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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

Selling Declines

How can we profit from the pain of other participants as stocks fall? Where should short sales be entered to capitalize on their fear? And how can we shift trading strategies as the new uptrend takes over?

Answers to these questions can often be found by watching the countertrend rallies between dynamic falls. Hidden rules of proportion guide Five Wave Declines. One general tendency expects the first corrective wave to drop about 38% of the next larger up trend, while the second falls to 50% and the final thrust all the way down to 62%. However, 5WDs will sometimes correct 100% (or more) of the first wave, creating a classic double top.

Selling short during 5WDs is more difficult than you might expect. The down trendline consists of only two points unless the first Top lines up with the subsequent two impulses. So you may not know a trendline exists until several entry points pass. Fortunately this barrier also marks the highest level the first post-bottom (Drop) rally should reach. This pinpoints a good trade setup when price gets close enough to the line. However, the reward potential is smaller than during other declines and selling short is now a countertrend entry.

The best short sales in the 5WD pattern arise from natural breakdown points, as impulses violate prior support. Frequently this requires foregoing entry on the very first impulse since this wave can complete with little or no selling pressure. This changes dramatically during the 2nd and 3rd falls when the crowd becomes highly emotional.

The 5WD trendline becomes a signpost for long trades that follow the first breakout through it. Immediately buying the break works exceptionally well on clean gap moves. Pullback entries routinely appear after breakouts as price returns to test the trendline from above. But watch out for very weak breakouts. Stocks may use this side of the trendline to initiate a new downward impulse, with price gently sliding along the line until the prior low is retested.

Downtrends do not easily give way to new uptrends. While a break of the 1-2 trendline marks the completion of the Five Wave Decline, subsequent price movement may not generate much momentum. Long entries initiated at the trend break can be very successful but a defensive posture is warranted. At these times, remember the old traders wisdom: the bigger the move, the broader the base. Bottoms can take time to form.

Reading The Breakdown: The 2nd downward impulse (1) of 5WDs often begin close to the same level as the 1st decline (Top). This sketches the classic double top breakdown pattern. Short sales can be initiated at the first violation of the prior up trend. But the danger of a short squeeze remains high during this early stage. Subsequent breakdowns are not as deadly to short positions as a new bear mentality weakens rally attempts.
 


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