Wave 2 Rule
The Wave 2 rule is one of three absolute, inviolable rules in Elliott Wave analysis. It states that Wave 2 can never retrace more than 100% of Wave 1. If price moves beyond the starting point of Wave 1, your wave count is invalidated. Period. No exceptions, no judgment calls. This makes the Wave 2 rule your most powerful risk management tool. When you enter a trade at what you believe is the end of Wave 2, you place your stop at the origin of Wave 1. If that stop gets hit, you know the count was wrong and you exit with a defined loss. The rule works because of what Wave 2 represents. It is a correction against the new trend established by Wave 1. If the correction wipes out the entire Wave 1 move, there was no new trend to begin with. In practice, Wave 2 typically retraces 50% to 61.8% of Wave 1. Retracements beyond 78.6% become increasingly suspicious and should put you on high alert. The rule applies in both bull and bear markets, on all timeframes and all instruments.
Crude oil rallies from $70 to $80 in what you label Wave 1. Wave 2 begins pulling back. You enter long at $74 (the 61.8% retracement) with a stop at $69.90, just below the Wave 1 origin at $70. The rule says if price hits $69.90, your count is wrong. Price drops to $71.20 and reverses sharply into Wave 3. Your $74 entry holds and oil rallies to $96 in Wave 3. The Wave 2 rule gave you a precise invalidation level, which kept your risk to $4.10 per barrel on a trade that eventually made $22.