Identifying that a trend has moved in 5 waves can help technical traders assess the risk: reward potential of a set up. The Hong Kong 50 cash index is currently an example.
5 wave rally
Trends often (although by no means always) take the 5 wave formation identified by RN Elliot. This can be a very useful trading pattern. However, my approach is only to use what look to be obvious examples of the 5 wave pattern
The rules for a 5 wave pattern are as follows
- There are 3 waves (or swings) in the direction of the overall move (Waves 1; 3 and 5
- There are 2 corrective waves (2 and 4)
- Wave 3 must not be the shortest of the 3 waves in the direction of the overall move i.e. it must be longer than either or both waves 1 and 5
- The corrective wave 2 must not move below the beginning of wave 1
- The corrective wave 4 must not move below the peak of wave 1
Hong Kong 50 triangle pattern
The triangle pattern on the Hong Kong 50 chart pattern above comes just after completion of a 5 wave advance.
This is useful to traders because once a 5 wave pattern is completed, the odds favour at least a decent correction of that move e.g. a move to at least the 38.2% Fibonacci retracement level, if not something much larger.
For traders making use of this characteristic of the 5 wave pattern, this triangle creates an opportunity to develop a strategy for a sell set up.
The triangle is placed to be a continuation pattern i.e. a brief pause before continuation of the downtrend that began at “5”
Pattern trading strategy and risk: reward
If the triangle is confirmed by another failure at resistance, a strategy would be to sell with a stop loss above the triangle support. That would position for a decline to the 38.2% Fibonacci retracement level.
Alternatively the triangle support might be broken without another test of the resistance. In that case a sell trade could be opened with the buy stop loss being placed behind the triangle support (new resistance)
Either way this type of approach represents an opportunity for a trade where the potential profit is likely to be larger than the loss if the stop is triggered (assuming no “gap events”)