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EURUSD: What Do You Do When FX Markets "Break a Rule"?

Elliott wave analysis has only three hard-and-fast rules. But just how “hard-and-fast” are they?

by Vadim Pokhlebkin
Updated: August 17, 2015

Elliott wave analysis has only three rules:

  • Wave 2 can never retrace more than 100% of wave 1
  • Wave 3 is never the shortest, and
  • Wave 4 never ends in the price territory of wave one:

Beyond these rules, there are many guidelines for wave formation. But a guideline is just that -- a guideline, while a rule is... well, something you cannot violate. Or can you?

Jim Martens, editor of our Currency Pro Service, got this question from one of his Twitter followers:

"IMO, in the real world of #elliottwave with human traders 'wave 4 lightly overlapped ...wave 1' is reality, not a violation."

The reader was referring to Jim's August 13 tweets about a possible wave 4/1 overlap in his EURUSD count:

EWI Forex Insider @FX_ElliottWave [Aug 13]
If $EURUSD rally yesterday was wave 3, then today's drop is wave 4. But then wave 4 lightly overlapped top of wave 1, an EW rule violation.

EWI Forex Insider @FX_ElliottWave [Aug 13]
But USDX is not showing this overlap. EUR is 57% of USDX; they are highly correlated. This non-confirmation keeps us looking up in the EUR.

Here's that EURUSD chart, from August 13 (copied from our Currency Pro Service, partial Elliott wave labels shown):

So, what do you do in a situation like that -- when there appears to be an Elliott wave rule violation on one chart (EURUSD, above), but on a chart of a highly correlated market (U.S. dollar Index, not shown) the same violation is not visible?

Here's Jim's answer:

Good point. Wave 4/1 overlaps do happen in forex, especially on short-term charts. And even Frost and Prechter's "Elliott Wave Principle -- Key to Market Behavior" (the “Elliott wave Bible”) says this:

"In an impulse, wave 4 does not enter price territory of (i.e., ‘overlap') wave 1. This rule holds for all non-leveraged ‘cash' markets. Futures markets, with their extreme leverage, can induce short term price extremes that would not occur in cash markets."

However, the book goes on to say:

"Even so, overlapping is usually confined to daily/intraday price fluctuations and even then is rare."

So overlaps are indeed rule violations and are always a red flag, even if the market "disregards" them and stays on its Elliott wave path.

Or, as Bob Prechter once put it,

"Application of the Wave Principle is an objective discipline. For this reason, only rigorously honest interpretations can be accepted as valid. If you want your hopes or whims fulfilled regardless of the evidence, the market will punish you for that weakness."

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