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So You Wanna Learn Elliott Wave Analysis? Part V
Here are just a couple of ways the Wave Principle helps you trade.
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So You Wanna Learn Elliott Wave Analysis?
For more reading on the basics of Elliott wave analysis, please read all parts of the series: Part I, Part II, Part III, Part IV, Part V
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In Part I of this series, you learned about the basics of Elliott wave patterns. Part II introduced you to "alternate counts" and ways to identify the market position in the wave pattern. Part III talked about the Fibonacci sequence and the ratios within the sequence that guide the shape of Elliott waves. Part IV showed you how to use Elliott to establish investment strategy and reduce risk.
This is the last article in the series, and it covers the ways you can take advantage of the Wave Principle in trading.
If you remember, in this real-time coffee chart that you saw in Part IV, we expected wave 2 to retrace one of these common Fibonacci ratios of wave 1 (in order of probability): approximately 5300 (62%; most probable), 5500 (32%) and 5400 (50%). That would be the preferred Elliott wave count; after reaching one of those targets, you would expect wave 2 to end.
Once the price stalled near a Fibonacci point and started to reverse, you could decide that wave 2 is ending and wave 3 to the upside is about to start – a nice bullish opportunity. The most likely entry point would be near the end of wave 2 – of course, only after you've observed five waves up in 1 and three waves down in 2, the definition of a completed Elliott wave sequence.
But what if the price falls substantially below the 62% point at 5300? Then probability shifts away from the preferred, bullish wave count. The good news is that you know that wave 2 cannot go past the beginning of wave 1 (just under 5000) – the First Rule of Elliott says that wave 2 cannot retrace more than 100% of wave 1, remember? That’s the point where you know that your bullish “one-two” wave interpretation is wrong and it’s time to switch to an alternate count (we covered those in Part II) – if you haven't already done so.
There are several other ways for you to take advantage of the Three Rules of Elliott and Fibonacci retracements. If you're a shorter-term investor, you might decide to take advantage of each of the sub-waves of waves 1 and 2. For example, as you watch wave 1 top, you know a 38% retracement is the most likely minimum downside potential for wave 2. You could short the market accordingly, watch for an acceptable a-b-c pattern unfold to the downside and signal the end of wave 2, close the short position and prepare to catch the expected rally in wave 3.
The chart below zooms in on an even shorter time frame and shows the action in the same Coffee that followed the “one-two” preferred count we’ve been working with. You can clearly see the reversal at the wave 2 low and the impulsive action that followed. From the end of wave 2, you could have confidence to expect a rally in wave 3 – well beyond the top of wave 1:
I’d like to leave you with one last thought. Because Elliott waves develop exactly the same way in bull and bear markets, if you “flip” upside down every chart you’ve seen in these series of articles, you would be looking at the same opportunities, but to the downside. Neat, eh?
That wraps up this series, a brief introduction to trading and investing with the Wave Principle. Once you learn this discipline, you will learn to establish a coherent investment strategy and reduce risk in your trading. To continue your studies, there are several good options. The best one is Prechter & Frost's classic text, Elliott Wave Principle – Key To Market Behavior*.
I also invite you to join our free Club EWI and explore the multitude of free learning resources we have prepared for you on the Free Stuff page.
*You get a free copy of this book with a subscription to EWI’s most popular market-forecasting package, The Financial Forecast Service. Get instant, risk-free access now.