Three-Wave Pattern

The Three-Wave Pattern

Prices move in patterns. This is a function of the multitude of investment crite­ria of the investment community. An investor places money into a position, based upon their individual investment goals. Whereas one investor may be buying for the long-term, the next investor may be in the position for a short-term trade. Whatever the reasoning for an investor to commit funds to a trade, the price movement of any trading entity will be predicated upon the emo­tional sentiment of how that price movement reacts. Simply stated, the magni­tude in which a price moves will create changes in investor sentiment.

A price that moves up too fast for normal expectations will cause profit taking to occur. A price that moves in a slower consistent fashion will have a different result in investor sentiment, causing a different pattern. The fact that prices move in patterns/waves is evident in the existence of technical analysis. Stochastics, Fibonacci numbers, Elliot Wave theory, trendlines and a host of other technical methods have been developed as a result of prices moving in predictable fashions.

The most predominant study of wave patterns comes from the Elliott Wave theory. Over 50 years ago, R.N. Elliott observed that price movements move in a series of dramatic patterns. He analyzed that these patterns were based upon the natural progression of the sentiment shift in mass investor psychology These patterns or WAVES illustrated the oscillations between investor fear and greed.

Elliott observed various types of wave patterns. His research formulated two basic types of wave patterns. The impulse waves, waves which moved in the direction of the predominant trend of the market consisted of five smaller ways. The corrective waves, waves that moved counter to the main trend con­sisted of three smaller waves. Unfortunately, these two wave patterns are just the basic wave counts. The major difficulty of Elliot wave analysis is analyzing and correctly labeling which wave count is currently occurring. It is always difficult to define which wave count is in progress. Wave patterns can occur inside other wave patterns.

The wave patterns in the Elliot Wave analysis can also have variations to the basic wave patterns, having seven or nine wave counts. Even R.N. Elliott admitted that with the numerous variations of wave counts that could be ap­plied to a trend, each trend could be analyzed differently, depending upon the initial wave analysis. He admitted that the interpretation of the wave counts could not always have a stringently defined set of rules.

Apparently there are students of the Elliot Wave analysis that have been able to convert their knowledge of how the waves perform. They can produce very good profits for their trading programs. The one consistent factor that successful Elliot wave analysts reveal is that to become successful at analyzing the waves profitably takes many years of experience. This is all well and good for those that want to spend many years in learning how to invest successfully.

For those investors that want investment methods that can be learned and used effectively in a much shorter period of time, there are aspects of waves that are much easier to utilize. Using candlestick signals in a three-wave pat­tern becomes much more productive. A three-wave pattern can be defined as any wave pattern that starts from a point where a new wave or trend becomes apparent. This approach makes the wave pattern a projection element versus an anticipatory element.

The candlestick signals remained the main analytical tool for identifying a trend reversal. The three-way pattern becomes a projection tool for how that new trend may perform. A three-wave pattern has a few different identifiable moves. As illustrated in Fig.5-1, a trend can move up and then pullback. The third leg of the trend now moves back up to test or exceed the previous high.

A trend can also move up, with the following leg 2 moving sideways until leg three begins the final leg of the pattern as seen in Fig. 5-2. This sideways movement, once observed, can have some timing elements built into it. That timing can be a result of the stochastics retracing to the oversold area and curling back up. Then a candlestick ‘buy’ signal appears at the end of a flat trading period. The end of the flat trading can also be correlated to the inter­secting of a major moving average. Most importantly being able to visually identify the three-wave pattern set-up allows the candlestick investor to exploit the proper timing of getting back into a trade.

The same analysis can be made on trends in a downward direction. A down­ward leg will be followed with a bounce upwards. Then the final leg continues down to test or breach the recent low, fig. 3.

As in the upward trend, a three-wave pattern can be a down leg, a flat trading area, followed by the next leg to the downside as shown in Fig. 4.

Anticipating how a wave pattern is developing provides the candlestick investor with valuable information. It allows for the potential viewing of candle­stick signals at specific times, knowing that a leg of a wave pattern is forming. This may seem very elementary However, with the well-established knowl­edge that prices move in waves; then being prepared for a candlestick signal and a new leg of a wave pattern creates excellent timing characteristics.

Does a three-wave pattern always perform clearly? Not always, but often enough to know to start looking for the next pattern. Keep in mind, the candle­stick signals are the main parameter for entry or exiting a trade. The wave pattern is to provide a game plan for when those signals could appear. The advantage provided by candlestick signals is the more defined reversal points. Whereas Elliot wave analysts may want to hold a position through wave one to five, the candlestick investor has the advantage of selling at the top of wave one, then buying back at the end of wave two, etc. This produces much better use of the invested funds, not losing equity during the pullbacks.

“Think simple” as my old master used to say-meaning reduce the whole of its parts into the simplest term, getting back to first principles.

Keep your wave count simple. Profits are not made by being able to proficiently count wave counts. Profits are made by effectively buying at the proper time and selling at the proper time. Utilizing candlestick signals, then evaluating what the wave movements might be, will greatly enhance your profitability.