Impulse Waves Explained

Although markets may appear unstructured to an outside observer, if you look closely, there is structure. Prices change patterns that tell a retailer's story through emotion of their own imbalance in action, either as a buyer or the other side, a seller. One of the most commonly used methods for creating projectable patterns is the Elliott Wave Theory. In the Elliott Wave Theory, market cycles are recognized to repeat as cycles or waves.

The Elliott Wave Theory of price movement is based on impulse waves - these directional moves that break trends from the evolution of their most simplistic start.

Have you ever wondered how or why markets exhibit movement in swings as opposed to drifting randomly? The answer is impulse waves. In this guide, we will break down the definition of impulse waves, how it is formed, the rules of impulse waves, and how traders are using them in today's real-life market opportunities. When you are finished with the guide, you will understand the topic of impulse waves to a level of personal comfort.

What Are Impulse Waves?

An impulse wave consists of a strong, trend-following move, as measured by price action in the Elliott Wave Theory. Impulse waves are comprised of five segments or sub-waves that trend in the direction of the trend. In a bull market, an impulse wave will show price climbing upward and out through this five-waving timeframe with a slight pullback in the middle.

Impulse waves occur when market psychology is firmly engaged, meaning a retail market participant's emotions are driven either up (uptrend) or comparably down (a downtrend), and prices surge upward helter-skelter to their end of a twenty-strong trend-following interval objectives, either up or down. 

Impulse waves are always compared to corrective waves, which move against the trend in smaller up and down price swings, waggling together with whiplash price movement. This relationship or dance between the impulse and corrective waves creates the recognizable rhythms we observe in market action or price movement.

The Five-Wave Structure

The main component of the impulse wave is a five-wave structure:

Wave 1 – the first short burst in the trajectory of the new trend. It is often inconspicuous, as most traders still do not believe in the reversal.

Wave 2 – a pullback that retraces some of Wave 1. However, it does not go below the starting point of Wave 1 in an uptrend (or above it in a downtrend).

Wave 3 – typically the most powerful and longest. Traders identify the trend and start trading in that direction, further accelerating the trend.

Wave 4 – the corrective phase, where recent weather is consolidated. This wave is usually small and milder than Wave 3.

Wave 5 – the last logical push in the trend direction, driven mainly by late buyers. It can extend or show some divergence in momentum indicators, showing that the move is near exhaustion.

The five-wave sequence completes one impulse. It is followed by a corrective wave (labelled A-B-C) that usually moves against the trend ahead of the next impulse.

Impulse Wave Rules

For a wave to be classified as an impulse, specific rules must be adhered to:

• Rule 1: For Wave 1, Wave 2 can never retrace 100%.

• Rule 2: Wave 3 can never be the shortest impulse wave of the three (1, 3, and 5).

• Rule 3: Wave 4 does not overlap with the price territory of Wave 1 (There are a select few exceptions in unpredictable markets).

These rules ensure consistency and avoid mislabeling price action randomly as an impulse.

Understanding Market Psychology during each Wave

Impulse waves are more than just a random set of numbers and charts; they all stem from human behaviour.

• Wave 1: A small group of market participants see an opportunity in the market, likely after a long correction.

• Wave 2: The opportunists become sceptics and pull away, allowing the price to establish a new lower high. The price did not drop completely, indicating that the stronger hands are below.

• Wave 3: Further momentum increases as even more market participants join in, creating momentum that is extremely powerful and broad-based.

• Wave 4: Traders take profits and create a base consolidation period, but the faith in the trend exists.

• Wave 5: Now we have optimism, the late-comers are now flooding in toward the opportunity, but momentum is likely starting to change, and a correction is often in the works.

Knowing the psychology of this behaviour gives traders the ability to understand and identify when an impulse wave is happening, while also understanding the sentiment that ultimately drives this forward.

Impulse Waves Looking at Bullish vs. Bearish (Trend Follow)

Impulse waves can be observed in both a bullish market and a bearish market. Here is how that will work in both ways:

• Bullish Impulse: Five waves indicating the structure is pushing prices higher, forming higher highs and higher lows.

• Bearish Impulse: A five-wave structure is pushing lower, which means that prices are pushing lower some more, creating lower lows and lower highs.

Recognizing impulse waves in both bullish and bearish trends is essential, as it provides the trader with bonus insight for both directions, regardless of price action or market conditions.

Practical Trading Applications with Impulse Waves

1. Finding Entries at Wave 3

Since Wave 3 is generally considered the most powerful wave of all, many traders build their trades to enter on the early side of Wave 3. Confirmation signals usually appear where the impulse wave breaks the previous move, like breaks above Wave 1 highs (uptrend) or below Wave 1 lows (downtrend).

2. Riding 5 Is Still Possible

Each of the impulse waves can also provide a trading opportunity, where you should be careful with that trade in any wave. The momentum of these waves tends to exhaust, leading to divergences with momentum indicators (i.e. RSI or MACD), confirming that the move has a high probability of fading.

3. Fibonacci Tools

In many cases, Fibonacci retracements and/or extensions line up nicely with the wave development. For example, Wave 2 will typically retrace to ~50%-61.8% of Wave 1, and Wave 3 usually extends to around 161.8% of Wave 1. These levels help provide entry and exit levels for traders.

4. Protect Yourself with Stops

As stated, impulse waves can fail or extend into other patterns altogether. Placing a stop loss order below Wave 1 for an uptrend (and above Wave 1 for a downtrend) helps protect your capital.

Common Mistakes When Analyzing Impulse Waves

• Forcing the Pattern: Not every fifth wave is an impulse wave. Again, if you "keep the rules clean", you will not get misread.

• Not Considering Context: Impulses are part of larger cycles. If you only focus on smaller charts, it is easy to forget about "the bigger picture" that leads to mistakes.

• Not Forgetting That Corrections Occur After Impulses: Sometimes, traders forget that it is after impulse waves that corrections will play out. If you are holding a long position in a Wave 5 trade, it is essential to watch for reversals when it begins.

Tips to Master Impulse Wave Analysis

1. Keep the Timeframe Higher - Daily or weekly decisions give more proof to impulses rather than intraday, which is always 'noisy'

2. Combine with Indicators - Indicator confluence (which includes momentum indicators) or even moving averages, in addition to using Wave analysis.

3. Be Flexible - The "Elliott Wave Theory" is interpretative - you should be prepared to change your wave count as a result emerges in price action.

4. Practice, Practice, Practice - The more you study charts, the more obvious impulse waves will reveal themselves to you.

Why Impulse Waves are Important to Traders

Impulse waves are not just an intellectual academic theory; they are practical tools that traders can employ. Impulse waves can help traders:

• Understand the trend direction prevailing in the status of the market.

• Provide appropriate entries with a sense of elevated confidence.

• Exiting safely (where congregating trend strength weakens)

• Care less about getting caught in a countertrend motion or move.

For swing traders and position traders, impulse waves can provide a structure for a trading strategy, all on their own, just the trading of impulse waves.

Conclusion: Accessing the Strength of Impulse Wisdom

In conclusion, impulse waves are the "heartbeat" of market trends; in essence, they allow a five-part breakdown of price movement, and allow traders to purposely think through the psychological analysis of impact behaviour to what constitutes buying and selling.

When traders learn to identify the Wave counts, but also combine the process rules, they will have a more rational map of what the trend behaviour in the context of the market can or will move in next. Impulse waves will never have the "absolute prediction" of price movement (no method predicts), but organize the structure and context among what often feels like a chaotic world.

Specifically, to help define a perceived opportunity if the trade is entered correctly, to manage risk when the trend weakens, and to increase confidence or trust in the trading decision process.

So the next time you have noise in your charts, opening the following chart helps in the process of defining an impulse wave; you might be surprised how it appears.