Although fundamental analysis is essential, since the central bank’s movement is key to establishing the monetary policies that cause major swings in the market, every day technical analysis is also vital for helping investors to maintain an effective system of money management and to successfully execute day to day trading of assets.
There are a number of trading theories that are applicable to the swings made in the financial markets, all with the purpose of forecasting imminent price actions, and one of the most famous patterns observed on the technical charts is the waterfall effect.
Identifying the Waterfall Effect on a Chart
The waterfall effect can be identified in the second and third correction of a complex corrective wave such as a triple combination or triple zigzag. To identify the waterfall effect, the investor simply needs to measure the first correction’s length with a Fibonacci retracement tool, subtract 61.8% from it and project that from the first correction’s ending point. This will predict the end of the 2nd correction.
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By subtracting 38.2% again from the 1st correction and projecting it to the second correction’s end, this will predict the end of the 3rd correction and thus, the ending point of the entire complex correction.
The waterfall effect is widely known as one of the more complication technical analytical patterns and this is because it is solely formed from corrective waves, meaning that every single pattern is corrective, not impulsive. This is key as, if the waterfall effect is observed in a bearish trend, put options should be purchased on the retracement levels determined by the 2 corrections going in the opposing direction.
Should the first corrrection on the downside be a zigzag followed by an x wave, the corrective wave should be simple and unlikely to retrace further than 61.8% from the entire distance that the price is travelling from the start of the zigzag right up to its ending point. However, using a Fibonacci retracement level will give the trader the chance to scale into the position, e.g. purchasing put options on retracement up to the 23.6% level, followed by a retracement to 38.2% level etc. while calibrating the expiry date dependent on the time frame under consideration.
How to Trade Using the Waterfall Effect
In the case of a bearish pattern demonstrating the waterfall effect, it is possible to trade call options. These should, however, only be traded once the price is forming the final corrective wave. Usually, this corrective wave will be a triangle and the call option’s striking price should be determined by the moment when the market is making its new low following the just completed x wave.
In the unlikely situation that the waterfall pattern appears as the second wave of an impulsive move, the trader should expect a strong impulsive move as the 3rd wave, and therefore buying call options with a larger expiry date is recommended. There is also a possibility that this pattern will be the complete leg of a contracting triangle, and in that case, it will be followed with a corrective wave, with corrections in the opposite direction.
There is another special kind of impulsive move in which all of the legs are corrective, and in this case, the final, fifth leg may form a pattern – a triple combination that respects the waterfall effect. This pattern will most likely appear if the market is forming either a triple combination or a triple zizag and it will not be identified in an impulsive move. Therefore, when this complex correction is forming, being away of the levels that it respects will give investors the ideal striking price.
Other educational articles
- What is the Double Top and Double Bottom Pattern in Binary Options Trading?
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- What is the Contracting Triangle Pattern in Binary Options Trading
- What are Impulsive Waves in Binary Options Trading?
- What are Corrective Waves in Binary Options Trading?
- Triangles as Continuation Patterns in Binary Options Trading
- “Cross-market financial risk analysis: an agent-based computational finance.”, International Journal of Information Technology & Decision Making 10, no. 03 (2011): 563-584, Xiong, Xiong, Mei Wen, Wei Zhang, and Yong Jie Zhang.
- Trends of Global Exchange-traded Stock Index Futures and Options Market and Its Implication, Yang Shenggang Wang Chende