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Elliott Waves Theory – The Waterfall Effect

The Elliott Waves theory is strongly dependent on the Fibonacci numbers. Without the Fibonacci numbers, counting waves with the Elliott principle is simply not possible. So far in our Forex Trading Academy project we’ve seen Fibonacci ratios being used everywhere: when establishing if a pattern is a zigzag or a flat pattern when calculating the extended wave of an impulsive move when looking for the retracement levels in small and large x-waves. Fibonacci numbers are everywhere in the Elliott Waves theory! However, the Fibonacci ratios have further uses, not only in showing the type of the pattern the market is forming. They can be used in finding the exact end of a pattern, or the target for a specific trade. One of these situations is being given by the so-called waterfall effect. Despite what the name suggests, it is not referring only to bearish moves the market may form, but also to bullish ones.

Trading with the Waterfall Effect

Before even going into more details regarding the waterfall effect, we should say that such an analysis can be used only with corrective waves. Moreover, out of all corrective waves possible with the Elliott theory, this refers to triple combinations only. As a quick recap, a triple combination is being formed out of three simple corrections connected by two small x-waves. It is exactly this situation that the waterfall effect is referring too: the alternation of the three simple corrective waves. The basic idea is to interpret the possible length of the second and the third corrections, based on the length of the first one. For this, Fibonacci ratios must be used. Trading with the waterfall effect can be made both in the direction of the complex correction, as well as trying to pick a top or a bottom the market may form. It requires a few steps to be taken in order for the whole process to be a logical one.

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Use the 1st Correction’s Length

Traders will not know when a complex correction will form. All traders do know at any one moment of time is that after an impulsive wave, a correction should follow. If the correction is a simple one, it must be confirmed by future price action. If such a confirmation is not coming, then the correction must be a complex one. This means at least one x-wave should follow, and this will give plenty of time for the overall waterfall effect trading plan to be made. Such a plan should start from the moment the x-wave is completed and the market is moving beyond the end of the 1st correction. At this very moment, we do not know if the market is going to form a double or a triple correction, but, the waterfall effect is going to give us a clue regarding what to expect. To solve this riddle, the following things need to be done:

In doing that, traders have an educated guess about where the end of the second correction should be. If the market indeed goes to that 61.8% measured move and reacts at that level, it means a triple combination will follow. On the other hand, if there is no reaction at that level, or maybe the level is not even reached, it means that the complex correction is most likely a double combination. This way, we already established the nature of the pattern that is about to form based on the first condition of the so-called waterfall effect.

Use the 2nd Correction’s Length

the waterfall effectIf the market is reacting to the 61.8% measured move as explained above, a trade in the opposite direction should be open. The idea here is to trade the retracement of the x-wave, and such a retracement we know that is not possible to extend more than 61.8% of the whole 2nd correction. A proper target should be 38.2% of the 2nd correction and the stop loss should be set based on a risk-reward ratio. Such a ratio should be at least 1:2 normally but in our case even 1:1 should be enough as we’re trading just a small retracement. By the time the 38.2% retracement of the second correction comes, a trade in the direction of the overall triple combination should be opened. Basically an opposite trade: if the previous trade was a long one, this one should be a short trade. The idea behind it is to trade the third correction in a triple combination. If you refer to the article dedicated to triple combinations, you’ll find out that these patterns end almost always with a contracting triangle. Having said that, it means that we already know the type of the third correction: a contracting triangle. What would be an appropriate target for the newly opened trade? The thing to do is to use the Fibonacci retracement tool again and this time to measure the length of the second correction in the triple combination pattern. The idea is to take 38.2% out of it and apply it at the end of the a-wave of this second correction. The resulting level represents the area where the a-wave of the contracting triangle, the last segment of the triple combination, is supposed to end. That area should be the target for the opened trade already in place and the area where a new trade, this time in the opposite direction, should be opened. What would be the target for this last trade? First of all, consider this trade to take some time as there are still four other segments of the triangle to follow. Second, a triple combination is rarely completely retraced, so choosing the exit for this trade should not consider full retracement. A typical take profit should be set anywhere between 50% and 61.8% retracement from the start until the end of the triple combination. This way, we traded the whole pattern using this wonderful waterfall effect.
The name of this strategy comes from the fact that, by respecting these Fibonacci ratios, market moves in locked steps. Keep in mind that, as mentioned earlier, such a trading tactic can be used on bullish trends as well, not only on bearish ones.

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