22/06/2011 – How to Set Protective Stops Using the Wave Principle

Over the years that I’ve worked with Elliott wave analysis,
I’ve learned that you can glean much of the information you require
as a trader – such as where to place protective or trailing stops
– from the three cardinal rules of the Wave Principle:

1. Wave two can never retrace more than 100% of wave one.
2. Wave four may never end in the price territory of wave one.
3. Wave three may never be the shortest impulse wave of waves
one, three and five.

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.

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