Do you have problems with actually trading wave patterns?
The Elliott Wave theory might sound logical on paper but remains difficult to use for actual trading purposes – unless you had read our first article which explains practical ways of trading waves.
This second part explains how traders can understand patterns and Fractals for a deeper understanding of the market structure.
Discover how to finally understand concepts such as: path of least resistance, Fractals, Chaos Theory, energy, gravity, price patterns and much more.
P.S. Don’t miss out the summary of the article and video at the bottom.
Step 1: Systematic Approach for Spotting Price Swings
The first step towards understanding wave patterns is a systematic method for identifying price swings – the start and end of such swings.
Wave patterns are nothing more or less than a sequence of price swings, which can either be corrective or impulsive (more later on). Wave analysis labels those swings with numbers and letters, which add a “story” to the chart. But before traders can add labels and determine the next swing, they need to correctly define what is a price swing (wave).
Traders can spot price swings by for instance analysing candle highs and lows. Multiple candles pushing in one direction is momentum whereas a chart pattern such as a flag often indicates correction.
The ecs.SWAT method uses four distinct approaches to find the price swings:
- ECS Fractals
- Awesome Oscillator (AO)
- Momentum and correction
Momentum and Correction – HMA
All price swings are either impulsive or corrective:
- Impulsive price action means quick and one directional price action.
- Corrective price action means slow and choppy price action.
Usually impulsive price action belongs to one price swing whereas corrective price action belongs to one bigger price swing as well.
For instance, a strong bearish fall is often one price swing on its own right… Whereas a bull flag correction is considered to be a seperate and corrective price swing.
The HMA moving average helps identify what is momentum and what is correction.
Price action at the top is corrective, the price drop is impulsive.
The ecs.SWAT method also uses the AO (Awesome Oscillator) for spotting price swings. We analyse the AO bars that move from and back to the zero line for that purpose:
- AO bars moving above the 0 line and back is one bullish price swing.
- AO bars moving below the 0 line and back is one bearish price swing.
The fractals help traders find key turning spots on the chart. If price is moving fast into one direction then no fractals will appear, which is an impulsive price swing.
If many support and resistance fractals appear, then price is building corrective price swing(s) because price is turning up and down – hence creating the fractals.
Step 2: Understanding Wave Pattern Context
Labelling waves does not make sense before you are able to identify a) the price swing, b) the rough start and end spots of each price swing, and c) momentum and correction swings (see step 1).
Once you have experience and practice with identifying price swings, only then does it make sense to move on by adding wave labels (numbers and letters) to these price swings.
Unfortunately, many traders do the reverse: they label first and enter setups based on their wave counts, but then give up quickly when things go wrong (no wonder if there is no experience). Sufficient education and training is key.
In principle, wave analysis is nothing more or less than identifying and labelling price swings and patterns. Simply said, its an educated assumption about direction.
Impulsive and correction price swings are like building with Lego pieces. Sooner or later, we will connect the dots and see the bigger picture unfolding on the charts.
Purple boxes represent consolidation zones (corrective/choppy price action), green arrows show bullish momentum, orange arrows show bearish momentum.
Fractals and Chaos Theory Explained
The market moves in waves and patterns (visible for everyone who sees a chart), which repeat in a similar way over time (they repeat) and on larger and smaller time scales (they are fractal).
The fractal nature of the financial markets is in many regards similar to the fractals found in nature, music and shapes such as the sea costs, music notes, and the shape of a snowflake.
These things appear chaotic and random but they are actually more organized then we expect, which is what Chaos Theory explains.
Chaos Theory explains that traders can understand the financial charts in a more advanced way when they are able to understand, recognize, read and interpret patterns.
Simple said, patterns tend to repeat themselves. The financial markets are not (as) well understood when applying linear mathematics but make much more sense when analysing chart and price patterns via the primism of Fractals and Chaos Theory.
Path of Least Resistance
Charts build impulsive and corrective price swings that follow the path of least resistance, which means that:
- Impulsive price action tends to break weaker support or resistance.
- Corrective price action tends to respect stronger support or resistance (S&R).
The interplay between S&R and momentum creates a path. Keeping this formula in mind allows traders to understand what is the path of least resistance for each financial instrument and chart.
Here below you can see how I applied the path of least resistance to the USD/JPY on 8 June 2018. I expected that price was completing a wave X, a downside for wave Y of wave X (purple), and then a bullish bounce and upside continuation as part of wave Y.
Four days later, the chart looked like this. The chart fully followed my expected path of least resistance. Of course, price will not always behave so nicely. But these concepts allow traders to build a path of least resistance. We need to monitor whether price will follow this path.
This path of least resistance depends on energy (impulse) and gravity (counter trend back to mean or average). Strong momentum will create energy but once price impulse slows down, price will return back to the mean and average. This is why moving averages are a key factor for charts.
Image showing SWAT method and how price neatly respects moving averages.
Patterns and Expected Price Path Remain Probabilities
There is no guarantee whether price patterns and expected path of least resistance will actually unfold as traders expect. The ability to understand the charts in a deeper way via patterns does not mean that traders can forecast the future. They can only assess the probability of each step along the way and adjust accordingly when new information is available.
New information could eventually lead to a change of the probability that your analysis plays out as expected: the setup could become more probable (confirmation), less or zero probable (invalidation) or remain the same.
Simple said, nothing is guaranteed, all patterns and setups are mere probabilities.
The change of patterns could be similar to what is called ‘Wave function collapse’ in quantum physics. This concept explains how probabilities change when patterns develop.
Step 3: Finding Trades in Patterns and the Path
Trading the waves takes experience. But if you break the down the core of waves into understanding patterns and swings, the learning curve will be become shallower. Your learning curve will also become shorter if you apply our ecs.SWAT method which simplifies waves and patterns in learnable, applicable and tradeable approaches.
The most difficult part is identifying the correct pattern and understanding when the patterns are likely/looking to break down. Once you can identify it, then you can trade it.
The patterns create a trading bias. But you need a bias to trade. Trading without any bias will mean lack of commitment to the trade. Many traders also trade based on a ‘false’ bias, which is based on feelings of fear.
Traders must trade based on a solid bias which is based on experience with patterns. A strategy is preventing a trader from entering a trade when your forecast proves to be incorrect.
Elite CurrenSea teaches you via its ecs.SWAT system how to read the charts, patterns, ups and downs. It is the same as reading a chart of the terrain. It takes time and dedication to learn.
The chart is our road map.
- Understand the importance of identifying price swings
- Understand how to find start and end of price swings
- Recognize price swings via AO, Fractals and momentum and correction
- Price swings are either impulsive or corrective
- Labelling price swings / waves only makes sense once you can identify swings
- Wave analysis is nothing more than identifying and labelling price swings and patterns
- The charts are fractal of nature, repeating in history and on all time scales
- The fractal nature of the charts is part of Chaos Theory, which explains that traders can understand the financial charts in a more advanced way when they are able to understand, recognize, read and interpret patterns – patterns repeat
- The chart is a continuous battle between energy (impulse) and gravity (price back to mean and average)
- Price, charts, financial instruments follow the path of least resistance, which is based on repetitive impulsive and corrective patterns (Fractal/Chaos Theory)
- Patterns can change, which is based on the ‘Wave function collapse’ from quantum physics
- The probabilities of patterns playing out can change depending on new information
- The most difficult part is identifying the correct pattern and understanding when the patterns are likely/looking to break down. Once you can identify it, then you can trade it.
- The patterns create a trading bias. But you need a bias to trade. Trading without any bias will mean lack of commitment to the trade.
- Base your bias on patterns
- The chart is our road map
Many green pips,