Welcome, Readers,
Today we’ll be taking a look at my first analysis piece on
the IWM/RTY. As I’ve stated in my introduction article, my analyses and trading
signals are greatly influenced by the Elliott Wave Principle, Fibonacci mathematics, and a series of technical indicators used by technical analyst Connie Brown. I have
attempted to prepare this analysis such that you do not need to have an
in-depth understanding of these methods and indicators, but a basic understanding
of the Elliott Wave Principle will be necessary today. A short summary will
follow below, but keep in mind that this is only an explanation of the essentials
related to the wave principle. A more complete understanding can be gained from
understanding the materials listed in my introductory article.
Ralph Nelson Elliott outlined his wave principle in writings dating back to the mid 1930’s. Much of this literature would have been lost to history were it not for Robert Prechter Jr. A thorough discussion of the wave principle can be found in his textbook “Elliott Wave Principle: Key to Market Behavior”. In short, a move in the direction of the larger underlying trend will take the form of five waves. Three waves move price in the direction of the underlying trend. These are denoted as waves 1, 3, and 5. The intervening waves 2 and 4, are counter-trend waves that serve to correct the preceding price movement. Once these five waves have completed, a larger correction takes place in the form of three waves labeled as a-b-c. You can find the classic simplified structure of these waves in the image below, but be warned that price is rarely simple.
One of the defining characteristics of the wave principle is
the assumption that markets are fractal in nature and so this rally and
correction structure can be found in all time scales and across all markets. It
is a simple graphical representation of mass human psychology. Furthermore,
these structures can be combined to form similar wave counts on larger degrees
or subdivided into internal structure that mirrors the larger picture. While
the figure above shows a classical five-three structure for a bull market, the
same structures can be found in bear markets as well. This is only a simple
explanation of the structure found in price using the wave principle and I
heavily encourage you to read Prechter’s book if you truly wish to understand
the notation used in my longer-horizon analyses. However, all you will need to
understand today’s long-horizon view is that after a five-wave move completes,
there is a three-wave correction to move price back down.
Okay, let’s take a look at the IWM on a daily time horizon
and get an idea for where we are in the larger degree wave structure. Below is
the daily chart of IWM as of May 6th, 2024.
This chart shows my view of the IWM on a long-term basis.
Following the Elliott Wave Principle, I am counting the top formed in 2018 as
the top of the largest degree cycle wave 3 of 5. Following this top, we see a
multi-year corrective wave that culminated in the Covid crash as wave 4 of 5.
During the post-Covid recovery period, we saw the IWM rally to just above
$240/share in 2021 forming what I believe was the top of wave 5 and the
completion of the largest cycle degree wave structure. Now, following the basic
explanation of the Elliott Wave Principle shared earlier, we know that if this
is indeed the top of wave 5 then we should expect a three-wave corrective move from
these highs. The first leg of this corrective move occurred through the period
ending in the middle of 2022. This is the first wave of the correction, wave 'a' on the chart.
Afterwards, the IWM meandered sideways all the way up until October of 2023 where
it began to move in-sync with the SPX. The sideways movement was only
two-thirds of the second wave however with the move up starting in October as
the final portion of this second-wave, wave 'b'. From here, I am anticipating a
larger-degree five wave move down to complete the remainder of this corrective
move in wave 'c'. This move down will also only be the first leg of a much larger correction shown on the daily chart as wave (a) with a general
price target within the orange box. I expect this move will unfold throughout
the 2024 year. Now I want to drill down to the 4-hour chart so that we can
continue to unpack the more recent price action and how it fits into this picture.
I have placed a green arrow on the chart and I want you to use that as the
starting point as we move from the daily timeframe down to the 4-hour
timeframe.
On the 4-hour chart above, the green arrow is located at the
exact same point in price as shown on the daily chart. The beginning of this
move up from the sideways correction is labeled with a (b) and that is because
the larger wave can be subdivided into three smaller waves also labeled a-b-c.
(I know it is confusing, but please dig into the literature and practice. It
will become clearer as you continue to test your counting skills). The final
leg of this larger 'b' wave will unfold as a five-wave move. The first four
waves labeled (i), (ii), (iii), and (iv) are given on the chart with the larger
third-wave move is sub-divided again into waves 1, 2, 3, 4, and 5. The final
wave of the larger-degree (B) wave, wave (v), did not unfold in a traditional
impulsive wave. Instead, it took the form of a special wedge pattern known as
an ending diagonal (more on this can be found in Prechter’s book). An interesting
quality about these ending diagonal patterns is that once they complete, they
often retrace quickly back within the vicinity of their origin point. In this
case, that point is the $187-$188 level. The internal wave-structure of this
final move in wave (v) is shown on the chart. How do we know the ending
diagonal pattern is complete? There are two ways. The first is that the move
from the origin of the pattern to the top of wave 1, the move from wave 2 to
the top of wave 3, and the move from bottom of wave 4 to the top of wave 5 can
be connected by straight lines with continuously decreasing angles. This is a
tactic used by Connie Brown to ensure that the ending diagonal pattern shows the
appropriate internal geometry. The same wave structure from the 4-hour chart
above is shown again below with a thick yellow line overlaid on each of these
swings so you can see the declining angles between each wave (i, iii, and v). The second is that price has rapidly fallen back towards the origin of the diagonal in approximately half the amount of time it took for the pattern to form.
Okay, we’ve identified an ending diagonal structure to end the second wave, wave 'b', of this three-wave corrective move. So now what? Well, we need to finish wave 'c' of the decline. The thing about 'c' waves is that they have to unfold as a five-wave move. This can be either in the form of a typical impulsive wave or as one of these special “ending diagonal” patterns as we saw unfold in wave (v) of 'b'. So, let’s drill down to the 1-hour timeframe and continue our analysis.
Some of the preceding waves that comprise the end of wave 'b' are still visible in the chart as well as their internal a-b-c subdivisions. Ignore them and instead focus on the decline that starts at the top of wave (v) that completes the end of wave 'b' (I forgot to label the top of wave (v) with a massive ‘b’, but did not want to recapture each image, so you will have to use your imagination). I must concede that the decline from top of wave (v) is not an ideal impulsive structure. I have not made an attempt to label the internal wave structure yet as it could count as either an impulsive wave with some less-than-ideal proportions or another form of diagonal that shows up in the first wave position of a move known as a leading diagonal. Regardless of the final count, the result is the same. It is the first wave of a wave five-wave move that I believe will take price in the IWM down to the $130-$150 zone. However, the initial decline in wave (i) should retrace the price move up off the October lows and take price back to the $187-$188 level. It did not completely retrace the entirety of the move, but a large overnight decline in the RTY futures contract came within only a handful of points of the origin of its ending diagonal pattern which I consider to be close enough for my own comfort level.
After the price low struck around the middle of April, we
see what I believe is a clearly corrective bounce. It is highly overlapping
price action with internal structure that can be clearly divided into (a), (b),
and (c) sub-waves. Of which, I believe we are about two-thirds through the
final (c) wave that will complete wave (ii). Afterwards, I expect we will see
an initial five-wave move down from the top of wave (ii) to begin the third
wave of this decline that should target an area just above my final price zone
at ~$160-$170. However, it is clear that the corrective move is not finished.
We need to get an idea of where overhead resistance is so we can determine
where to enter a trade if we want to play the downside. To do this I am going
to use a Fibonacci retracement method outlined by Connie Brown in her book
“Fibonacci Analysis”. For this, we will only need the Fibonacci retracement
tool set to the 38.2%, 50%, and 61.8% subdivisions. You can delete the rest of
the levels, they’re useless for this technique.
We’re going to start with the last swing low that occurred
Friday, not long after the spike that materialized from the economic data.
For our pivot low, we’re going to select the cluster of closing and opening prices that
form just above the wicks on the swing low. Why? Those wicks are areas where
bears who were late to the party go trapped. We don’t want to use any pivot
high or low to start our measurements where traders got trapped. So, we’ll
start just above the key reversal where price forms a nice line of closes and open
that all occur at the same price level. If I use a candlestick wick for a
Fibonacci measurement, then I need a good reason to do so.
Now we’re going to drag our retracement tool up to an
internal marker, a bar that starts one of the strong moves down in price. We could select the
start of the gap down in price that occurred between Tuesday, April 9th
and Wednesday, April 10th (in fact, I have used that marker before
for a previous measurement). The issue is that all three of our Fibonacci
sub-divisions will fall within the current price action and we want to know
where price could go, not where it currently is. Instead, we’re going to select
the top of the strong red candle starts the waterfall downwards in price on
Thursday, April 4th. That will give us the Fibonacci sub-divisions
as shown in the image above. On their own, each of these zones will act as
minor resistance. That’s not very useful, because a minor resistance zone will
only be a short speed bump for price. We want to know areas of major
resistance. So we need more Fibonacci sub-divisions.
Okay, we've added a second measurement to our chart shown above. This next bit is important for this technique, so I’m going to put it in bold and emphasize sections of it with caps lock. To find Fibonacci confluence zones, each measurement MUST start from the SAME PRICE LOW, but END at DIFFERENT PRICE HIGHS. The areas of MAJOR RESISTANCE will form overlapping zones from TWO DIFFERENT FIBONACCI SUB-DIVISIONS. This means that we would like to see a pair of different Fibonacci ratios (e.g., 50% and 38.2%, not 50% and 50%) overlapping at the same price level or within a couple dollars of each other to define a zone of major price resistance. On the chart above, the second retracement starts at the same price low and now measures resistance upwards and ends at a different price high, the start of the the strongest bar within the initial move down from the top on the hourly chart. We see that there could be a Fibonacci confluence zone at $205.07 and $205.37. This is a good start, but let’s add a third retracement to our chart.
This retracement also starts from the same price low and ends at the top wick of the candle at $208.70. Remember how I said I needed a good reason to use a candle wick in my measurements? Look to the left along the blue line that defines the top of this measurement. There is a strong downward signal to the wicks that closed out the session on Monday, April 1st. The moment price even looked at the $208.70 level, it was pushed downward. Even further to the left, there are two candles with a close and open that fall right on the blue line. This is a level of resistance that price respects, so we should use it. We have two tight zones of confluence that have developed with this third measurement between $205.07-$205.11 and $205.96-$206.16. What if we add a fourth zone to the chart?
The final measurement is shown in aquamarine and is not as
useful because it terminates so close to the yellow zone. We need two different
Fibonacci relationships to define a confluence zone. A 50% and a 50% that
overlap aren’t useful. Regardless, we do see that this retracement adds an
important detail. It forms a confluence zone with the price we identified
earlier at $205.37. Now let’s mark all three zones with yellow lines that
define the boundaries of each zone and delete the retracement tools so we can
unclutter the screen.
Here is the final chart. We have three zones identified
where price is likely to fall. I’m still new to this technique and it is
entirely possible that the two zones lowest in price (at $205.05 and $205.35,
respectively) should be treated as one singular zone of major resistance, but
for now I’ll mark them as separate zones. So, now I know where price is likely
headed if we travel higher over this week. First, price should target the zones
between $205.05 and $205.35. If it breaches these zones, I expect price to then
rise up to meet the zone at $206. From there, I would like to see an initial
five-wave move down followed by a smaller three-wave corrective move to set up
a larger decline. With price sitting just below this zone at $204.50 I have
opened my first speculative position in very small scale only putting
approximately $250 into this trade as far as sizing is concerned.
- Opened IWM 185/175 put debit spread, Dec. 31, 2024 expiration. Average fill price 0.9, size: 3 contracts. Max risk: $270, Max gain: 300% at price target of $168. -
Do keep in mind with aggressive short positions like this I
consider the risk my entire premium paid. If I had to designate a stop, it
would be the previous high struck near the turn of the month at $211.87. If we
get a strong short setup that would be characterized by an initial five-wave
move down and three-wave corrective retrace, I will start to open larger short
positions. If price trades through the $206 level. I plan to take a step back
and reassess the possibility that the wave (B) may not have been completed yet.
However, a resolution to wave (ii) followed by a resumption of the decline to
lower lows is the most likely scenario I can see at the moment, so I do not
have an immediate bullish alternative.
Now, this trade is a set up designed to capitalize on the
first initial move down off the highs that could take the remainder of the year
to materialize. What are my short-term expectations for IWM? For that we’d need
to turn to the futures contracts in RTY, or more specifically, M2K (I trade the
micros). Below is a 1-hour chart for RTY. I’ve added labels for the wave (v) of
the wave (B) top, the initial wave (i) decline and the wave (ii) bounce. Let’s
dive into this a little closer to get an idea where the futures could head this
week.
We’re going to want to draw the Fibonacci confluence zones from the same price lows we used in the IWM although the actual placement will be slightly different as there is more price data to work with. We are still going to truncate the move down, but we are going to do so at the close of the large red hourly candle from Friday morning. It is marked with a red arrow. The first measurement ends at the top of the wick for the largest red candle down. I’m more keen on using cand wicks for futures data simply because the large size of the moves that can occur in pre-market outside of regular trading hours data. How do I know if this wick is the correct price point to pick? Again, we look to the left. Price has respected the 38.2% level of this retracement measurement in the past during the initial decline that started in April.
We seem to be picking a lot of candle wicks on this move
down. Here’s another reason why we are doing so. You cannot select any bar to
end a Fibonacci measurement that has been retraced by price. When we see these
little spikes up that retrace an area of price consolidation and then turn
down. All we are left with is the candle wick, so we must use it. In this case
we already have a clear confluence zone forming between the blue 61.8%
retracement and the orange 50% retracement. We’ll keep that in mind as we add our third and fourth
measurements.
We’ve added two more measurements now, one in green and one
in white. What we see is that price has currently run into a wall at a zone
that forms between 2075.5 and 2078.0. Price can grind through this area, but it
explains why it’s been slow moving since Friday morning’s economic release. In
fact, there is another confluence zone not shown on this chart that I measured
a week ago at 2070-2071. Price will be grinding a lot to get through these
resistance levels unless we get a strong catalyst this week or next…. Now, we
want to mark the confluence zones again using yellow lines like I’m going to
show in the chart below. Once we’ve marked the zones we can delete or hide our
measurement tools to clean up the chart.
Okay, so here’s the situation as I see it. Price is currently underneath a Fibonacci confluence zone. However, the final move up to finish wave (c) of (ii) needs to be a five wave move. As I count it, we currently have 4 of 5 waves needed to complete wave (c) of this correction. Furthermore, the swing into the high to end wave (ii) should be symmetrical. Price at its current level lacks proportionality, so I believe we’re due for one last stab higher. We can make a quick measurement of proportionality using a rectangle to get a rough idea of which confluence zone price will prefer. To do so, I’ve added a red line to our RTY chart. This red line is a confluence zone that I drew about 10 days ago when price started making its corrective move higher. You can see from right to left that price has used this red line as resistance on it’s initial move up as well as during the spike and reversal that formed during Jerome Powell’s interview last week. We’re going to measure a rectangle from the pivot low marked by the red arrow up to the red line. It will be shown as a white rectangle on the chart below. This rectangle is approximately half of the expected move off of the pivot low.
We’re now going to copy that rectangle and move it to the red line again so that the bottom of our new rectangle lines up with the top of our old one. The top of our new rectangle shown in the chart below lines up well with our middle confluence zone that is located just over our current resistance level.
Using the same method we discussed earlier, we’ll copy the blue box and move it down so that the bottom of the first box and top of the second box touch at the middle confluence zone. To get a better idea of potential price levels that may act as support on the way down, we’re going to subi-divide this new rectangle using our retracement tool. Our initial price target will be the 38.2% retracement level at ~ 2055. However, just because price enters this zone does not mean I would necessarily cover a short position. For that, we’d need to rely on our technical indicators and read what they are telling us. That is a discussion for a different day.
I’ll be out of state this weekend traveling with my partner
to visit family, so I may not have an update until the middle or end of next
week. I will continue to revise my analysis as necessary and now that both the
long-term and short-term time horizons have been summarized, my next update
should only be minor adjustments or trade setups. Until then take care of
yourself, manage your risk, and always keep learning each step of the way.
Best,
DW
No comments:
Post a Comment