Perhaps the most popular trading theories among retail Forex traders, the Elliott Wave Theory has its roots in human behavior. While the theory goes back in time, it is nothing new to our days. Crowd behavior fascinated researchers for many years. People have a strong tendency to react the same way when specific conditions met. Elliott found the market did the same. After all, the market moves as a result of human behavior. If there are more buyers than sellers, and the volume is bigger, the market will rise. The opposite, of course, is true as well. As such, Elliott Found itself in the ingrate position to develop a theory that filters the market moves. In doing that, we established a set of rules to guide the analytical process. After all, the Elliott Waves Theory is nothing but an analytical process. Any trade that might result at the end of it is the result of a logical decision.
Elliott started with acknowledging that the market moves in cycles. This is visible to our days to. All trading platforms allow traders to use different time frames for their analysis. Virtually, these represent different cycles. Elliott split them in a top/down process, a so called top/down analysis process. As such, notions like a super cycle and a grand cycle appeared. Furthermore, Elliott divided the moves the market makes into impulsive moves and corrective moves. He laid down rules for both.
However, the main question an Elliott Wave trader must answer is if a move is impulsive or corrective. From that moment on, if the trader can answer it, the analysis goes to the rules and behavior expected for that type.
Corrections with a Large X-Waves
Corrective waves are more common than impulsive ones. This is normal. When an impulsive wave forms, the market trends. The problem is that trends do not form that often. As such, traders get caught in labeling corrective waves. This is true on the Forex market too. While the Elliott Waves Theory was developed on the stock market many decades ago, it rules still represent the best way to portray human behavior in financial markets.
Elliott further split corrections in simple and complex ones. Moreover, the complex ones, in two categories: corrections with a small and with a large x-wave.
Before offering more details, we should mention what an x-wave is. This is still a corrective wave. However, its purpose is to connect the two or three simple corrections. Together with the simple corrections, the x-wave/x-wave’s form a complex correction. Elliott made a clear distinction between different complex corrections based on the length of this x-wave. The x-wave is also called an intervening or a connecting wave. Based on how much it retraces into the previous correction’s territory, Elliott made the distinction between corrections with large or small x-waves.
As a rule of thumb, corrections with a large x-wave see it retrace beyond 61.8% of the first simple correction. You should know by now that Elliott Waves Theory is built almost entirely on different Fibonacci numbers and ratios. The golden ratio (61.8%) plays a central role. Everything depends on what the price action will be around it. In fact, it is the most important ratio/level in all aspects surrounding us, not only when trading the currency market. However, in a correction with a large x-wave, the intervening wave can go way deeper in the territory of the previous simple correction. It can reach levels difficult to imagine for the ones not familiar with this trading theory.
This is one of the most difficult concepts to grasp. The conventional wisdom calls for a correction to end into the territory of the previous wave of the same degree. For example, let’s take an impulsive wave. This is a five-wave structure, labeled with numbers: 1-2-3-4-5. But, all those numbers represent different waves of a lower degree. The 1st, the 3rd and the 5th ones show impulsive activity. The 2nd and the 4th, corrective activity. Typically, Elliott Waves traders wait for the 2nd wave to retrace into the 1st wave’s territory. Then, they look for the market to reach the 50% or even 61.8% levels. As such, the conventional wisdom is that the 2nd wave must end in the 1st wave’s territory. However, that is not true all the time.
Sometimes, the 2nd wave ends beyond the 1st wave’s end. In a bullish impulsive wave, it literally means the 2nd wave ends higher than the 1st one. How is this even possible? The answer comes from the large x-wave. When this happens, not only that the x-wave retraces more than 61.8% of the first correction part of the 2nd wave, but it goes much higher.
Traders call this a running correction for the 2nd wave. This is a very dangerous concept. The problem for many traders comes from the fact that the 161.8% extension should apply from the end of the 2nd wave. Hence, from levels higher than the end of the 1st wave. This is one reason why most of the retail traders fail. They simply fail to understand the importance or the mere existence of a running correction. Hence, the mere existence of a correction with a large x-wave.
Corrections with a large x-wave form more often than people think. While some may be running corrections, other will be classical ones. In any case, the x-wave must retrace beyond 61.8% of the previous first correction. That’s mandatory. If not, the market forms a complex correction with a small x-wave.
One thing is for sure, in all corrections with a large x-wave. The price action that follows forms the extended wave in an impulsive move. Or, the extended correction, if that’s the case. The more time the price spends consolidating in such a correction, the more powerful the move that follows will be. In a way, they are directly proportional, even if the market forms a running correction.