A Low-Risk Entry Into Tesla
There are a lot of traders who are watching the incredible rally in Tesla TSLA (TSLA) and wondering whether there will be any safe level to enter this volatile stock. Elliott Wave analysis could be of some help here. Traders who use technical analysis are familiar with the Elliott Wave Theory which says that all bull cycles are made up of five waves, of which the third wave is usually the fastest. The second and fourth waves are corrections that come in between. With that brief introduction, let us examine whether we can plan our entry into TSLA.
It is important to bear in mind that Elliott Waves is an approach to trading. It is not a magic formula where one can calculate some ratios and expect the market to do one’s bidding. Once you know the theory well, you have to learn how to use it to your advantage. Let us see how we can do that with TSLA now.
The first chart below shows some tentative labels for the three waves we have seen so far. It is a long-term chart, going back to the IPO time. We saw a low of around $3 sometime in July 2010 and that becomes a significant low, where we place the point zero. Typically, first waves of a bull market take many forms. It is rare to see a clean formation, where the sub waves are neatly formed. But we can deduce where the third wave has commenced and place the end of wave 2 there. That is a useful approximation for our purposes here. It is usually very easy to spot third waves because the rally goes ballistic, and there is an increase in volume as well. Fundamentals also often support the sentiment. Anyone who attempts to sell during the third wave rally will get killed.
Now let me state one thing very clearly. We don’t know for sure that wave 3 has ended at $884 levels. It is just an assumption. An extending third wave ends when it ends! However, we are not making any predictions. We want a low-risk entry into the stock. And if our assumption is right about wave 3 having ended already, then we can anticipate where wave 4 could possibly end. But more about that later. Let us examine waves 1 and 2 a bit more closely.
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A second wave corrects the first wave. Generally, a deep correction comes down below the 50% retracement of wave 1. The chart below is a close-up view of the first and second waves of Tesla.
There is a useful guideline in the Elliott Wave Theory that is known as the principle of alternation. Briefly, when wave 2 is a complex correction, then wave 4 is likely to be a simple correction. A simple correction is made up of just three waves, whereas a complex correction is often a combination of two or more sets of three waves, separated by an intervening wave labeled as the X wave, as seen above in wave 2. Thus, we should expect wave 4 of Tesla to be a simple wave.
Generally speaking, when wave 2 is deep, wave 4 tends to be shallow. In my experience, a shallow correction that comes after an extending wave tends to travel to the 23.6% retracement of the prior impulse wave that it is correcting, and occasionally to the 38.2% retracement level. Sometimes, it ends between these two levels.
The following chart assumes that wave 3 has already ended, and we draw the Fibonacci retracements to figure out possible end points for wave 4.
Now comes the planning of our trade. Assuming wave 4 comes down to the 23.6% level, we could place our bids a short distance ahead of that level, say at $690. However, because there exists a chance to continue lower still to the 38.2% level, we need to keep some capital to buy some more near this second level.
As with any trade, a stop loss order has to be placed at an affordable level. Additionally, I only take trades that offer at least a three-to-one profit for the amount we risk. A technical stop can be below the 38.2% retracement, or at $550. That means we will be risking some 80 dollars on this trade. This would make sense only if wave 5 will go up by at least three times that, or over $240. Let us see the possible targets for wave 5 in the next chart. As explained in my book “Five Waves to Financial Freedom”, we can compute potential targets for wave 5 by measuring the distance traveled from the point zero to the top of wave 3, and then computing three standard Fibonacci ratios, viz 38.2% 50% and 61.8%. We then add these to the anticipated bottom of wave 4 to arrive at potential wave 5 targets.
In the first chart below, we add the three results to 684, the first anticipated low for wave 4 and see that the earliest target for wave 5 comes at 1021. That is a move of $330, which is over four times what we will be risking.
Should wave 4 dip to the lower target of the 38.2% retracement, then the targets for wave 5 will be as shown in this chart.
Thus, we have a plan of action to get on board the Tesla dream run. True, the stock could go up some more without coming down to 690. In that case, we will wait for the rally to run out of steam and call the new high as the end of wave 3. After that, we merely rework the targets for wave 4 by following the same method as explained above. A smart application of the Elliott Wave approach can make a tremendous difference to one’s trading results.