Introducing Elliott Waves Theory
Elliott Waves theory is one of the most subjective trading theories of them all. However, it is one of the most exact in the sense that it offers a trader the possibility to play with different scenarios.
What does this mean? Well, it means that by doing a top down/analysis, starting with the bigger time frames and coming down to the ones that we can actually trade, the trader is confronted with clear situations in which those scenarios are being validated or not.
In the end, the real one survives and we can heavily trade into that direction. If it is a bullish scenario, we should trade call options, and if it is a bearish scenario, we should trade put options.
One of the way to differentiate if a specific move is an impulsive one or not is to use the 2-4 trend line in an impulsive move.
This means that we should effectively draw a trend line from the end of the 2nd wave and drag it all the way to the end of the 4th wave and projecting it also beyond.
How to Draw the 2-4 Trend Line?
The ability to draw the 2-4 trend line implies the trader knows where the second and fourth waves are ending and this is possible to know only if after the 4th wave is completed. It is strongly recommended to look at the alternation principle to be respected, I mean the alternation between the two corrective waves, and it is being said that they should differ in at least one of the following: complexity (meaning one should be a simple correction and the other one a complex one), distance traveled by price (in the first case from the end of the first wave until the end of the second one, and in the second case from the end of the third wave until the end of the fourth one) and, last but not least, structure (composition of the two corrective waves should be different).
That being said, the next thing to take into account is that corrective waves are not always ending at the highs or at the lows as they can end, for example, with a triangle or with a flat that has a failure (it means wave c is failing to break the lows/highs in the previous wave a). In both cases, the correction is not going to end at the high/low of the whole wave but for drawing the 2-4 trend line we must know exactly where the waves are ending.
Implications on the Third Wave
As a rule of thumb, it is not acceptable that the third wave is breaking the 2-4 trend line and if this is happening than the move you are seeing and analyzing is not an impulsive move. Impulsive moves should be as clean as possible and the 2-4 trend line as well.
Moreover, by the time we can draw the 2-4 trend line it means that the impulsive move is almost completed and the 5th wave is most likely in place or about to end. Judging by how market is moving after the 2-4 trend line is broken we can assume the next step and have an educated guess if the impulsive move was part of a bigger degree five wave structure or it was wave c of a flat pattern.
Depending on which one is the extended wave in the original five wave structure, we know what to expect for price action after the 2-4 trend line is broken.
In a first wave extension, by the time the 2-4 trend line is broken (in this case market will have the shape of a wedge) we should look for 50% retracement of the whole wedge. If the wedge has overlapped between the second and the fourth waves, it means the whole wedge eventually will be completely retraced.
It is worth mentioning that in the above situation it is common for price to retest the 2-4 trend line after the break but that is not mandatory.
Finding Dynamic Support and Resistance
If market is forming a third wave extension, then the 2-4 trend line offers the possibility to find dynamic support or resistance and, depending if the move is bullish or bearish, call or put options can be traded as well.
The way to go is to copy the 2-4 trend line and paste it over the end of the third wave. The resulting channel should see the price action to come finding resistance in a bullish impulsive move, so put options can be traded, or support in a bearish impulsive move, so call options can be traded.
More about what an impulsive move really is and how to interpret the 2-4 trend line in all possible extended situations are to be found by watching the two video analysis that are coming with this article as it is crucial to understand how a five wave structure is affecting the overall price action after the 2-4 trend line is broken.