Stop Using Stops: Trading with Elliott Wave Analysis

Bob Prechter has done a lot of thinking about how to trade successfully. One startling conclusion he's come to: traders should often avoid using stops. Here's why: If you analyze the market you're trading, you shouldn't need a stop to tell you when to get out of the trade. In fact, the point of using Elliott wave analysis is to determine where the market is in a wave count, so that you are able to see where the trend is most likely to turn. (This excerpt is taken from the March 2003 Elliott Wave Theorist, the publication Bob has been writing for more than 25 years.)

Let’s talk about stops.

Bob Prechter: I think people lose more money on stops than anything else. When a trader suffers five stop-outs at 10 S&Ps contracts apiece, that trader now has 50 points to make up. Every book says to use stops, but it is often a bad idea. Before you recoil in horror, consider that I know a futures trader who steadily makes $200,000-$400,000 every year, and he never uses stops.

A stop takes only one aspect of analysis into account: price. There is much more to analysis than price. A stop also makes you lazy. If the market and your analysis turn against you, you are prone to think, “Well, if the market takes my stop, then I’m out.” But if you have already decided that your position is wrong, you should already be out! On the flip side, when you already have a stop in and decide it’s in the wrong place, there is a psychological impediment to widening it. If you don’t act, the stop is typically taken out, and then the market turns your way without you. So it can hurt you two ways.

So what should a trader use in place of stops?

Bob Prechter: A trader should use real-time analysis. The question isn’t so much whether a level is broken but what the analysis indicates as it breaks. Suppose you are short, and the market gaps up one morning. This could be a breakaway or an exhaustion gap, so at the time of the opening, you might have little knowledge of which it might be. Then suppose the market runs ticks hard but to a lower peak than earlier in the rally, which is typical of exhaustion gaps. Shortly after the high, you see a dramatic reversal in the 60-minute bar and non-confirmations against highs of the previous week in related market averages. At that point, the bear evidence becomes bigger than the bullish evidence, and your analysis tells you to stay short.

When entering a position, you have to give the market time to bounce around against you as it creates the bottom or top. That process almost always involves stopping most traders out with fancy footwork before really heading in the direction they expected in the first place. Most stops are harmful because where you decide is a cautious “too far” is where everyone else thinks is too far, so that’s where everybody’s stops are. The only way to make money is to let the market work itself out.

So what is the alternative?

Bob Prechter: Once you have a strong indication from your analysis and decide to take a position, place a stop at a “horror” level in case of disaster with the idea that you would never hold your position all the way to that point under normal circumstances. Then, watch the market. Every day, sometimes every hour, you get more information. You might have a bearish opinion but find that suddenly the put/call ratios (or some reliable sentiment indicator) shows traders shorting the market heavily for three days in a row. Now the analysis is telling you to be cautious or get out of your position or perhaps go long. It is a more sensible reason to act than a price stop.

What do you say to those who insist that without stops, they would get killed?

Bob Prechter: I say, you are trading with too much leverage. Leverage forces you out so often that all you will have after years of trading is a long string of losses from stop-outs. Trade well within your capital so that you can allow the market time to respond to the forces that you detect developing in your analysis. If you cannot watch the market closely or do not have time to do analysis (or don’t have someone doing it for you), you shouldn’t be trading in the first place. Aside from all that, there may in fact be occasional times for close stops. But treat them as exceptions that analysis demands.

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Applying Elliott Wave Analysis to Everyday Trading

Elliott wave analysis appeals to the instincts and to the intellect, but sometimes it's difficult to see how to trade using Elliott waves. The beauty is that the practical application is within anyone's reach. In today's Market Perspective, we'll see how Bob Prechter explains the Wave Principle and its application. (This excerpt is taken from the latest edition of Prechter's Perspective, published 2004.)

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You've said that the Wave Principle is relatively easy to understand. How about application?

Bob Prechter: The basic idea is easy to understand. The intricacies can take a fair amount of time to learn. Once you've learned them, it becomes an easy step to recognize forms in the market. When you can recognize five wave moves, A-B-C corrections and Elliott triangles, a glance through your commodity charts will show definite buys and sells with no additional work whatsoever. It offers the best reward-for-the-effort-expended ratio I know.

On the other hand, you've also said that it is mastered by a relative few. Out of all investors, how many do you think the Elliott wave method is geared for?

Bob Prechter: Only people who want to put in the extra effort. That's frankly a very small group. I think everybody will find the idea of the Wave Principle fascinating. People who aren't even in the market find it an interesting concept. But the people who should actually apply it are only the people who want to make the market a very large part of their lives. You can't make money at something without working at it. The Wave Principle demands that much, because the market demands that much. They are one and the same.

It's deceptive ?a construct that is simple and easy to understand, but because of the inherent uncertainty, it demands rigorous and disciplined application.

Bob Prechter: Well, the rules of chess are simple, but winning the game is not so easy.

So the essence of the task is to order the probabilities correctly. How is this accomplished on an ongoing basis?

Bob Prechter: The first thing you have to do is eliminate the impossible by applying the rules of wave analysis. At any market juncture, there are certain events that are impossible. Remaining may be a formidable list of possible interpretations. However, each possible interpretation must then be judged according to its adherence to the guidelines of the Wave Principle, including alternation, channeling, Fibonacci relationships, relative sizes of waves, typical targeting methods based on wave form, and volume and breadth, if appropriate.

The interpretation that (1) satisfies the most guidelines and (2) does so the most satisfactorily is the one that must be considered to be indicating the most likely path of the market. The next most satisfactory interpretation indicates the next most probable path, and so on. These are sometimes referred to as preferred and alternate interpretations.

The analyst must then monitor the market closely to determine if and when any one of the less probable interpretations becomes the most probable due to the elimination or decline in probability of other interpretations.

This sounds complicated.

Bob Prechter: Not really. Often, the best interpretation is so clearly superior that an investment decision is easy. Similarly, sometimes, the top two or three interpretations have the same implications regarding market behavior, also making an investment decision easy. At other times, interpretations with different implications carry nearly equal weight, dictating a "stand aside" posture. In the latter case, sooner or later the scales always tip in favor of one particular conclusion.

Forecasts of the Markets You Follow. No More, No Less.

In a perfect world, you would custom-build your own financial service. From the dozens of markets out there, you would select which ones to follow. You would get professional-grade forecasts. And you wouldn't pay for coverage you don't need.

We can't give you a perfect world, but we can give you the service described above.

We have unpackaged the comprehensive services that we supply to hundreds of institutions around the world. So now, our specialized forecasts of the world's major markets are far more flexible and affordable. You can pick and choose to create a forecasting service tailored to meet your unique needs. Each service is a bargain, and the more you choose, the less each one costs.

Specialty Services cover nearly all major world markets:

Stocks	Currencies
Commoditites	Metals
Interest Rates	Energy

Intraday Forecasts ? You get short, clear forecasts of the market's direction as often as market action warrants. For some markets (currencies and S&P futures, for example), you get updates 24 hours a day, often with short-term charts. Precise support and resistance points help you stay in control of your position risk.

Daily, Weekly & Monthly Forecasts ?Every evening after the market closes, our labeled daily price charts give you concise directional forecasts for tomorrow. And you'll always have our current long-term outlook, complete with weekly and monthly price charts updated as the market requires.

Whether you take a few major positions a year or trade intraday ... whether you're trading currencies, stocks, bonds or others ... EWI's Specialty Services give you the forecasts you need.

The Percent "R" Indicator: How to Make it Work for You

The Percent Range (%R) technical indicator was developed by renowned futures author and trader Larry Williams. This system attempts to measure overbought and oversold market conditions. The %R always falls between a value of 100 and 0. There are two horizontal lines in the study that represent the 20% and 80% overbought and oversold levels.

In his original work, Williams' method focused on 10 trading days to determine a market's trading range. Once the 10-day trading range was determined, he calculated where the current day’s closing price fell within that range. The %R study is similar to the Stochastic indicator, except that the Stochastic has internal smoothing and that the %R is plotted on an upside-down scale, with 0 at the top and 100 at the bottom. The %R oscillates between 0 and 100%. A value of 0% shows that the closing price is the same as the period high. Conversely, a value of 100% shows that the closing price is identical to the period low.

The Williams %R indicator is designed to show the difference between the period high and today's closing price with the trading range of the specified period. The indicator therefore shows the relative situation of the closing price within the observation period.

Williams %R values are reversed from other studies, especially if you use the Relative Strength Index (RSI) as a trading tool. The %R works best in trending markets. Likewise, it is not uncommon for divergence to occur between the %R and the market. It is just another hint of the market’s condition.

On specifying the length of the interval for the Williams %R study, some technicians prefer to use a value that corresponds to one-half of the normal cycle length. If you specify a small value for the length of the trading range, the study is quite volatile. Conversely, a large value smoothes the %R, and it generates fewer trading signals. Some computer trading programs use a default period of 14 bars. Importantly, if an overbought/oversold indicator, such as Stochastics or Williams %R, shows an overbought level, the best action is to wait for the futures contract’s price to turn down before selling.

Selling just because the contract seems to be overbought (or buying just because it is oversold) may take a trader out of the particular market long before the price falls (or rises), because overbought/oversold indicators can remain in an overbought/oversold condition for a long time--even though the contract’s prices continue to rise or fall. Therefore, one may want to use another technical indicator in conjunction with the %R, such as the Moving Average Convergence Divergence (MACD).

The trading rules are simple. You sell when %R reaches 20% or lower (the market is overbought) and buy when it reaches 80% or higher (the market is oversold). However, as with all overbought/oversold indicators, it is wise to wait for the indicator price to change direction before initiating any trade.

Larry Williams defines the following trading rules for his %R: Buy when %R reaches 100%, and five trading days have passed since 100% was last reached, and after which the %R again falls below 85/95%. Sell when %R reaches 0%, and five trading days have passed since 0% was last reached, and after which the Williams %R again rises to about 15/5%.

Like most other "secondary" tools in my Trading Toolbox, I use the Williams %R indicator in conjunction with other technical indicators -- and not as a "primary" trading tool or as a stand-alone trading system.

More information on the Williams %R indicator can be obtained from Williams' book: "How I Made $1,000,000 Last Year by Trading Commodities." It's published by Windsor Books, New York.

Why Successful Traders Use Fibonacci and the Golden Ratio

Support and resistance levels on bar charts are a major component in the study of technical analysis. Many traders, including myself, use support and resistance levels to identify entry and exit points when trading markets. When determining support and resistance levels on charts, one should not overlook the key Fibonacci percentage "retracement" levels. I will detail specific Fibonacci percentages in this feature, but first I think it's important to examine how those numbers were derived, and by whom.

Leonardo Fibonacci da Pisa was a famous 13th century mathematician. He helped introduce European countries to the decimal system, including the positioning of zero as the first digit in the number scale. Fibonacci also discovered a number sequence called "the Fibonacci sequence." That sequence is as follows: 1,1,2,3,5,8,13,21,34 and so on to infinity. Adding the two previous numbers in the sequence comes up with the next number.

Importantly, after the first several numbers in the Fibonacci sequence, the ratio of any number to the next higher number is approximately .618, and the next lower number is 1.618. These two figures (.618 and 1.618) are known as the Golden Ratio or Golden Mean. Its proportions are pleasing to the human eyes and ears. It appears throughout biology, art, music and architecture. Here are just a few examples of shapes that are based on the Golden Ratio: playing cards, sunflowers, snail shells, the galaxies of outer space, hurricanes and even DNA molecules. William Hoffer, in the Smithsonian Magazine, wrote in 1975: "The continual occurrence of Fibonacci numbers and the Golden Spiral in nature explain precisely why the proportion of .618034 to 1 is so pleasing in art. Man can see the image of life in art that is based on the Golden Mean."

I could provide more details about the Fibonacci sequence and the Golden Ratio and Golden Spiral, but space and time here will not permit. However, I do suggest you read the book "Elliott Wave Principle" by Frost and Prechter, published by John Wiley & Sons. Indeed, much of the basis of the Elliott Wave Principle is based upon Fibonacci numbers and the Golden Ratio.

Two Fibonacci technical percentage retracement levels that are most important in market analysis are 38.2% and 62.8%. Most market technicians will track a "retracement" of a price uptrend from its beginning to its most recent peak. Other important retracement prcentages include 75%, 50% and 33%. For example, if a price trend starts at zero, peaks at 100, and then declines to 50, it would be a 50% retracement. The same levels can be applied to a market that is in a downtrend and then experiences an upside "correction."

The element I find most fascinating about Fibonacci numbers, the Golden Ratio and the Elliott Wave principle, as they are applied to technical analysis of markets--and the reason I am sharing this information with you--is that these principles are a reflection of human nature and human behavior.

The longer I am in this business and the more I study the behavior of markets, the more I realize human behavior patterns and market price movement patterns are deeply intertwined.

Why Successful Traders Use Fibonacci and the Golden Ratio

Support and resistance levels on bar charts are a major component in the study of technical analysis. Many traders, including myself, use support and resistance levels to identify entry and exit points when trading markets. When determining support and resistance levels on charts, one should not overlook the key Fibonacci percentage "retracement" levels. I will detail specific Fibonacci percentages in this feature, but first I think it's important to examine how those numbers were derived, and by whom.

Leonardo Fibonacci da Pisa was a famous 13th century mathematician. He helped introduce European countries to the decimal system, including the positioning of zero as the first digit in the number scale. Fibonacci also discovered a number sequence called "the Fibonacci sequence." That sequence is as follows: 1,1,2,3,5,8,13,21,34 and so on to infinity. Adding the two previous numbers in the sequence comes up with the next number.

Importantly, after the first several numbers in the Fibonacci sequence, the ratio of any number to the next higher number is approximately .618, and the next lower number is 1.618. These two figures (.618 and 1.618) are known as the Golden Ratio or Golden Mean. Its proportions are pleasing to the human eyes and ears. It appears throughout biology, art, music and architecture. Here are just a few examples of shapes that are based on the Golden Ratio: playing cards, sunflowers, snail shells, the galaxies of outer space, hurricanes and even DNA molecules. William Hoffer, in the Smithsonian Magazine, wrote in 1975: "The continual occurrence of Fibonacci numbers and the Golden Spiral in nature explain precisely why the proportion of .618034 to 1 is so pleasing in art. Man can see the image of life in art that is based on the Golden Mean."

I could provide more details about the Fibonacci sequence and the Golden Ratio and Golden Spiral, but space and time here will not permit. However, I do suggest you read the book "Elliott Wave Principle" by Frost and Prechter, published by John Wiley & Sons. Indeed, much of the basis of the Elliott Wave Principle is based upon Fibonacci numbers and the Golden Ratio.

Two Fibonacci technical percentage retracement levels that are most important in market analysis are 38.2% and 62.8%. Most market technicians will track a "retracement" of a price uptrend from its beginning to its most recent peak. Other important retracement prcentages include 75%, 50% and 33%. For example, if a price trend starts at zero, peaks at 100, and then declines to 50, it would be a 50% retracement. The same levels can be applied to a market that is in a downtrend and then experiences an upside "correction."

The element I find most fascinating about Fibonacci numbers, the Golden Ratio and the Elliott Wave principle, as they are applied to technical analysis of markets--and the reason I am sharing this information with you--is that these principles are a reflection of human nature and human behavior.

The longer I am in this business and the more I study the behavior of markets, the more I realize human behavior patterns and market price movement patterns are deeply intertwined.

Switch Time Frames For Better Exits

I just returned from a weeklong Trader's Camp hosted by Dr. Alexander Elder in a beautiful island nation in the South Pacific called Vanuatu. When I studied geography in school many years ago, Vanuatu was known as the New Hebrides islands. Vanuatu is located about 1,000 miles west of Fiji.

If you have read Elder's excellent book, Trading For A Living, you will recall that Dr. Elder is an advocate of using multiple time frames for trading both stocks and futures. For example, he suggests looking at the weekly chart to make sure that the weekly trend is firmly up before trading the long side of a market based on the daily chart patterns. This approach makes good sense and I highly recommend his book and his strategy.

While listening to Dr. Elder explain his multiple time frame strategy for entries, my thoughts wandered to the application of his ideas to my favorite subject - exits. One of my goals in trading is to find exit strategies that do a good job of protecting open profits. One method of accomplishing this goal is to simply move the daily stops closer once a specific profit objective has been reached. However, it might also make sense to simply switch to a chart with a shorter time frame once we have reached a reasonable profit objective.

Here is an example of how such a strategy might work. Let's say that we have been trading XYZ stock on an intermediate term basis using daily charts. The trade is working out very well and we now have six ATRs of open profit. (See previous Bulletins for an explanation of how to use Average True Range to set profit targets). Up to this point we have been using our well-known Chandelier trailing stop placed at 3 ATRs below the high point of the trade.

However, now that we have reached our primary profit objective we want to tighten up our stop to protect more of our profits. We could reduce our Chandelier stop from 3 ATRs to 2 ATRs and continue using the daily bars or we could switch our chart to one hour bars and continue to trail the Chandelier exit at 3 ATRs based on the intraday one-hour bars. The basic idea is to switch to a chart with a shorter time frame once we have reached our profit objective. This procedure should allow us to let our profits continue to run but we would be protecting our open profits with much closer stops by using the chart with a much shorter time frame.

Combining our exit strategy with Dr. Elder's entry strategy would provide the following sequence: for entries we first examine the weekly chart and then use the daily chart to trigger the trade. Once we are ready to exit our trade we examine the daily chart and then trigger our exit using the hourly chart.

Of course this strategy would require some extra work as well as the use of intraday data. The alternative would be to simply reduce the number of ATRs used to hang the Chandelier exit on the daily chart. Either way we do it, the logic is to move our stops closer once we have achieved a worthwhile trading profit.

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Notes On Bear Markets

One of the best ways to gauge a bear market is to observe the reaction to good and bad news. In a bear market the averages go down even when the news is good. (For example, look what happened the last time the Fed cut interest rates.) We will know that the bear market is finally over when we observe the market reacting favorably to good news. In the meantime, we can take some consolation in the fact that at the present rate of decline we will soon be at zero. At least at that level we should be able to safely resume trading stocks from the long side.

Doubly Adaptive Profit Objectives

Having well-planned profit objectives is the best way to maximize closed-out profits. The tendency is to either take profits too soon or too late and most traders tend to err on the side of taking profits too soon. Taking a quick profit always feels good and helps to maintain our winning percentage because these "nailed-down" profits will never turn into losses. However, taking profits too soon can be one of the most costly of all possible mistakes.

It has been argued that profits in trading (especially in futures) are possible because the distribution of prices is not normal and is not a typical bell-shaped curve. The tail on the right hand side tends to be surprisingly thick indicating that unexpectedly large profits are possible. The opportunity for large profits comes our way more often than one might expect. However if we went for big profits on every trade we would also be making a big mistake. Major profit opportunities are the exception not the rule.

In very general terms there are two ways of having an advantage or "edge" in trading. One is to have gains much larger than losses and the other is to have more winners than losers. To succeed as traders we need to do our best to maximize both the percentage of winners and the size of the winners. These two worthy goals appear to be mutually exclusive. If we take the quick small profits we can have a good winning percentage but we eliminate any possibility of more substantial profits. However, if we fail to take some of the small profits they may well turn into losses.

Wouldn't it be ideal if we could know when it was best to take small profits and when it was best to hold patiently for big profits?

In previous Bulletins we have discussed the advantages of using profit objectives expressed in units of Average True Range. To quickly summarize that discussion, the ATR expands and contracts with the volatility of the market. In a quiet market a profit objective of 2 ATRs might bring us a profit of $600. In a very volatile market, two ATRs of profit might be $1400 or more. By expressing our profit goals in terms of ATRs instead of fixed dollar amounts we make them highly adaptive to what is going on in the market in terms of variations in volatility. However, what we will propose in this Bulletin goes a big step beyond that highly recommended procedure.

We have done a great deal of research using the Average Directional Index (ADX) that leads us to believe it is possible to vary our exit strategy to stay in tune with the trendiness of the market as well as the volatility. By having a doubly adaptive profit-taking strategy we can happily accept small profits when that is the best the market has to offer or we can change the strategy and hold out for unusually large profits when those opportunities are known to be present.

Volatility as measured by ATR is obviously important but daily volatility does not always relate to direction and trendiness. It is quite possible that we can have lots of big ranges in a market that is merely going sideways or we could have small ranges in a market that is highly directional. It is the correct combination of directional price movement and volatility that will allow us to maximize our profits in relation to what is happening in the market at any given time. For the best possible results we want to combine our knowledge of ATR and ADX.

As we have described in previous Bulletins, ADX tells us the underlying strength of any trend. When the trend is strong the ADX will rise. When the trend is weak the ADX will decline. This is true in stocks as well as in futures. It also applies in downtrends as well as in uptrends. A rising ADX means a strengthening trend and a declining ADX means a weakening trend.

Let's go back to our earlier example where our plan was to take our profits at the 2ATR level. With this adaptation to volatility we are counting on the changes in volatility to produce large profits and small profits based on a constant target of two ATRs of profit. However we can go a step further and get even better results. Under our new plan, when the ADX is declining we will reduce our expectations and accept profits of only 1.5 ATRs instead of two. And when the ADX is rising we will double our expectations and wait for profits of 4 ATRs instead of 2. Now we are adapting our exit strategy to both the current volatility and to the amount of trendiness in the market we are trading. As you might expect the difference in results is dramatic because our profit-taking strategy is doubly adaptive.

The logic of this strategy should be obvious. When the market is not trending strongly we improve our results by reducing our profit expectations and maintaining our winning percentage. When the market is trending strongly we know it is time to abandon our small profit targets and time to take advantage of some unusually large profit opportunities.

The examples of 1.5 ATRs as a profit target in a non-rending market and 4 ATRs as a profit target in a strong trending market are just broad guidelines and we need to vary these parameters depending on the particular market and type of system we are operating. Short-term systems may require smaller objectives and long-term systems may require much larger objectives.

We suggest you start with a 20 day ATR and a 14 to 18 day ADX. Play around with the units of profit and see what a dramatic improvement you can make in your trading results by combining ADX and ATR.