How to Put Market Corrections to Good Use

Hi, my name is Nady Laymoud. I’m the U.S. Interest Rates analyst here at Elliott Wave International. Today’s ETV video is about how to wisely enter the market and the importance of corrective patterns.

Back when I learned about the Wave principle, I was fascinated with the impulse pattern, specifically that third wave. After all, this third wave is the meat and potatoes of the impulse pattern. It’s responsible for the most lucrative price action.

But then I started applying the Wave principle to my trading. And while identifying impulse waves is important to know when to exit a given market, I still hadn’t identified that sweet spot where I should enter the market in the first place.

That’s when I realized the importance of corrective patterns, zigzags, flats, triangles and combinations. If I studied them closely, I’d know when to enter the market. Furthermore, when to augment my positions.

For the record, I tried to follow the trend every chance that I got. So, identifying the countertrend debs is essential to that trading style. The good news is these patterns are pretty easy to find. Zigzags are the most common corrective structure.

So, let’s focus on that pattern. It consists of three legs: A, B and C. Five waves for wave A, three legs for wave B, and five legs for wave C. We see it tends towards equality with wave A. A zigzag always runs against the larger degree trend.

So in this example, the larger degree trend is up, and we see that the zigzag is unfolding in the opposite direction. Let’s quickly go through what I look for to identify a corrective pattern.

It goes without saying that identifying the trend on the timeframe of your choice is the logical first step. My primary tool here is using the Elliott Wave Principle, but you can also use trendlines, moving averages, or any tool in your trading arsenal. The advantage of using the Wave principle is to know which wave prices are tracing. This would give you an edge to know whether that trend is healthy or nearing its end.

Corrective patterns are contained within parallel lines. Most of the time you will notice that the countertrend moves are contained within a channel. Once drawn, I look for a breakout, the midline, or the boundary of that channel. Using the midline breakout is not for the faint of heart as it adds an extra layer of risk.

The third point is that the slope of wave C is less steep than the slope of wave A, which is evident in this diagram shown here. So all it takes to identify a corrective pattern are three simple points. Very simple stuff.

Now let’s view a real market example to help drive this point home. This is the 90-minute chart of the U.S. 30-year T bonds, which we cover in our Interest Rate Service, day in and day out.

Now, the first step that we discussed is to identify the trend. And we can clearly see that the trend has been up and that this pullback is a countertrend move.

Next, we draw our corrective channel. And once we can confirm that this pullback is contained within parallel lines, we can move on to our third step, which is checking whether the slope of wave C is less steep than the slope of wave A.

If we draw a line for wave A here and project that line onto wave C, we can notice that it indeed fits our criteria, as the slope for wave C is indeed less steep than the slope of wave A. All that’s left to do is wait for a break of that upper boundary here of that channel, or if you can handle the extra risk, the middle line of that channel here.

Keep in mind that in this example, at this specific stage, we have prices flirting with that lower boundary of the channel before moving back up to test that middle line. If we have taken that extra risk to enter prematurely, we would have been vulnerable to the emotional rollercoaster that accompanies trading. But knowing that we are following the trend can ease up that emotional stress that almost always accompanies trading.

My final two cents here are that the more text book the pattern is on the chart when compared to the diagrams illustrated in the Elliott Wave Principle book by Robert Prechter and A.J. Frost, the more likely the outcome that you are looking for will be fulfilled. That’s all from me today. Happy trading!