How To Use Market Sentiment To Improve Your Trading/Investing (Part 5)

For the last few weeks, we have provided you with proof that movements in markets occur within waves, as discovered by R.N. Elliott, and that decision making and changes in trend are governed by Fibonacci mathematics and the properties of Phi. So, how do we apply this to our own trading to generate profits?

Elliott theorized that public sentiment and mass psychology move in 5 waves within a primary trend, and 3 waves within a counter-trend.   Once a 5 wave move in public sentiment has completed, then it is time for the subconscious sentiment of the public to shift in the opposite direction, which is simply the natural cycle within the human psyche, and not the operative effect of some form of “news.”

This mass form of progression and regression seems to be hard wired deep within the psyche of all living creatures, and that is what we have come to know today as the “herding principle,” which gives this theory its ultimate power.

But what gives Elliott Wave analysis the power to determine where those turns in public sentiment will occur is Fibonacci mathematics.  And, this is where our contribution to the Elliott Wave world comes in.  This is something that I observed within the Elliott Wave structure, and have adapted it to a trading methodology, which I lovingly call Fibonacci Pinball.

Since 3rd waves in the Elliott Wave structure are the strongest and most powerful of all the waves, it is the ideal wave to trade.  Furthermore, since 3rd waves themselves have to be composed of 5 sub-waves, it helps us determine how we trade this structure in a relatively low risk manner.  Let me explain.

After the market or stock finds a bottom after a correction, it begins a new uptrend.  Such uptrends take the form of a 5 wave Elliott Wave structure, as represented in the charts in front of the room.  And, since I hope most of you can count to 5, the general chart does not need much explanation. 

However, what I do want to point out is that each of the impulsive waves – waves 1, 3 and 5 – are all comprised of 5 waves each, and waves 2 and 4 are comprised of 3 waves each.  So effectively, each impulsive wave can be further broken down to a 5 wave structure ad-infinitim. 

This is what we mean when we say that the market is fractal in nature.  It means that the patterns are self-similar at all different degrees of scale.

Now, since wave 3 is subdivides into 5 waves, and once we have waves 1 and 2 in place, it makes trading the rest of waves 3, 4 and 5 relatively easy to prognosticate in a standard impulsive wave.  This is what I refer to as Fibonacci Pinball.

Allow me to explain.  Once waves 1 and 2 are set up, we then set up our Fibonacci extension based upon those two waves.  Since wave 3 subdivides into 5 waves, we can use the Fibonacci extensions to provide guidance as to how wave 3 will now develop.

Wave 1 within roman numeral wave iii will often target the .382 or .618 extension.  We will then see a pullback for wave 2 to the .500 or .618 retracement region of wave 1. 

From this point, the market will usually target either the 1.00 extension for wave 3 of roman numeral iii – as you can see on the left chart - or as high as the 1.236 extension – as you can see on the right chart.  We will then see a pullback towards either the .618 extension or the .764 extension, depending upon which extension the market targeted for wave 3 of roman numeral iii. 

In the case of the 1.236 extension, if the market were to break down below the .764 extension, about 70% of the time, this is the early indication that the impulsive pattern up will ultimately fail and that the market will be coming down hard and moving below where the move began.

But, assuming that the market maintains support at the .764 extension, it then moves up to the 1.618 extension to complete all of roman numeral wave iii. 

From this point, the market will usually pullback in a roman numeral wave iv back to the 1.00 extension, and then begin a final 5th wave rally to target either the 1.764 or 2.00 extension to complete the 5 wave pattern.

Now, of course, this is simply a standard framework within which we track an impulsive wave structure through waves 3, 4 and 5.  There can be further extensions beyond the 1.618 extension that wave 3 will target, which will most likely change the targets for waves 4 and 5 as well.   But, the purpose of this exercise is to provide you with a framework through which you can track most moves for any stock, market or commodity a great majority of the time.

What makes this method so valuable is that it provides natural stops on the way up to lock in gains as each phase completes its upward trajectory.

In summary, over the last few weeks, I have attempted to show you how news can lead one to be looking the wrong way in the markets.  I have also provided to you studies that show that market’s will move along the exact same Fibonacci-ratio-based patterns whether news is present or not.  Further, I also provided you another study which showed that even “surprise” news events have not affected markets in the manner many had assumed they would.  These studies should show you that the news is not the true driver of markets. 

And, finally, I provided you with a framework within which you can track sentiment from a Fibonacci-based perspective, as discovered by R.N. Elliott, and enhanced by our own Fibonacci Pinball method.  Adding this system into your investing/trading took box should make you a much more successful trader and investor.

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See charts illustrating the wave formations that occur in Fibonacci Pinball.