How To Trade Breakouts Using Elliott Wave Theory

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How To Trade Breakouts Using Elliott Wave Theory

When professional accountant Ralph Nelson Elliott published The Wave Principle in 1938, he launched a decades-long dispute. According to his pattern recognition theory, market trends unfold in five waves when going in the direction of a fundamental impulse and three waves when traveling in the opposite direction. According to this hypothesis, each wave will split into three waves that follow the trend and two that do not. Finally, it describes a fractal market in which each wave produces comparable patterns across increasingly shorter and longer time periods.

Elliott Wave Theory (EWT) has an unusual place in market legend, with devotees spending years learning its secrets and sceptic onlookers rejecting it as voodoo, preferring a more conventional approach to price prediction. Over the years, Wall Street has been especially scornful of the technique, but conspiracy rumors abound, such as unproven allegations that large participants often confer with wave theorists to make crucial market exposure choices.

To take use of EWT’s immense power, we don’t need to join a secret club or spend a decade learning a thousand rules and exceptions. In reality, we can immediately apply three simple wave ideas to a popular breakout strategy and see how they increase market timing and profit output. After a large low develops and a financial instrument tests a critical breakout level, we’ll check for particular Elliott Wave requirements.

Image by Sabrina Jiang © Investopedia2020

Following a lengthy rise, Aetna (AET) reached a high around 86 in July 2014. It corrected in the traditional ABC pattern, reaching 72 in October. In early November, the market soared back to resistance near the summer high, churning out two rallies waves before stalling out until mid-month. Because the purchasing spike into resistance indicated the shape of waves 1 through 4 of an Elliott 5-wave rally set, three EWT concepts helped us forecast what occurred next.

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We’ll put this theory to the test by using the first two of our three principles.

A. The bottom of the 4(2selloff) wave must not be higher than the top of the 1wave.

On October 27, the first wave finished at 79.64. Following a sharp drop to 76, the stock shot up to resistance just above 85. It halted at that level, forming a possible four-wave pattern that found support at 82. So far, there is plenty of room between the two blue lines that represent the top of the 1wave and the bottom of the 4wave. This increases the likelihood of a 4wave consolidation followed by a 5wave breakthrough and upswing.

B.A continuation gap is often precisely aligned with the center of the 3(2rally) wave.

A continuation gap occurs when a rising price prints a large gap and then continues to move, doubling the length of the wave before its appearance, as described by Edwards and Magee in their 1948 bookTechnical Analysis of Stock Trends. Aetna gapped up on October 31 (red circle) and continued up, with that level being the halfway point of the 3wave. This is important information in our trade analysis because it increases the likelihood that sideways price movement near resistance will result in a breakout and even higher prices.

With this knowledge, we may purchase the instrument inside the 4wave, anticipating the breakout. We may also set a stop loss below the trading range to limit our losses if we are proved incorrect. This gets us to our last and third fundamental.

C.In terms of price growth, two of the three major waves are likely to be similar.

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We discovered and entered a four-wave trade setup that is expected to create an uptrend of the same length as the first wave, which added 7.84 points, or the third wave, which added 8.81 points. Using the third principle, we divide the difference and add 8.30 to the bottom of the fourth wave, which is at 81.93, creating a minimum reward objective slightly over 90.

Image by Sabrina Jiang © Investopedia2020

The Bottom Line

In mid-November, the stock launched a 5-wave rally, reaching a swing high of 91.25, which was higher than our Elliott goal. Solid risk management is thus required since it is useless to sell just because the increasing price has reached a notional end point. Indeed, when buy signals go off and momentum traders flood into positions, many Elliott wave rallies subdivide higher and higher.

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