With Elliott Wave Theory, traders have a method for reading the rhythm of the market. Elliott discovered in the 1930’s that price action on a chart is not random; it is a chain of repetitions of emotion-driven, collective human behaviour. It is common knowledge among traders that a five-wave impulse sequence and a three-wave corrective sequence comprise the basic structure of the Elliott Wave. 

However, there is also a pattern that occurs at the very beginning of any significant trend, and this pattern is not widely understood–the leading diagonal Elliott Wave. 

This guide will provide you with an overview of what leading diagonals are, the psychology behind them, and how to identify and trade them. Whether you are just starting to learn about the Elliott Wave or you’ve been following this discipline for years, please make sure that you can properly identify leading diagonals in your analysis.

What Is a Leading Diagonal? Definition and Core Structure

A Leading Diagonal forms at the very beginning of a new trend and consists of five waves. The pattern itself does not resemble what we would expect to see from a regular impulse wave, as it consists of a contracting wedge shape that connects wave highs and wave lows through Trend Lines that eventually converge. 

One of the key ways to identify a Leading Diagonal as opposed to an impulse wave is that waves 1 and 4 overlap, as opposed to the prohibition of wave 1 and wave 4 overlapping in an impulse wave. The overlap in a Leading Diagonal is a key characteristic of the pattern and not a mistake or some sort of mistake in your count.

The best way to describe a Leading Diagonal is to think of it as a compressed spring. The market will be exhibiting overlapping price actions, with either buyers or sellers attempting to take control of the prevailing price action. During this period of time and the construction of the wedge, one group is making incremental progress toward control and eventually takes over.

Leading Diagonals have a distinct characteristic of defining a new trend in contrast to defining an extension of a current trend. This distinction is significant in terms of the application of trading strategies.

The 5-3-5-3-5 Internal Structure

The specific details of a leading diagonal pattern are also what make it different from an impulse wave. Even though many novice analysts may be able to "spot" a lead diago, it takes both an understanding of wave counting and knowing how to count sub-waves.

The sub-wave count in a lead day follows a 5-3-5-3-5 sequence. Wave 1: 5 sub-waves. Wave 2: 3 sub-waves. Wave 3: 5 sub-waves. Wave 4: 3 sub-waves. Wave 5: 5 sub-waves. When looking at a conventional impulse wave, the sub-waves are counted as follows: 5-3-5-3-5, but with rules preventing any overlap and longer 3rd waves.

Because the compression in a lead diago continues into the final leg, the waves are generally similar in magnitude due to their compressed nature.

Many of the leading diagnostic structures had 5 lesser waves within them. On the late 2022 ETH chart before the 2023 strong rally began, the structure had 5 small waves moving to the high and were overlapping and coming closer together in a rubber band manner to explode after the end of the 5th wave.

If you are counting waves, and you notice the down wave 1 and up wave 4 are overlapping, and of the contracting shape, look at the sub-wave count before you reach any conclusions. When counting a lead diago, the necessary 5-3-5-3-5 composition has to be there.

Position Counts When It Comes to Wave Count

The leading diagonal can occur only in 2 locations: Impulse Waves 1 or A. If you see what looks like a leading diagonal, and it is located in either Wave 3 or 5, then it is not a leading diagonal.

Identifying the correct position is half the health of the market. A leading diagonal in the wrong location alters the directional bias the market is providing and does not indicate a good trade.

The leading diagonal that occurs in Wave 1 of an impulse structure is the beginning of an entirely new impulse move. A leading diagonal appearing here occurs at a time when the previous downtrend has finished, and the market creates a hesitant history of the previous downtrend before accelerating with the new uptrend.

The interpretation of a leading diagonal appearing in Wave A of a corrective structure differs from the interpretation of the leading diagonal appearing in Wave 1 of an impulse structure. The leading diagonal formation in Wave A suggests that the broader trend is only pausing, potentially to begin corrective action, rather than to originate a new primary trend.

You can think of the leading diagonal formation in Wave A of a corrective structure,e analogous to how you would think of the first chapter of a book. The first chapter of a book will determine what type of story you are reading. The opening of a new uptrend could either occur during the first chapter of the book or during the first chapter of a temporary retracement of a larger downtrend. 

The leading diagonal alone will not provide you enough information to determine whether the leading diagonal in Wave A of a corrective structure represents the beginning of a primary trend or an interim position of the market. The larger wave context will determine this. 

The Psychology Behind

Markets form patterns as a result of psychological processes and experiences of those involved in the financial marketplace. Understanding the psychology behind the formation of a leading diagonal gives one insight into why the pattern is more intuitive than many may anticipate.

Traditionally, when a big move down occurs, creating a clean transition from one trend to a new trend takes some time. Smart money begins to accumulate, but because of the prior major downward trend, retail traders are left with memories of the pain consequent to the preceding move. As such, they wonder if the previous trend has turned into a new trend, or if this is just another temporary rebound.

Because of this tension surrounding the transition, you have overlapping price action. In Wave 1, buyers will push the price higher, just not as strongly as one would expect from a true impulse wave. Wave 2, sellers push the price back down, and the market pulls back down again to re-establish the prior Wave Level. 

In Wave 3, buyers attempt once more to push prices higher than they did in Wave 1, but once more lack the volume needed to meet impulse level. Wave 4, prices pull back to retake the level reached in Wave 1. The price action in Wave 4 overlaps with the price after Wave 1 appears to be another representation of indecision in the market.

By Wave 5, one side of the trade has made its case, and the accumulation has ended, the weak hands have been shaken out through the erratic overlapping price action, and the large directional move that follows the diagonal will commence.

An excellent example of the leading diagonal is seen through the movement in the crypto marketplace. As the sentiment in the crypto marketplace evolves, it creates large fluctuations. The accumulation phase for BTC before a large amount of purchasing activity has always exhibited some sort of compressive wedge with overlapping price movement, thereby frustrating both buyers and sellers as they wait for the trending move.

Where You Will See It: Crypto, Forex, CFDs

While the leading diagonal is a pattern exhibited across every liquid cash and futures market, the clearest examples of leading diagonals occur in futures markets where emotions dominate decision-making. The crypto market continuously provides us with that emotional investment. 

The swings in sentiment in crypto will typically be substantial, as well as the reversal of securing profits to the magnitude of the original trend, and when you recognise them clearly for the leading diagonals created through compressive wedges, you will be provided with clear examples within the crypto marketplace.

In the foreign exchange marketplace, or forex, the leading diagonals are frequently created in major currency pairs, i.e., EUR/USD and GBP/USD, which are at significant turning points, particularly after lengthy trends are broken as a result of major macroeconomic events. This is due to the collective FX marketplace reassessing the new direction of that particular currency pair.

In the CFD marketplace, the leading diagonal is the increasingly common pattern that is seen at the onset of recovery rallies following significant sell-offs, for example, oil recovering from a cycle low, the bottom of an equity index market following a bear phase. Thus, one should notice a compressive five-wave structure; the market will then transition to the new directional trend.

The overall market confirmation for all of the aforementioned trades constitutes volume confirmation. The fifth wave of a legitimate leading diagonal will complete all five waves and present declining volume as the wedge compresses; at the point at which the price breaks through the upper price trendline of the diagonal, it will provide a notable increase in volume, thereby confirming that the unequal accumulation phase has concluded.

How to Actually Trade It

The leading diagonal is the most common mistake that a trader makes when entering a leading diagonal too early. The structure is still in formation, and the wedge has not completely converged, and it is very tempting to enter the market before wave 5 completes. The leading diagonal is an entry point for the pattern, not a signal.

A breakout from the leading diagonal will give you your signal.

Here are the steps:

1. Wait for the trendline to break. The trendline connecting the highest points of both wave 1 and wave 3 will provide you with an entry point. 

2. Once the price has closed above that trendline going forward, you will have the trigger you need to enter.

3. Confirm your breakout with volume! A real breakout from a leading diagonal will show you that volume is confirming the price has broken above the trendline. Thin volume breakouts will more than likely fail.

4. Place your stop below wave 5 (for the bullish set-up) once the breakout occurs. If the diagonal is valid, you should not return down to wave 5 low once the breakout occurs; if you do, your count was wrong.

5. Your initial target is the starting point of the diagonal (wave 1). Your 2nd target would be wave 3 or wave 5 impulse moves to a greater degree from the diagonal.

6. The risk/ reward ratio using a leading diagonal is attractive because your stop loss is below wave 5 low with a potential upside target way above the breakout of the leading diagonals; thus, a good risk/reward ratio.

Common Mistakes to Avoid

A regular wedge pattern will be confused with a typical falling wedge, which could be a continuation and/or reversal pattern. However, a typical falling wedge does not typically have a strict 5-3-5-3-5 internal structure. If you do not count sub-waves, what you see is just a wedge and a leading diagonal. 

Getting the position of the leading diagonal in Wave 3 is a totally different animal. Leading diagonals will be found only in Wave 1 or Wave A. You should always step back and figure out where in the overall count the leading diagonal sits.

When the place is an entry in the Wave 4 pullback, the Wave 4 pullback may be retracing to a very high level because it allows for overlap with leading diagonals and could easily prompt you to enter before the pattern is confirmed. When Wave 5 finishes, you should only enter after Wave 5 and then only after the breakout of Wave 5.

The leading diagonal shows that the next wave up is starting, but this does not give you an indication of how strong the move may be. If you zoom too far in, you may be trading a leading diagonal in a very small area of one of the minor corrective waves down, while the overall trend is still down. Use the larger time frames before you go to the smaller time frames.

The leading diagonal is very choppy and can create the illusion of a trading range. Buying and selling based on smaller time frames can lead to loss of commissions instead of realising the breakout as the trade will be.

Both the structure and the position must be correct for identification. If you only have one or the other, it will be an inaccurate identification.

FAQ

What is a leading diagonal Elliott wave? It's a five-wave structure that appears at the start of a new trend (Wave 1 or Wave A). It forms a contracting wedge shape with a 5-3-5-3-5 internal composition, where Wave 1 and Wave 4 overlap. The pattern signals the beginning of a new directional move, often after a major trend reversal.

Is the leading diagonal bullish? In the context of an uptrend, yes. A bullish leading diagonal in Wave 1 signals the beginning of a new upward impulse. The breakout from the upper trendline typically leads to a strong Wave 3 advance. In a bearish context, a leading diagonal can appear at the start of a downtrend in a similar fashion.

Where does it appear in Elliott Wave theory? Only in Wave 1 of an impulse sequence or Wave A of a corrective sequence. These are the only two valid positions. Any other placement means you're looking at a different pattern.

How do you confirm a leading diagonal? Three things need to align: the 5-3-5-3-5 sub-wave count, the Wave 1 or Wave A position in the larger count, and a confirmed trendline break with volume expansion. All three need to be present before acting on the setup.

Can a leading diagonal appear in crypto markets? Absolutely. It shows up frequently in crypto because of the sharp trend reversals and high emotional participation in these markets. Bitcoin and Ethereum cycle tops and bottoms have repeatedly featured this structure before major moves in either direction.

It's not easy to accurately identify the leading diagonal Elliott wave pattern due to its difficulty. That's what makes it valuable. When a genuine leading diagonal Elliott Way pattern confirms with correct sub-wave counts, is located correctly, completes on a trend line and has volume confirming the breakout, you now have one of the best technical analysis trades.

Do your best not to enter the trade too early. The pattern isn't promising anything; it is just making a case. You should only trade the pattern once the case has been confirmed and developed.

Not sure if you've identified a leading diagonal or just a messy wedge? Bring your chart to TradeWill's Elliott Wave desk — our analysts call the wave count, so you don't have to guess the breakout.