The Waterfall Effect

Trading is part technical analysis, part fundamental analysis. Simply put, it is a sum of the two.

While fundamental analysis is extremely important as the moves a central bank makes in establishing the monetary policy are the ones that trigger big swings in the market, the day to day technical analysis is the one that helps a trader keep an objective money management system through stop losses and take profits.

The swings market makes are predictable with various accuracy degrees and this gave birth to a lot of trading theories: Elliott Waves, Gartley, Gann, etc, and they all have the purpose to forecast price action on the right side of the chart. One of the most famous pattern is the so called waterfall effect markets make. For example, in a complex corrective wave, like a triple zigzag or a triple combination, the second and the third correction can be identified using this waterfall effect. All one has to do is to measure the length of the first correction with a Fibonacci retracement tool, then take 61.8% out of it and project it from the end of the first correction. That should give us the end of the second correction.

Moreover, by taking 38.2% out of the first correction again, and projecting it at the end of the second correction, should give us the end of the third correction and, therefore, the end of the whole complex correction.

The waterfall effect is one of the most complex patterns in the technical analysis and this comes from the fact that it is formed only out of corrective waves. It means that each and every pattern is corrective and not impulsive. This is important as if the waterfall effect is coming in a bearish trend for example, then we should look to buy put options on the retracement levels given by the two corrections that go in the opposite direction.

Scale into Position by Using Fibonacci Retracement

For example, if the first correction to the downside is a zigzag then the x wave, the one that is correcting it, should be a simple one and it is unlikely to retrace more than 61.8% from the total distance price is traveling from the beginning of the zigzag until its very end. But, using the Fibonacci retracement level gives you the opportunity to scale into a position, for example buying put options on a retracement to the 23.6% level, then to a retracement to the 38.2%, and so on, while calibrating the expiration date depending on the time frame that is considered.

In a bearish pattern that respects the waterfall effect call options can be traded as well. These call options should be traded only after price is forming the last corrective wave. This last corrective wave is a triangle normally and the striking price for the call option should be given by the moment of time when market is making a new low after the x wave that was just completed. It means wave a is in place and in such triangles that signal a bottom in our case wave a is usually the longest one. This makes a call option from that level extremely appealing.

What to Do After the Waterfall Pattern is Completed?

Well, it depends very much where it appeared and what are the implications on the right side of the screen.

For example, if it appeared as the 2nd wave in an impulsive move (which is highly unlikely by the way), then we should embrace for a strong impulsive move as the third wave so call options with a bigger expiration date are recommended. That comes from the fact that any bounce from that area is likely to be met with nothing but new buyers as stop losses are going to be triggered by the time market is making a new highs and fresh bulls will want to join the party too.

There is also possible that such a pattern is appearing as being the entire leg of a contracting triangle and in this case it is going to be followed by a corrective wave as well only this time the corrections is going to be in the opposite direction.

Last but not least, in a special type of an impulsive move, when all legs are corrective, the last one, the fifth one, can form a pattern, namely a triple combination that is respecting the waterfall effect.

All in all, it should be noted that such a pattern appears most likely when market is forming a triple zigzag or a triple combination. In other words, it is not to be found in an impulsive move so when such a complex correction is forming then knowing the levels that it respects is giving us the perfect striking price.