Why is Elliott Wave so Useful?

The most accurate method of forecasting

The first time I came into contact with Elliott Wave was in my first seminar on technical analysis by a U.K. analyst. After the two day introductory course to analysis I returned to my trading room full of enthusiasm, armed with all the patterns and techniques this guru had imparted upon the fledgling analysts, ready to take the market by storm.

However, he clearly he didn't think very much about the principal since his only comment was "wave bye-bye to Elliott Wave."

So what did I have left?

• Golden crosses and dead crosses. Tried those - they were almost 100% the opposite of what he taught.
• Overbought & oversold momentum. Well good but they don't tell you where price is going and perform so badly in a trend.
• Reversal patterns and continuation patterns. Well they didn't happen that frequently and what were you meant to do in the meantime? My traders wanted to know where price was going to go.

I began to read more. Ah! Fibonacci! 38.2% and 61.8% - wow they worked really well… I thought I found the secret elixir to the fountain of profits… Then they suddenly didn't work.

Desperate for clues I read other analysts' commentary on the data vendor platforms. Some provided anemic comments while others actually forecast exact targets and how it would reach there. Some were ok, some were bad (but enthusiastic) and some were actually pretty good. This fascinated me. Who were these guys that were actually forecasting where price would go? How did they do that? The answer was Elliott Wave and it was these services that actually provided real information and had the greatest rate of success.

So I decided to read about Elliott Wave and tried to teach myself. Of course I didn't tell my guru - I didn't want to incur his wrath.

I can guess what some of you are thinking, "yeah, yeah, 12345 ABC." Well basically, yes. But it is a lot more. I bought a couple of books, devoured them and went to my charts to decipher and scribble numbers and letters all over them. It wasn't as easy as the books made them out to be. It was a struggle trying to decide where waves started and ended and how far they would move and I did give up for a period but the problem was that nothing else really gave true forecasting techniques.

So I persisted. I did my analysis and I read other banks' forecasts and tried to work out why they were right - or indeed, why they were wrong. I have to say it took me around 18 months before I felt comfortable using the principal to forecast, and even then it was still a little hit & miss.

As with any form of analysis there are good points about Elliott Wave and there are bad points. The bad points are:

• The counting of waves can be very subjective. There is a common joke that says: "Place 5 Ellioticians in a room with 1 chart for one hour and they'll come out with 20 different wave counts". True…
• The development of individual waves can vary dramatically
• The experience required to recognize the type of variation takes a good few years and a great deal of patience to acquire
• Sometimes waves are impossible to recognize
• Filtering wave counts to obtain the most likely ones can be difficult
• Elliott's description of the wave structure is actually incorrect for Foreign Exchange - a fact that took me many years to realize
• Once you start using the principal it is impossible to look at a chart without counting waves…
• It can cause you to make incredibly inaccurate forecasts if not utilized properly. (I recall one analyst that called USDDEM higher from 1.72 to 2.46 and 3.46… it actually went down to 1.44…)

Against that the good points are:

• Elliott Wave can predict market moves to the point at times - nothing else can
• Waves are related and thus you can use Fibonacci relationships to recognize waves, where they started and where they have greatest chance of ending
• It tells you how a move will occur. This is vital
• It will warn you that your wave count may be breaking down if the wave development doesn't go as planned
• It is the only form of analysis (that I know of) that gives you an understanding of market behavior as if it is an extension of a living force
• The principal helps an analyst/trader to understand the structure of a market from monthly charts down to 1 minute charts, a reflection of the fractal nature of markets.
• It can provide incredibly easy trades from time to time just using basic guidelines

The biggest element to success with Elliott Wave, apart from several years of experience, is understanding how to filter your wave counts. The very best way is to understand the cyclical nature of the market forces. If the analyst who had predicted USDDEM to move higher to 2.46 and 3.46 had incorporated cyclic analysis he would have seen that the major cyclic pressure was still lower. That in itself will keep you closer to the right count. Cycles have assisted me in recognizing direction to moves and when they should reverse - which combined with Fibonacci projections to structures can allow precise forecasting.

Momentum analysis can help you recognize when the pattern you have been following is breaking down and become more complex. Even a basic guidelines that the last Wave B will provide approximate support or resistance on retest can produce excellent trading opportunities.

So now what are you waiting for? Go pick up a book on the Principal but remember nothing is easy in this market and it will take time and dedication. If there was a simple solution then everyone would use it. If everyone used it, then it probably wouldn't work so well…

How I use Bollinger Bands in My Trading

The Bollinger Bands (B-Bands) technical study was created by John Bollinger, the president of Bollinger Capital Management Inc., based in Manhattan Beach, California. Bollinger is well respected in the futures and equities industries.

Traders generally use B-Bands to determine overbought and oversold zones, to confirm divergences between prices and other technical indicators, and to project price targets. The wider the B-bands on a chart, the greater the market volatility; the narrower the bands, the less market volatility.

B-Bands are lines plotted on a chart at an interval around a moving average. They consist of a moving average and two standard deviations charted as one line above and one line below the moving average. The line above is two standard deviations added to the moving average. The line below is two standard deviations subtracted from the moving average.

Some traders use B-Bands in conjunction with another indicator, such as the Relative Strength Index (RSI). If the market price touches the upper B-band and the RSI does not confirm the upward move (i.e. there is divergence between the indicators), a sell signal is generated. If the indicator confirms the upward move, no sell signal is generated, and in fact, a buy signal may be indicated.

If the price touches the lower B-band and the RSI does not confirm the downward move, a buy signal is generated. If the indicator confirms the downward move, no buy signal is generated, and in fact, a sell signal may be indicated.

Another strategy uses the Bollinger Bands without another indicator. In this approach, a chart top occurring above the upper band followed by a top below the upper band generates a sell signal. Likewise, a chart bottom occurring below the lower band followed by a bottom above the lower band generates a buy signal.

B-Bands also help determine overbought and oversold markets. When prices move closer to the upper band, the market is becoming overbought, and as the prices move closer to the lower band, the market is becoming oversold.

Importantly, the market's price momentum should also be taken into account. When a market enters an overbought or oversold area, it may become even more so before it reverses. You should always look for evidence of price weakening or strengthening before anticipating a market reversal.

Bollinger Bands can be applied to any type of chart, although this indicator works best with daily and weekly charts. When applied to a weekly chart, the Bands carry more significance for long-term market changes. John Bollinger says periods of less than 10 days do not work well for B-Bands. He says that the optimal period is 20 or 21 days.

Like most computer-generated technical indicators, I use B-Bands as mostly an indicator of overbought and oversold conditions, or for divergence--but not as a specific generator of buy and sell signals for my trading opportunities. It's just one more "secondary" trading tool, as opposed to my "primary" trading tools that include chart patterns and trend lines and fundamental analysis.

Head & Shoulders: a Close-up

A Cinderella among the Nobles

Trading methods are not only different and, most of the time, personalized ways of looking at the market or the developments that take place on it. In most cases, they turn into a sort of living entities that have their own histories and lives. Unlike some of the famous methods, shrouded in myths and invented by some celebrated, charismatic, and enigmatic personalities to whom they owe their popularity, the well-known Head & Shoulders method was neither concocted by any controversial trading guru nor is it promoted by the less lucky in trading offspring of the latter, who opted for the marketing of their great grandfather's dubious legacy having considered the other option of setting up a diners for the local townies round the corner. And this is what gives another reason to look more closely at why the technique is so popular with so many traders.

How It Works, or You Still Need a Head on Those Shoulders

Basically, the head & shoulders technique is rather simple as compared to most other methods. You don't need to painstakingly select any inputs to train your software, measure the planetary influence of Saturn or count the number of successful UFO landings on it. It's all pretty much down to earth, and, probably, this is one the method's major merits: you can clearly see the advantages and disadvantages of what you entrust your hard-earned bucks to.

The Head & Shoulders pattern is comprised of four equally important parts: the left shoulder, the head, the right shoulder and the neckline. The starting point for the formation of the figure on the whole, and the left shoulder in particular, becomes a sharp rise in the trend-line followed by a fall, a downward advance, and the largest volume in the pattern. The peak volume is accounted for by the growing number of buyers, joining in as the upward move continues.

Now we have the left shoulder. The head is formed by an upward and shorter advance toward the highest peak in the formation, a fall, and a peak volume for this part of the figure. The right shoulder starts with a high-volume sell-off and an upward trend. This upward trend breaks lower than the head peak to cause the volume to fall to the lowest point in the pattern as the public starts awakening to the reversal in the making. The main element in the pattern is the neckline, drawn between the lowermost points of the shoulders. The pattern is complete when the neckline, being a support line, is pierced by the right shoulder. The "lifespan" of the pattern is normally from several weeks to several months, and it's unlikely to be suitable for use over the longer haul. One the face of it, getting the hang of the whole thing is like a cinch: definitely no nerdy background is a requirement. But as a thinking trader you are aware that everything can be so simple only in that software with the one magic button, fools spend their whole lives looking for. Therefore, what are the pitfalls and how to avoid them?

Identifying the Familiar Silhouette

A really big problem about the Head & Shoulders method is that if you really want that to happen, you'll see signs of the pattern occurring everywhere. A sign of a true occurrence of the pattern is a very sharp rise in the price and a distinctly large volume this rise is accompanied with.

Also, one should always bear it in mind that for this specific pattern volume is of greatest importance. A very low volume on the right shoulder means that a reversal is happening. A true reversal is also accompanied by the price falling far enough below the neck-line. The market tries to overcome the previous high, fails to do so, and, thus, experiences the deepest drop for the entire pattern. Most probably, it is largely this simple, "trustworthy", and entirely logical explanation that the technique owes the trust many traders put in it to. Please note, that if the price trend-line is simply bobbing along the neckline, you may well expect an upward move.

Another helpful sign is that the peaks of the two shoulders should take roughly the same amount of time to develop and be roughly of the same height.

Overall, one can say that the possibility of error while recognizing the true occurrences of the pattern, especially with novice or less experienced traders, is pretty high. The chances can be approximately estimated as 50/50. That is why, to reduce the related risks, it would be expedient to use this method as an "auxiliary" method along with the other methods you use until you feel more confident about your pattern recognition ability. In any case, another result that coincides with the result of your forecasting results will not do any harm.

Can Moving Averages Be Used to Forecast Price Direction?

In a single word: No.

I often hear of or read the comment that analysts use moving averages to predict price direction and even the next close. I started my career as a technical analyst way back when I was working in Hong Kong and my treasurer sent me on a technical analysis seminar where I learned about golden crosses and dead crosses. In particular, stated the presenter, use a 20 days and 60 average to represent a 1 month and 3 month average.

"Great!" thought I, "this is going to make my life easier. I can't wait to get back into the dealing room to try this out."

In those days the fashion was to draw your own charts to get a better "feel" for the market and thus I used to draw the averages on large charts stuck to the wall.

What a waste of time…

Every time the 20 days average crossed above the 60 days average price reversed lower.

OK. Then throw average out of the window… Since that time I have never used averages in my analysis again.

That was around 1989-1990 just as real time technical analysis systems started appearing in trading rooms. Over the 1990's I became interested in building systems and it was around the mid 90's that I kept hearing this statement about how moving averages predict price.

Well, using a programmable technical analysis software I set up the software to write a report for me that summarized the close to close profit or loss generated from using the underlying moving average direction. Hence, when the moving average was rising I would then measure the profit or loss generated from close to close over the next day, and vice versa when the average was declining. Which average did I use? For the sake of simplicity I used the market favorite, the 20 period moving average used by the fund management industry.

The following are the results for six currency pairs showing the average profit & loss and the percentage of winning trades:

	USDJPY	EURUSD	USDCHF	GBPUSD	GBPJPY	AUDUSD
% Winning Trades	50.06	49.55	48.42	48.93	48.64	49.13
Average Profit	0.62	0.0053	0.0079	0.0066	1.01	0.0035
Average Loss	0.60	0.0050	0.0072	0.0062	1.06	0.0033

Note that in all cases the average profit is not any higher than the bid-ask spread and mostly lower. This doesn't really give me any confidence in using a moving average to predict the next day's close to close movement.

The moral of the story? Don't expect too much from your indicators. There is nothing magic about any of them in providing anything but circumstantial supporting evidence of a trade. All indicators, whatever the creator's claim, are lagging indicators since they are based off historic prices and therefore reflect what has been and not what will be. They can provide you with information about the general characteristic of price action at that time but the real information you require is all in price and it is in the understanding of price and trading mentality that will help you pick better trades.

Andrews's Pitchfork: Thinking Approach

Trading approaches are much like people: some aren't worth a dime but have a lot going for them: their genius creator's legendary bios, intricate, if bizarre, theories behind them, commercial websites, full of promotional puffery, and hordes of steadfast followers, who keep the former afloat. Others are rather modest but talented and really able to help trade profitably. No doubt, one of such talentedly developed methods was invented by Dr. Alan Andrews in the beginning of the 1960-s to become one of the simplest, most efficient and reliable technical analysis techniques. So what makes Andrew's Pitchfork a valuable analysis technical tool and what are the benefits and risks one should be aware of while applying this method?

As we have already mentioned, the method is quite simple. It shows the areas of resistance and support using three lines: a median, starting from the most recent contract's low or high, and two more lines, being the "tines" of the pitchfork. The upper "tine" originates from the peak of the first upward move. The lower "tine" originates from the low of the downward move that follows the first upward move. The pattern looks like a triangle. The idea is to buy at lows and sell at highs. Simple, isn't it?

You may ask: "And what's the big deal? Does this give a better guarantee than the other commonly used methods?" The answer is "No". Andrews's Pitchfork is about as precise as most other methods (our estimate would be around 60%). But the precision level, ensured by Andrews's Pitchfork, is, actually, not the reason for which the method is valued so highly or should be used. What makes the method a great trading tool is the inestimable possibility of being able to analyze one part of the pattern using the other parts. In other words, you can analyze the different trends that make up the pattern as parts of the same figure, for example, you can most effectively and very easily forecast the size of the second bullish trend based on the length of the first bullish trend.

We will agree with those who will say that Andrew's Pitchfork should not probably be used as the bulk, determining method of your trading combination. However, its importance as that of an extremely valuable "tactical" method should not be overlooked.

Gann Studies: Reality Behind Legend

A Live Legend of All Times

Even in the boisterous world of finance, where there never seems to be a dearth of men of renown, it is rather seldom that figures of this size and reputation appear: Mr. William Gann has been referred to as a trading legend and the most successful trader since the early 1920-s. For the sake of justice, one should mention that probably since about the same time he has been called none other than a lucky marketer of ideas by some others. In any event, his unique predictive abilities and the forecasts he made on both trading and non-trading issues are still well-remembered and beyond any doubt. The somewhat mystical air that the alleged use of astrological concepts in his predictions made Gann an all the more mysterious figure and his theory more attractive to many.

William Delbert Gann was born to the family of a cotton rancher on a Texas farm June 6, 1878. Being obliged to provide for his numerous younger brothers and sisters, he had never attended grammar or high school. Having moved to NY at the age of 25, he set up a brokerage of his own called W.D. Gann & Co. Gann's major predictions include the end of WW1 in 1918, the end of the Great Depression in the States in 1932 and Perl Harbor. He is the author of 8 books and one of the most popular trading theories ever.

William Gann's ascension to the heights of the world of finance began in 1908 when he invented a theory called "the market time factor." By using his newly invented trading approach, he was able to make several tens of thousand dollars using two accounts that contained a total of just USD 450. A true Wall Street celebrity, Gann was a tremendous success as a commodities trader.

The Technology behind the Legend

The basis of Gann's theory was formed by the following three maxims:

1. There is nothing else to take into consideration besides price, time and range;
2. The markets move through certain cycles;
3. The markets are geometric in nature.

The theory could be used for three major types of predictions: price, time and pattern forecasts. To make a forecast, you first need to select a time period (normally an intermediate or short-term time period) and choose the high and low that will become the starting points for the Gann lines. Normally, the high and low are determined by employing some other technical analysis method. When the high and low are determined, a 1x1 or 1x2 pattern is applied, the difference being in the angle of the line being drawn. After the pattern or 'cycle" is completed by linking the two points, similar 'cycles" down the trend-line are searched for. Probably, this is what has been so fascinating about the Gann method - seemingly, it's like falling off a log, just tack a crack, and you are a success. But when you come to grips with the technique, all the ease is gone. To locate the low and high, Gann used some mathematical methods, including and similar to Fibonacci. His amazing command of those and, as is surmised now, some other clandestine methods, is what is responsible for most of his financial success.

During his life, Gann kept secret the astrological methods he used for predicting stock market actions. It is now said that all the astrological work for Gann was performed by two outstanding Canadian astrologists of the time - Lorne Edward Johndro and Kenneth Brown. All this says that there is a lot more to the Gann theory than what the average trader knows and can apply. Consequently, the average trader is highly unlikely to be able to hone the technique to the point when it starts bringing in the kind of profit it earned for its inventor. Most likely, the technique will serve him as just another method that allows drawing support and resistance lines. And unless you are prepared to spend years on research and mastering the technique, it is best to use the Gann studies as just another method in your combination that will help you prove a decision made by applying the whole of the combination. Or, better still, avoid using the method altogether.

Counting on the Waves: A New Look on the Celebrated Trading Method

The Elliott Wave theory has been a major thing in trading for decades now and, undoubtedly, Mr. Ralph Nelson Elliott should be held in high esteem by all those who trade the markets these days. However, while some steadfast followers consider his theory to be a highly effective pattern recognition technique able to help predict market developments, others are prone to regard Elliott's creation as a commonly used methodology, a brilliantly created means of seeing the recent past of the market, rendering this past with stunning clarity. Who's right and who's wrong?

The Elliott approach construes market actions as recurrent phases, comprised of two major moves: a five-wave advance and a three- wave decline, customarily referred to as the Impulse Wave and Corrective Wave. According to the Elliott theory, the market phases are scalable and the same market actions can constitute the same but larger or smaller phases and be considered over time periods that differ in duration significantly. By identifying the current position in the phase, it is possible to predict the kind of market action that will follow. This is made easier by the following interpretation rules for the counting of the waves:

1. Wave 2 should not end below the beginning of Wave 1;
2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree;
4. Rule of Alternation: Wave 2 and 4 should unfurl in two different wave forms.

One of the sub-waves 1, 3, 5 of the Impulsive Wave is supposed to be an extended wave. For a better understanding of the Corrective Wave phase, the Elliott theory delineates the following types of sub-waves that can make up the Corrective Wave: Zig-Zag, Flat, Irregular, Horizontal Triangle, Double Three, Triple Three. This stringently ordered, if a bit complicated in places, and revered by many theory seems to provide an effective means of analyzing market developments and only God knows what would happen if it worked completely as stated. Basically, all you have to do is determine which of the itemized wave forms is going to arise next. And here is where the pitfalls start. And God forbid we call into question the accuracy of Mr. Ellliott's concept, Fibonacci's Golden Ratio it is based on, or the laws of the Universe the latter claims to explain. The problems are a lot more trivial. How will you determine the starting point for your count of the waves? Out of five people who will look at the same chart two will most probably see the starting point differently. Right from the outset, the ticket for your journey to success seems to be hard to get hold of.

However, if you've been able to identify the starting point correctly, you will very soon understand that identifying waves as they are occurring is something altogether different from identifying waves when they have already occurred. And this is the second and biggest disadvantage of the Elliott theory. Unfortunately, there are several more. Is there going to be the fifth wave? Will the correction be flat or zigzag? Which of the waves will have the extension? All these are questions Elliott's theory has difficulty answering.

It is true that many experienced traders who have extensively dealt with the "bugs" the theory contains use the Elliott method as a predictive technique. However, all the above has caused many thinking traders to form a vision of the Elliott theory as of a methodology, rather than a predictive technique. In their opinion, this methodology has been extremely helpful in naming and identifying different states of the market: strong and week trends, complex and simple corrections. This can help gainfully use the other methods in your combination at the opportune time.

This view on the Elliott theory and the approach on which some of the thinking traders base their use of Elliott waves seems to be quite correct: the main value of the method is the possibility of determining the phase the market is currently in. And this is too valuable an addition to any thinking trader's arsenal to overlook or underestimate.