Wave 4

Wave 4 is the second corrective wave in an impulsive move. After a strong Wave 3, traders will begin to take profits thereby initiating a profit-taking correction (W4). Wave 4 can be a simple ABC (Zig-Zag) correction or a complex correction. If a correction goes past a simple ABC correction, I will just refer to it as a complex correction. I don’t find it useful sitting around and trying to put a count on a complex correction. The simple ABC Zig-Zag can be either 3, 3, 5 or 5, 3, 5 in its structure. The most common structure I see is the 3, 3, 5.

There are a couple of rules/guidelines that apply to W4′s. The principle of alternation states that if Wave 2 is a simple correction, then Wave 4 will be complex; and vice versa. The rule that applies to Wave 4 is that “Wave 4 cannot enter into the territory of Wave 1″. In highly leveraged, volatile markets like ES, some overlap is allowed by AdvancedGET (17% default), and some traders have restated the rule that “Wave 4 cannot close within Wave 1″. The most useful Fibonacci relationship for projecting the end of Wave 4 is the retracement of Wave 3. There are otherFibonacci relationships that are used, but I find these the most useful on a day-to-day basis. I like to keep things simple, so I won’t cloud the simple with a lot of trivia that I don’t use. The Fibonacci levels that I use for projecting W4 are the 38.2%, 50%, and 61.8% retracements of Wave 3.

How about a couple real-life examples of Wave 4′s. The first example is the major correction that took place in the summer of 2009. This was a large correction and was a very tradable move. As Wave A unfolded and began to look impulsive to me, I projected that we would be having a Wave B and Wave C to follow to lower lows. I projected Wave B to the tick, and I called the end of Wave 4 the day after it ended. This was all based on an understanding of the structure of a W4. All this was at a time when the trading world was in love with a H&S formation, and were calling for a market top. I called for a failed H&S based on EW analysis. A few days later I projected an extended Wave 5 that would carry to a minimum of 1126.25. That was met with a little ridicule.

Here is another archive where I make one of my successful calls based on an understanding of Wave 4. It is a larger picture of the W4 above and my actual posting where I make the call that W4 is over. The instructive part of the posting below is the rationale based on W4 guidelines that I used to make the call. The Head & Shoulder formation that everyone was talking about is obvious on this chart.

And lastly, I have an intraday chart where an understanding of W4 was useful to me in my trading. This was a classic setup for trading W5. I was hoping that W5 would “be all it could be” but unfortunately it turned into an ending diagonal and didn’t make a new low. It was still a good trade and is a very typical W4 that is worth studying.

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