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The 1>2<3 wave count is based on a number of rules and the idea that in an uptrend there are higher tops and bottoms and in a downtrend lower tops and bottoms.
Any up or down move should consist out of minimum 3 waves.
The move starts with a wave 1.
Wave 2 is a correction wave smaller than wave 1.
Wave 3 continues the move beyond wave 1.
Mostly the smaller correction wave 2 will be a Fibonacci retracement between 23.6% and 50%.
Larger corrections retrace to the 61.8% Fibonacci retracement level or more. A retracement between 61.8% and 100% is a warning signal that price will more easy continue past a 100% retracement, changing the direction of the move.
A wave 2 retracement is valid if it does not retrace more than 100% of wave 1.
The top (bottom) of a wave 3 is considered a new wave 1 top (bottom) and therefore the start of a wave 2.
We annotate consecutive higher (lower) 3 waves with an additional number to indicate that there are more wave 3 tops (bottoms) before this one.
The first top (bottom) is called wave 3.1.
A wave 2 correction passing beyond the start of the previous wave, is the start of a trend reversal.
Past that point we assume a trend reversal and consequently we are renaming wave 2 to wave 1 (annotated 2>1) in the opposite direction of the previous 123-move.
The exception to the rule is when a new lower (higher) level 3 is reached compared to the previous wave 3 low. In that case wave 2 is renamed to 3.x (2>3.x). Meaning the previous downtrend (uptrend) is continued and confirmed with a new lower low (higher high).
In figure the wave 2 reaction for the upper wave 3.2 is first renamed to a wave 1 when the start of the upper wave 3.2 is broken. But in the rare case where price goes further down and also breaks the low of a previous down wave, it is renamed to the new lower wave 3 (here wave 3.3).
After a new wave 3 low (high) level and a valid wave 2 correction, we expect a new wave 3 with a new lower low (higher high).
If price next turns before reaching a new lower low (higher high), we renumber the expected wave 3 to a wave 2 (3>2) and logically the previous wave 2 correction to a wave 1 (2>1). Price changes from a downtrend (uptrend) to an uptrend (downtrend).
Changing the number of a wave is of course not a problem in the case where the wave continues to move in the same direction. It offers the possibility for more profit.
Less good is a normal valid wave 2 up (down) correction followed by a wave 3 that turns before making a new low (high). Probably you have an open position in the last wave 3 direction. You must change the count once there is a valid reversal detected. This will represent mostly only a small loss.
The general idea is to trade in the direction of a wave 3 (or 1) and only as an exception in the direction of a correction wave 2.
For all the basic techniques, please consult my book “Capturing Profit with Technical Analysis”, published by MarketPlace Books and available HERE
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