The Second to Last (Penultimate) Pattern

Fourth wave triangle patterns are a warning that the larger trend is about to turn the opposite direction. This is an Elliott Wave rule: It happens every single time we get a triangle in a fourth wave position. Every time!

That’s the pattern we’re in now, and it means that we’re just a few weeks away from a new all time high.

This weekend, I’ll take apart the triangle pattern a bit and try to provide more information as to what to expect going forward, as this penultimate pattern plays out.

Understanding Triangle Patterns

Elliott Wave Theory has two primary components:

• fibonacci wave relationships that give clues as to wave lengths (and probable measured targets)
• wave counts in impulsive waves and corrective patterns (each corrective pattern has its own rules and guidelines)

Trend waves, or impulsive waves (which we haven’t really had since 2007), consist of a five wave pattern that measures accurately to prescribed wavelengths. We’ll get a set of impulsive waves in the A wave down after the top of the market.

Corrective waves are typically in patterns. You’ll see a list of corrective patterns in the sidebar in the Trader’s Gold area. They’re there so you can become familiar with the rules and guidelines for the pattern we’re in.

Contracting triangles in a fourth wave position (which we have unfolding in ES and the SP500 at the moment) have rules, which cannot be broken (or the pattern is negated) and guidelines, which are typical attributes of the pattern, but don’t necessarily always play out.

With a contracting triangle, the rules are that it will have a set of five waves. However, the triangle pattern is never actually confirmed until the D (or fourth) leg is in place. That means the high probability trade is always the E leg, and the final fifth wave at the end of the triangle. Fourth wave triangles (or any type) warn that after a final fifth wave to a new high (bull market) or low (bear market), the trend is going to change.

However, within the triangle, there’s really only one rule: each of the five “legs” of the triangle will trace out in three waves. The C leg is usually the most complex, but this is a guideline. There are no other rules within the triangle, and this makes it a risky pattern to trade (within the upper lower trendlines. Keep that in mind as this triangle plays out, and for future triangle patterns.

There is Almost Always a Second Wave

Most traders over-trade. They don’t have the patience to wait for the set-ups. Set-ups (from and Elliott Wave perspective) consist of second wave turns (at a fibonacci retrace level of about 62%) and turns within patterns (once the pattern has been confirmed.)

Picking tops and bottoms is risk-prone. Probable tops and bottoms can keep going, and even if you have a measured objective (a fibonacci ratio), there is seldom just one measured fibonacci ratio to deal with. You don’t have to high probability spot to place a stop; it’s guess-work. Waves typically turn at a fibonacci measurement, but which one?

However, after a 5 wave first wave in either direction and a second wave in three waves that retraces 62%, you have a recognizable pattern with a very high success rate of completion. Your stop can go at the 76% retrace level, as waves that exceed this level usually retrace the entire previous first wave (which means it really wasn’t a first wave) or you can place your at the start of the first wave (less desirable).

It’s rare that you don’t get a second wave in a corrective pattern. You always get them in trend waves (impulsive waves); that’s one of the defining differences.

It’s more of a mind game than anything else. Traders have this fear of losing out on a trade, and often jump in early because of bias that the set-up is a correct one. However, in these markets particularly, with low volume and high volatility, it’s really important to be highly disciplined. Wait for the turn and honor your stops.

Have a pattern that you follow consistently, and wait for the turn. It’s better to miss a trade that’s risky than jump in early because you “believe” it’s about to turn soon. Waiting a little longer than usual and losing a percentage off the top is much less risky. The objective is to treat this like a business and only take on those projects that will prove to be profitable based upon a set of pre-defined objectives.

Trade what you see, not what you think.

There will always be another great set-up around the corner. It pays to be patient and wait for it.

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The Market This Week

Here's the latest daily chart of ES (emini futures)

Above is the daily chart of ES (click to enlarge, as with any of my charts).

This past week was bearish and produced a larger B wave in the continued rally of the D leg of the contracting triangle — the final fourth wave of the trend.

The drop this week changed the target slightly — that and the fact that the length of time for this rally is changing the level at which we'll connect with the down-sloping, upper trendline. The target on the upside now looks to be in the 2750 area.

After the top of the D wave, we'll turn down into the E wave, a higher probability trade, as the completion of the D wave actually confirms the triangle. It's not until that point that we have the slopes of the upper and lower trendlines in place.

After the E wave down is complete, we'll take off again to the upside in a fifth wave, which will simply finish off the pattern. We'll get to a new high and probably more, but don't expect (as I've been saying for a very long time) a large fifth wave that travels any great distance. (I think 3000 is possible but at the high end of the probability spectrum)

Summary:  We should continue up in the balance of the D leg this week. It looks like we'll have some weakness this weekend, but should turn up early in the week. Once D wave is complete, only the E leg (down) and a final fifth wave to a new high are left. That fifth wave up to a new high will be the end of the 500 year bull market.

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