How to Set Protective Stops Using the Wave Principle

[MadMarketScientist 11]

The 3 simple rules of Elliott wave analysis can help traders manage risk, ride market trends and spot price reversals.

 

EWI's Chief Commodities Analyst Jeffrey Kennedy values the Wave Principle not only as an analytical tool, but also as a real-time trading tool. In this excerpt from Jeffrey's free Best of Trader's Classroom eBook, he shows you how the Wave Principle's built-in rules can help you set your protective stops when trading.

 

Let's begin with rule No. 1: Wave two will never retrace more than 100% of wave one. In Figure 4-1, we have a five wave advance followed by a three-wave decline, which we will call waves (1) and (2). An important thing to remember about second waves is that they usually retrace more than half of wave one, most often making a .618 Fibonacci retracement of wave one. So in anticipation of a third-wave rally - which is where prices normally travel the farthest in the shortest amount of time - you should look to buy at or near the .618 retracement of wave one.

 

 

Where to place the stop: Once a long position is initiated, a protective stop can be placed one tick below the origin of wave (1). If wave two retraces more than 100% of wave one, the move can no longer be labeled wave two.

 

Now let's examine rule No. 2: Wave four will never end in the price territory of wave one. This rule is useful because it can help you set protective stops in anticipation of catching a fifth-wave move to new highs. The most common Fibonacci retracement for fourth waves is .382 retracement of wave three.

 

 

Where to place the stop: As shown in Figure 4-2, the protective stop should go one tick below the extreme of wave (1). Something is wrong with the wave count if what you have labeled as wave four heads into the price territory of wave one.

 

And, finally, rule No. 3: Wave three will never be the shortest impulse wave of waves one, three and five. Typically, wave three is the wave that travels the farthest in an impulse wave or five-wave move, but not always. In certain situations (such as within a Diagonal Triangle), wave one travels farther than wave three.

 

 

Where to place the stop: When this happens, you consider a short position with a protective stop one tick above the point where wave (5) becomes longer than wave (3) (see Figure 4-3). Why? If you have labeled price action correctly, wave five will not surpass wave three in length; when wave three is already shorter than wave one, it cannot also be shorter than wave five. So if wave five does cover more distance in terms of price than wave three - thus breaking Elliott's third cardinal rule - then it's time to re-think your wave count.

 

 

The Best of Trader's Classroom presents the 14 most critical lessons that every trader should know. You can download the entire 45-page eBook with a free Club EWI Membership. Download the free Best of Trader's Classroom now.

 

 

This article was syndicated by Elliott Wave International and was originally published under the headline How to Set Protective Stops Using the Wave Principle. EWI is the world's largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.

[thalestrader 14]

Good share, MMS. Jeffrey Kennedy at EWI is one of the few EWI advisory service guys from whom one can actually learn a great deal, not only about Elliot Wave, but about how the markets work generally, and trading as well.

 

Best Wishes,

 

Thales

[steve46 12]

Whenever I hear folks try to promote Elliot Wave, I am reminded of the comments by Jack Schwager in his first book, where is his waiting for a trade to develop (based on an Elliot wave setup) and it never materializes (actually a significant loss is what did materialize...

 

I think the main problem most folks find when they look into the system is the lack of standardization.

 

Good Luck

Steve

[MadMarketScientist 11]

Every system has its good and bad points ... Prechter was predicting the Dow to drop 90% to 1000 last July ... He completely missed the bull market of the last year!

 

MMS

[SIUYA 11]

Steve I agree with you - the issue is in counting and trying to fit a model to the markets......however using the principles can certainly help when used in conjunction with other things such as context, support and reisstance, fibonnacii, fundamentals even.....I think thalestrader does a great job showing this in the reading charts in real time thread.

You mention the point of standardisation.....to me this is key. Each trader has to work out what works, and probably more importantly what can help determine when a certain setup does not offer a good risk reward trade based on context.......and for them to then stick to it. Too often the theory of the market and how/why it moves is missing from some plans, even before looking for the perfect setup and trigger.

eg; taking longs when a guesstimate 5 wave up count is probably poor risk even if the setup looks identical to other days.

Nothing works all the time.

[roztom 10]

I spent a lot of time studying EW and at one time used Adv GET software by Tom Joseph to try to implement it in real world trading. At least for me the wave counts were only obvious after the fact.. since there can be waves inside of waves...ex 5 minor waves inside a wave 1 or wave 3, etc... IT only made sense in hindsight...

 

In reality, retracements are just Swing H/L's..you don't need a wave count to see that...

 

One good thing I did get out of it was having a better understanding of impulse waves, especially wave three's... In addition the fibinnocci retracement and extension projections were useful though I don't use them today.

 

Outside of that I couldn't use it for interday tradding..It was just another lagging indicator for me.

 

I'm sure others find it a valuable tool. For me it was a good concept piece.

 

Regards,

 

Tom