are composed of several impulse waves and a few corrections. Figure 2 shows how this unfolds.

Corrections are been circled in Figure 2. Corrections are often (but not always) composed of several corrective waves, all of which are smaller than the prior impulse. Similarly, impulse waves have smaller waves within them.

While I have given each wave a number for demonstration purposes, this is not required, nor recommended. I never number waves on my charts while trading. Don’t concern yourself with how many waves a trend has. Just trade in the direction of the impulses (some warnings signs of a reversal are given below).

Some trends have many impulse and corrective waves. Other times, you will see trends that lack follow-through; that means you have an impulse followed by a correction, but the next impulse fizzles out and then you end up with an impulse moving in the opposite direction. Figure 3 is an example of a strong trend. There are multiple impulse waves all moving to the downside, and the corrective waves in between provide favorable opportunities to get short.

Figure 3 shows a 9 wave trend, composed of 5 impulse waves down, interspersed with 4 corrections. While the corrections sometimes have multiple gyrations (or small waves) notice how all the waves in the correction are smaller than the impulsive waves. That says the trend is still intact and we want to trust in the direction of the impulse waves. Also see: Analyzing Price Action: Velocity and Magnitude.

After the 9th wave (bottom of chart) there is a strong move higher, and it breaks the high of the last corrective wave. This is an impulse wave in a new direction, and says that the downtrend may be over. We know it is an impulsive wave because it was larger than the last impulse down.

That is all well and good, but how do ranges fit into this? Price ranges, and other chart patterns such as triangles, are simply more complex corrections composed of many corrective waves. If you change your timeframe you’ll likely see the range or triangle is just part of a larger impulse, correction, impulse… structure.

You can also compare the current impulse to prior impulses to gauge the strength of the trend. In Figure 3 the last impulse wave down barely makes a lower low before stopping and then moving higher in a corrective wave (which turned into an impulse higher). That final impulse lower was smaller than the prior impulse waves which had no problem moving the price down to lower and lower levels. Therefore, that small impulse wave near the bottom of Figure 3 indicated the downtrend may be out of steam, and a reversal–which did occur–was probable.

• Fibonacci Retracements can help you find entry points in corrective waves/corrections,
  and
• Fibonacci Extensions can help you isolate where to take profits during the next impulse wave.

While some people find these tools useful, they are not required. The price tells us everything we need to know.

An uptrend can’t start without an impulse. And it is often forecast by impulse waves to the downside getting smaller or weaker (but not always, sometimes you have a drop, and then a bigger rally ensues…but in either case, the price tells us the uptrend is in play).

A downtrend can’t start without an impulse. And it is often forecast by impulse waves to the upside getting smaller or weaker (but not always, sometimes you have a rally, and then a bigger drop…but in either case, the price tells us the downtrend is in play).

Trends Change Quickly

Let’s dig deeper, and see how impulse and corrective waves can be used in the real world.

One of the biggest problems I see is that people get hung up on the word “trend” and think they should only be buying, for example, when the price is making multiple beautiful upward impulse waves in a row. While this is fine, this concept of a trend is severely limiting. In the Strong Trend Reversal Strategy, I show how one wave can reverse a trend. If that trend reverses, we have a new trend direction and can start trading in that new direction during the next correction.

Since we can’t know when the price is going to get choppy, or lack follow through, being able to spot new trends very quickly is important. Sometimes we only get that one trade before the trend fizzles out.

Here is a portion of a recent day trading day.

On the left is a strong uptrend. The arrows represent my entry point (bottom of arrow) and original target (top of arrow). Arrows are often slightly to the left of my actual entry bar (so they don’t obsure my entry bar when to look back and review my charts). Small blue horizontal lines represent my actual exit; if there is no blue horizontal line then the actual exit is the arrowhead. The + or – numbers represent the number of cents (or pips) made on the trade. I typically use the same position size for many of my trades. Therefore, X1.5 or X2 means I took 1.5 or 2 x my normal position size (because the stop loss was smaller than normal for the trade).

Initially, there is a strong uptrend. Impulse up, sideways correction. A long trade is taken on the breakout of the sideways correction and another impulse follows.

The next trade is a short, and an advanced trade. It was taken because of the potential for a further move down. But, it failed to materialize and when the price started moving back up I flipped the position and went long…twice. I went long the second time (+9) because I could move the stop loss of my first position up. The price stalled just before my target so I got out a bit earlier than my target.

The next two trades are the interesting ones. Most trend traders wouldn’t trade them…and they are missing out.

Prior to the short 18×2 trade, notice how the up waves have been getting progressively smaller. The wave of the +9 trade barely got above the prior high. Then the price flattened out. It tried to push one more time and then failed. This was followed by a sharp red bar which dropped below the low of the last three price bars. While overall the uptrend was still in play, this was an opportunity to take advantage of some short-term weakness. [While the 18×2 arrow appears below the first big red bar, the trade was actually on the next big red bar when it broke the low of that first red bar. The arrows simply moved over so I can see all the bars clearly when I go back to review my charts.]

The price did fall, and erased the entire last up wave. When that happens, it signals the uptrend is likely over. Uptrends are composed are higher highs and higher lows. Once the price fell back to the prior low, we no longer have higher lows. Combine that with the price making weaker and weaker movements to the upside, and we have another potential short trade setting up. As you may notice, I like trading consolation breakouts (most of my trades are some variation of this). The price breaks a consolidation and a short is taken leading to the +18 trade. Once again, a second trade is taken as the price compresses again and I am able to drop my stop loss on the first short trade. Price hits my first target and just misses the second, so I get out at the first target on the second position as well.

Trading decisions can’t be stuck in the past. Sometimes one sharp move, or a false breakout, tells we need to act. We need to be nimble and willing to adapt to a new outlook (if required) as each wave unfolds in real-time. Many traders would be so focused on the uptrend–stuck in the past–that they would completely miss the warnings signs that the trend was fizzling out. Even fewer traders would have capitalized on the decline, which the price action was already telling us was in play.

All these trades were almost entirely based on waiting for a consolidation breakout, combined with simply looking at the size of waves (and a lot of practice!). No indicators needed, just the price waves themselves. It certainly takes practice, but it is a skill worth developing. No matter what the market conditions are, use your analysis of impulse and corrective waves to make better trading decisions.

Below is a simpler day. Notice how the initial down move was completely erased by the next up wave. The bias shifted to taking longs. The price stalled out a couple times (tried to move higher but couldn’t…small waves in our trending can be a warning sign) so I got out of my first long. Ultimately the price did continue higher, but at the time I got out momentum had stalled so getting out was a reasonable decision. Holding it would have also worked out very well and target would have been hit; the trend was still up but momentum had stalled so it is a judgement call. We never know what price will do, all we can do is gather evidence for what it is likely to do. We don’t need to win every trade to be profitable.

On the next trade, the uptrend was well defined and this is a classic trade setup. The price hit my full target but it stalled for about three bars just below it, so I actually exited slightly below my initial target. This is followed by a sharp down wave which is bigger than the prior up move; that’s a reversal. Waited for the next pullback and then we have a nice break to the downside. Another classic trend trade. If we pay close attention to price action, it tells us what to do.

Elliott Wave Basics: Final Word

Prices move in a structured way: impulse, correction, impulse, correction, impulse, etc. Sometimes when this structure isn’t clear, it helps to switch to a longer time frame. This will allow you to see if the asset is possibly within a larger complex corrective pattern (a combination of corrective waves) which is why the structure is not very clear on the time frame you were watching.

Trade in the direction of the impulses until there is a reason not to. Reasons to avoid trading in the direction of the impulses include:

—Impulses are getting smaller and smaller, indicating lack of momentum and a possible reversal.

—An impulse in the opposite direction occurs, which means you’ll start looking for trades in the direction of the new impulse.

This does not necessarily mean you are in a trade at all times. You don’t want to be trading every price swing. If the price structure is not clear, step aside until it is.

No wave counting or complex theories are needed. Identify impulsive waves by their strong movement, and corrective waves by their relatively smaller movements.