(04/27/10) Understanding Elliott Wave (Part 2)

Continuing our Elliott Wave series, I am going to be writing about the basics of Elliott Wave (EW). I want to keep this as simple as possible, because it is simple. The other objective I have for this series is to make it relevant to trading. This is not for the academician…this is for the trader.

I will examine how EW analysis can be used to project turning points in the market.

Entering a trade at the end of wave two, or B, is one of my favorite setups. Wave two and wave B are both corrective waves, and will therefore have the same structure. The only difference in the waves is whether they are part of an impulsive wave or a corrective wave. There are two hints that would give me an idea as to which wave I am looking at. First, I may be expecting a corrective wave because of the count preceding the setup. Secondly, if the wave that this countermove is correcting was three waves, then I expect that I am looking at wave B since wave one is always a five-wave structure. Sometimes the time frame is too large to see the wave structure.

Structure: Both W2 and Wave B are three-wave structures. Usually, they are a simple ABC correction. Sometimes the correction is so sharp that the structure is hard to visualize.

Retracement levels: 50%, 61.8%, and 78.6%. I emphasized the 61.8% retracement level because, in my experience, this level is the highest probability for a reversal. The other level I see reversing the market a lot is the 78.6% retracement, especially on shorter time-frame charts and lesser degree swings. When I say that I am buying on dips or selling on rallies, I will probably be using the 61.8% retracement level. Of course, as the market gets close to that level, I am looking for a completed pattern also (see chart below), and may have to go to a one-minute chart to verify pattern completion. I would not take a W2 or Wave B trade unless a minimum 50% retracement has been made.

Limited Capital Exposure: When a trade is made at the end of wave two or B, capital exposure is known. My stop is placed one tick (at most two in a volatile futures market) beyond the beginning of W1 or A. This was discussed in a previous lesson. Sometimes, if I see a close beyond the 78.6% retracement level, I will exit my trade because it is no longer a high-probability setup and the trend may continue. That's a judgment call.

W2/B Trade Setup: Here is a real example of a trade I remember taking. I remember almost being stopped out when I moved my stop to one tick below the W2, once I got profitable. I remember taking some profit at the 50 MA before moving my stop up. I was flat at the end of the day. Too bad! Look at that nice gap up the next day. But I'm almost always flat at the end of the day.

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