More on 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 up trends. 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.
