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TradingDay.com > Technical Analysis Tutorial

T e c h n i c a l   A n a l y s i s   T u t o r i a l
by Alan Farley

Pattern Cycles: Trends

The cult of Elliott Wave Theory intimidates the most experienced traders. But don't let wave voodoo stop you from adding important elements to your chart analysis. Strong trends routinely print orderly action-reaction waves. EWT uncovers these predictive patterns through their repeating count of 3 primary waves and 2 countertrend ones.

Wave impulses correspond with the crowd's emotional participation. A surging 1st Wave represents the fresh enthusiasm of an initial breakout. The new crowd then hesitates and prices drop into a countertrend 2nd Wave. This coils the action for the sudden eruption of a runaway 3rd Wave. Then after another pullback, the manic crowd exhausts itself in a final 5th Wave blowoff.

Traders can capitalize on trend waves with very little knowledge of the underlying theory. Just look for the 5-wave trend structure in all time frames. Locate smaller waves embedded in larger ones and place trades at points where two or more time frames intersect. These cross-verification zones capture major trend, reversal and breakout points.

For example, the 3rd wave of a primary trend often exhibits dynamic vertical motion. This single thrust may hide a complete 5-wave rally in the next smaller time frame. With this knowledge execute a long position at the 3rd Of A 3rd, one of the most powerful price movements within an entire uptrend. While waves seem hard to locate, the trained eye can uncover these price patterns in many strong uptrends.

Many 3rd waves trigger broad Continuation Gaps. These occur just as emotion replaces reason and frustrate many good traders. Since common sense dictates the surging stock should retrace, many exit positions on the bar just prior to the big gap. Use timely wave analysis (and a strong stomach) to anticipate this big move just before it occurs.

4th Wave corrections set the sentiment mechanics for the final 5th wave. The crowd experiences its first emotional setback as this countertrend generates fear through a sharp downturn or long sideways move. The same momentum signals that carry traders into positions now roll over and turn against them.

The greedy crowd ignites a powerful December rally in AMGN. Note the embedded 5 wave patterns, typical with surging uptrends. The 3rd of a 3rd identifies the most dynamic momentum expected in a sharp price move.

As they prepare to exit, the trend suddenly reawakens and price again surges. During this final 5th wave, the crowd loses good judgement. Both parabolic moves and aborted rallies occur here with great frequency. Survival through the last sharp countertrend adds an unhealthy sense of invulnerability into the crowd mechanics. Movement becomes unpredictable and the uptrend ends suddenly just as the last greedy participant jumps in.

When trend finally turns back through old price, skilled traders then use past action to identify effective momentum and swing trades. Battles between bulls and bears leave a scarred landscape of unique charting features. For example, gaps provide one of the most profitable setups in all of technical analysis. Continuation gaps rarely fill on the first try, except with another gap. Use a tight stop and execute your trade in the direction of support as soon as price enters the gap on high volatility.

Past breaks in support identify low risk short sales. The more violent the break, the more likely it will resist penetration. Head & Shoulders, Rectangles and Double Tops leave their mark with strong resistance levels. These patterns often print multiple doji and hammer lows prior to a final break as insiders clean out stops at the extremes of the pattern.

Clear Air prints a series of wide range bars as price thrusts from one stable level to another. Rapid price movement tends to repeat each time that trading enters its boundaries. Potential reward spikes sharply through these unique zones. But watch out. Reversals tend to be sharp and vertical as well. Tight stops are advised.

Pattern Cycles recognize that important features may not be horizontal. What the eye resolves as uptrend or downtrend contains multiple impulses shooting out in many directions. The most common of these is the Parallel Price Channel. Use these price extremes to enter contrary positions with stop losses just on the other side of the parallel trendlines.

 


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