The major trend in every time frame takes the form of five waves (impulse wave) which, once complete, are corrected by three waves. The following is a bull market description: Wave One (1) is up and Wave Two (2) is down correcting W.1. When W.2 is finished, W.3 again moves upward followed by a downward W.4 that corrects W.3. The final upleg is labeled W.5 ending the entire swing. The corrective W.2 and W.4 normally retrace W.1 and W.3 by a Fibonacci relationship.
Wave 3 is generally the longest (price-wise) and strongest (technically) of the impulse waves. When wave 3 is the longest wave, wave 1 and wave 5 tend toward equality in both price and time. Wave 3 is never the shortest wave in terms of price. It does not have to be the longest either, but in such a case either wave 1 or wave 5 must be shorter.
The initial stages of the Wave 3 rally are slow, and it finally makes it to the top of the previous rally (the top of Wave 1). At this time, there are a lot of stops above the top of Wave 1.
Traders are not convinced of the upward trend and are using this rally to add more shorts. For their analysis to be correct, the market should not take the top of the previous rally.
Therefore, many stops are placed above the top of Wave 1.
The Wave 3 rally picks up steam and takes the top of Wave 1. As soon as the Wave 1 high is exceeded, the stops are taken out. Depending on the number of stops, gaps are left open. Gaps are a good indication of a Wave 3 in progress. After taking the stops out, the Wave 3 rally has caught the attention of traders.
Interested to get more in-depth analysis on the pattern? Please find it here.
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