SPX Update: Using Elliott Wave Theory to Choose Entries and Stop Losses

Yesterday the market formed a bearish reversal bar: it gapped higher at the open, but closed solidly in the red.  These types of bars sometimes indicate buying exhaustion.

The market is now as overbought as I've seen it, and if this is still a bear market, then this is a dangerous condition ripe for a serious decline.  If this is a new bull market, then it's par for the course, and the indicators could get even more overbought from here.  Materially, there isn't much to add to the last couple weeks of updates, so I'm going to discuss some of the ways I use Elliott Wave Theory for trading.

The market tagged my target zone yesterday before reversing, and there are now two ways to view the current structure.  I'm going to present both of them -- and then I'm going to talk a little bit about how one can use Elliott Waves to pick entries and exits for a trade, using the the current charts as examples.  This is not going to cover it exhaustively, by any means, but it could serve as a quick primer.  The disclaimer, of course being that none of this is to be taken as trading advice, and you should always consult your investment advisor, your spouse, your lawyer, your doctor, your priest, and a Magic 8 Ball before making any trading or investment decisions, etc..

Anyway, the charts below are the same time frame for the S&P 500 (SPX), but are each labeled slightly differently.  Both interpretations are viable.  So what does one do with this information, when the market "could go up or down"? 

Let's start with the bearish interpretation.  The bearish interpretation would view this as a complete five-wave rally, which would mean a larger decline is due. 

On the bearish chart below, the "c" label marks the potential end of the wave.  Obviously, any trade above that price point indicates that the wave isn't complete, so that becomes one's stop loss level for shorts.  On my charts, I label these as "KO" levels, meaning, in this case, that trade above that level knocks out (invalidates) that interpretation. 

In this particular instance, if one was inclined to go short, as I did yesterday when the rally reached the target zone, then the bullish interpretation (next chart) shows why you don't want to chase the decline and go short at random (you really never want to do anything at random as a trader, but the chart after this one emphasizes that point).

So, one would either wait for a bounce and short from higher levels, where one's stop loss is closer and manageable -- or one would stand aside and wait for the bullish interpretation to get knocked out entirely, since that should act as confirmation that the rally is indeed over.

The chart below shows the bullish interpretation and the knockout level.  If one was undisciplined and shorted at random -- say at a really dumb spot, like 1310 -- then one would be risking 23 points (from 1310 to the 1333 bearish knockout) to gain 14.  Why 14?  Well, because the bullish knockout level is only 14 points lower, at 1296.  If one missed going short near the top and can't get a better entry than our hypothetical dumb trader at 1310, then it's really much smarter to either:

1) Stand aside and wait for the bull count to get knocked out (1296) before considering taking any action on the short side. 
2)  Wait for a bounce back up toward the bearish knockout level (1333), where one can get a lower-risk short entry.

Is this starting to make sense?  There's a method to this madness.

Conversely, if one wanted to play the move from the long side, one could go long near the 1310 support zone and use the 1296 KO as a stop loss level. 

If one was already short, the 1310 zone is a good area to consider taking profits, since it seems almost certain that some type of bounce will develop there -- either a small bounce, or a stronger bounce to brand-new highs.  Needless to say, if the brand-new high scenario plays out, one gives back all of one's short profits and then some.  That's why I take profits often.  Bears can still make money in a bull run; they just have to be smart and nimble, and not turn into pigs (greedy). 

Once one is safely back in cash, one has several options, including the following:

1)  If one is still bearish, one can always short again from higher levels after a bounce. 
2)  Still using the hypothetical 1310 profit-taking level, if no bounce develops -- then worst case, one misses out on 14 points between 1310 and the bull count KO level.  Once the bull count is KO'd, one can always consider fresh shorts, since that should validate the bear case.
3)  If one is bullish, long positions could be taken for a ride up into the bull count target zone.  1296 becomes the SAR level (stop and reverse) for that trade.

Going back to the first chart, I personally wouldn't use the bear count's KO as a SAR level to go long, because it appears that even if the bullish count is playing out, then the rally is entering its final leg -- and with the KO level at 1333 and the lower portion of the target zone only a couple points above, at 1335, the risk/reward seems marginal.

Those are a few basic concepts.  As I said, it's by no means exhaustive.

So, which of the two counts am I favoring?  I thought you'd never ask!  (Yeah, right.)  Well, currently the decline is only three waves, which -- if it stays that way -- indicates it's corrective, which means it's just what it sounds like: a correction to the next larger trend -- which is up.  Tomorrow's action could change that -- if it adds another wave down in a proper Elliott way and turns the decline into a five-wave move, then that could be an indication of a trend change.  But at this exact moment, there's nothing to indicate that the trend has reversed.

If the bullish count is unfolding, then what would usually play out in this type of wave would be a bounce back up toward the mid-1320s and a subsequent decline to roughly 1310, before rallying up into the target zone.  It's also possible that the three wave decline the market formed yesterday was it, in which case all my talk about 1310 is meaningless, because the market is on its way to immediate new highs. 

If the bear count is unfolding instead, then ideally the market needs to keep the bounce that started just before yesterday's close below 1325.30 to keep open the bearish possibility of a nested series of first and second waves, or it needs to head down off the open to create a five wave move.  Note that the bull count could clear 1325.30 and then decline to 1310 without creating any rule violations.  Trade safe! 

The original article, and many more, can be found at http://PretzelCharts.blogspot.com