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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

Trend Waves

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. Sharp uptrends routinely print orderly action-reaction waves. EWT correctly recognizes these predictive patterns through their 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 impulse. 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 complex 5-wave rally of the next smaller time frame. With this knowledge execute your position at the 3rd of a 3rd, one of the most powerful price movements within an entire up trend. While waves may appear difficult to locate, the trained eye can uncover these price patterns in many strong up trends.

Many 3rd waves trigger broad continuation gaps. These occur just as emotion replaces reason and frustrate many good traders. Since common sense dictates the 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.

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 of the last sharp countertrend adds an unhealthy sense of invulnerability into the crowd mechanics. Movement becomes unpredictable and just as the last greedy participant places a bet, the uptrend ends unexpectedly.

Waves within Waves: In 1996, Worth Magazine declared that Isis Pharmaceuticals would be the next Microsoft. That was all the greedy crowd needed to hear. A powerful rally exploded and prices doubled in the next month. Note the embedded 5 wave patterns, typical in surging uptrends. The 3rd of a 3rd identified an excellent momentum trade.
 


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