Many traders look at longer-term charts and see the large moves that can occur on these longer time-frames. But not many traders catch these large moves. Is it impossible? The key to catching these large moves is using a low amount of leverage to limit your exposure, finding a high probability entry set up with an initial stop loss order that is tucked above or below a market formation and then using sound money management orders to ‘box in’ profits as they accrue.

Let’s look at a daily chart of the Euro FX Futures from early April, 2006:

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You can see that the Euro had appreciated significantly against the U.S. Dollar after September 2003 and then began a fairly steep pullback. As always, the question is this: Has the longer-term trend changed to the down side or is this a pullback in a long-term up trend. Price does turn back higher and begins climbing above prior swing highs but it then trades lower and briefly moves below the Lower Median Line Parallel. When price closes back above the Lower Median Line Parallel, it is a sign of strength and that strength is further confirmed when price makes a new high for this move, breaking above the prior swing high. At that point, I draw in a Sliding Parallel, a line that carries the same slope as the Lower Median Line but is drawn off the extreme low made below the Lower Median Line Parallel. This line should now contain any price pullbacks IF price is now in an up trend.

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Here’s a closer look at the same Chart so you can clearly see the price action as it breaks below the Lower Median Line Parallel and then closes back above it. You can see that as price breaks above swing highs, I add in the Sliding Parallel.

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When price comes back down to test the Sliding Parallel below the Lower Median Line Parallel, I initiate a long Euro FX position at 1.2538, with a stop 15 ticks below the prior swing low, at 1.2488. I believe this has all the makings of a long-term up trend that could take months to unfold. The key is to find an area that allows me to hide my initial stop loss order underneath a market formation, where buyers are likely to come into the market. These new buyers should act as a buffer, protecting my stop loss order from being filled unless I am truly wrong about the direction of this market.

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Good things come to those that wait, or so I am told. About five months later, after an orderly climb, price climbs above a prior swing high just above 1.3450. When price makes takes out this swing high, I cancel my initial stop loss order and move it below the latest swing low, at 1.2888. I have a nice profit locked into this trade now [more than 300 ticks], but I think this is just the beginning of a major move higher. My goal on this trade will be to catch a ride to the Median Line, a move more than 800 points from the current price. To do this, I will have to strike a careful balance between protecting my ‘boxed in’ profits and not moving my stop profit orders too close to the current price action.

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Longer-term trading takes patience and attention to detail. Several months later, Price makes what appears to be a significant high and then sells off to test the up sloping Lower Median Line. It then bounces out of the hole. When it makes a new high for the move, I move my stop profit order from 1.2888 to just below the swing low at 1.3306. Once again, it is a balancing act of protecting some of the potential profits I have in this longer-term trade while still leaving my stop profit orders far enough away from the current action to give the trade the freedom to mature and hopefully trade up to meet my profit target—the Up Sloping Median Line.

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After making a new high, price again sells off, this time breaking through the Lower Median Line Parallel and tests the Sliding Parallel. Because I am less than 100 points from being profit stopped out of my original position as price tests the up sloping Sliding Parallel—and I still have almost 500 points in profits—I add a new long Euro position at the test at 1.3386. I use the profit stop I am already using for the first long Euro position at 1.3306 for this new position as well, since it is tucked below the prior swing low. I am now long one unit at 1.2538 and a second unit at 1.3386.

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Once again, a little patience and careful planning goes a long way. Price climbs out of the hole and makes a new high for the move and when it breaks above the prior swing high, I move my stop order from 1.3306 to 1.3366, below the swing low that recently tested the Sliding Parallel and the area where I added my second position. I can continue to ‘box in profits’, as long as I don’t get too close to the market’s action.
How long can I ride this wave? I’ll keep riding this wave higher until price either makes it to my profit target at the up sloping Median Line or price hits my trailing stop profit order. At this point, it doesn’t matter which order gets hit—I stand to make a good amount of money per contract.

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Patience generally does get rewarded and you can see price eventually begins to pull away from the Lower Median Line Parallel to the up side. I am eventually able to cancel my stop profit order at 1.3366 to 1.4013, just below the most recent swing low. I now have just under 1500 points of profit in the first long Euro position and about 600 points of profit per contract in the second position.

I am still carefully balancing ‘boxing in profits’ without getting too close to the current price action, because the prices on this chart still look like they want to run higher and test the up sloping Median Line, and if possible, I want to protect some of my potential profits but still give this trade all the room it needs to mature.

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Price finally makes it to the up sloping Median Line and I close out both positions at 1.5625. Though this was a very long-term trade, it paid off handsomely: I got long the first position in October of 2006 and netted just over $38,000 per contract; I entered the second position in August of 2007 and netted nearly $28,000 per contract. The wave was long and the ride demanded patience and a balancing act between protecting profits and letting the long-term trade mature. But by carefully hiding my stop orders below market structure, I was able to let this trade mature and stick with it for the long ride.

Catching these larger moves can be very profitable and extremely rewarding if you have the patience and perseverance to stay with the plan and ride the wave to its final destination.

I wish you all good trading!

Best,

Tim Morge

tmorge@sbcglobal.net email me

www.medianline.com

www.marketgeometry.com

I am writing this tutorial to show the basics of Elliott Wave Theory. I will not
show all the different variations of corrective waves and some other more advanced
charting of Elliott Wave Theory. I recommend reading more complete
Elliott Wave Theory material that will show all the intricacies involved in the
Theory. I have listed other resources in my Information and Link page of
shepwave.com.

Elliott Wave Theory was discovered by Ralph Nelson Elliott in the 1930’s. He
came to the conclusion that the markets don’t move in random movements and
that directional changes have a correlative relationship with other
directional movements in many different time frames. His methods can explain
all the movements of any market in history. This gives the Elliottician a better
understanding of the future direction of the market.

Basically markets move five waves in the impulsive or motive direction and
three waves in the corrective direction. The drawing below shows how this
basically looks. I have written this tutorial as an example for a bullish
market scenario. For bearish market simply invert drawings.
Note that waves 1,3 and 5 are motive. Moving in the direction of the trend for
the entire five wave move.. Waves 2 and 4 are corrective and usually don’t
violate the starting point of the previous motive wave.

Figure 1

The view of the chart above can be used to describe any time frame.
Basically a one minute chart of a market will display the same characteristics
of a weekly chart of the same market. The motive or impulse directional
waves will be able to subdivide into five waves of a smaller or larger degree.
In a corrective wave the wave could have impulsive/motive waves that can be
broken down into a five wave move within the three wave corrective move of
a larger degree

The drawing above shows how a five wave move subdivides.
One can keep going to a smaller or larger degree and get the same wave look.

Corrective patterns are what give most Elliotticians the most problem. They
can have complex patterns that sometimes are difficult to indentify until they
are finished. There are basically three types of corrective wave formations.
The Zig Zag is a 5-3 5 wave formation. A Flat correction is a 3-3-5 wave
formation and a Triangle is a 3-3-3-3-3 formation. Figures 3, 4 and 5 will show
simple examples of these types of corrections. There are also corrective
patterns that will unfold as a combinations of one or more corrective patterns.

The corrective patterns shown in Figures 3,4 and 5 occur in waves 2 or 4 of
corrective wave formations of varying degrees. The drawings show the basic
patterns for each simple correction. Corrections can have combinations of
simple corrective patterns. I will not get into that in this Elliott Wave Tutorial.
I suggest further study of these patterns and other complex Elliott wave formations.
I will refer to these patterns often in my updates.

Elliott Wave “Rules”

There are a few basic rules that wave counts need to follow to be considered
Impulsive Waves. The basic rule is that wave 4 cannot violate wave 1. That is;
wave 4 cannot go into the territory of wave 1. That would make it a motive
wave and not an impulsive wave. Also, wave 3’s of an impulse pattern are
usually the longest wave and never the shortest. There are numerous variations
of wave extensions. But those are the basic rules.

For further study one needs to keep in mind that waves usually have a
relationship in length and even time. I use fibonacci ratios to compare relative
wave lengths and retracements in my updates. Go to shepwave.com Educational
and Research Link to get further information of these ratios.

As mentioned in various sections of Shepwave.com there are plenty of
resources to gain knowledge of Elliott Wave theory. I mention Robert Prechter
Jr. frequently and suggest every one read his book “Elliott Wave Principle” along
with his other publications. The website elliottwave.com is a great site to find
information. Another website that I suggest is Wavespeak.com. They also
have a free Elliott Wave Tutorial. I recommend reading it as well.

Good luck in your trading and investments,

Shep

Elliott is my primary method of analysis and it allows me to make most of my forecasts. It is a fairly simple theory and consists of two basic principles:

• Impulsive action consists of five waves – see figure X.1 below
• Corrective action consists of either three waves or a more complex pattern

But in order to understand this we first need to define “impulsive” and “corrective.”

An impulsive move is one in the direction of the main trend and such a move is usually fast, direct and easy to classify.

A corrective move is contra-trend and tends to dither and dather, wibble and wobble. It is not easy to classify and generally if you are not sure what you are seeing it is more likely it is corrective.

Here is an Elliott five-wave impulsive rally:

Figure X.1 - an Elliot Wave “five”

The Elliott five should obey the following rules:

• Wave 3 is never the shortest and is generally the longest
• Waves 1 and 5 do not overlap.
• Wave 2 and 4, which are “corrective” are generally of a different shape from each other – this is called “alternation.”

We will now look at an Elliott five in the real world:

You may say, “but this chart does not look anything liked your illustration!”

In some ways I would agree with you but a stylized illustration is always going to look different from real life. The key points are that we can count five waves and that the move obeys the rules.

Now we will look at another real-life example:

Chart X.2 – FTSE Daily

This chart goes back a few years but it is the best signal I have ever seen Elliott give. From the peak labeled “Cycle B” you will see I have labeled the decline down to “Inter 1” as a i, ii, iii, iv, v move.

Yes, you can count five waves in declines as well as rallies.

This brings us to the next point – Elliott waves are “fractal!” Yes Elliott discovered “chaos theory” many years before anyone else!

The concept is simple but can seem confusing at first. Basically all the waves subdivide into “fives” and “threes” themselves. Here is Figure X.1 with waves 1 and 2 so subdivided.

I suggest you do the same. Take what you find useful and make it your own.

I do have a fairly major problem with the way some people interpret Elliott and in particular the hype that is sometimes involved. Elliott is good for trading markets but it is also very good if you happen to write a market letter. Elliott often comes up with big forecasts and big forecasts sell subscriptions.

But let the marketing department loose on your advertising copy and it is not long before Elliott becomes a gift from the Gods, a technique that never fails. Now that kind of stuff is DANGEROUS because it can fool traders into not using proper risk control and money management.

If someone tells you that Elliott is “always right” then they are talking bollocks!

But the system does allow for many very complicated wave counts and in this way it can count all market action. To me this is useless, if the system accommodates everything a market may do then it loses all ability to provide good trading opportunities.

I prefer to keep it simple. I really only look at two factors and those are impulsive and corrective action. If I can correctly identify which of these we are seeing then I can draw appropriate conclusions:

• If corrective I know that the main trend should resume shortly so I look for a signal that is happening or has happened.
• If impulsive I know to trade with that trend and if we are in the fifth wave I know that we may get a contra-trend signal.

So my version of Elliott is a lot simpler than you may find elsewhere. But I would encourage you to do further research and reading a few books on Elliott is worthwhile – even one good idea can reap a very healthy harvest. As I indicated above I do allot time every day for research and would suggest at least one hour per day for this vital task.

But even in this simplified version there is still a fait bit to take in.

So far we have covered the basics. For the remainder of this article I am going to use real life examples, often linked to winning trades, to illustrate how I apply the principles of my version of the Elliott Wave Theory.

Here is the first one.

The above chart formed the basis for two winning trades, the first on Friday 29th June; and the second, the next session, on Monday 2nd July.

Spend a few minutes studying the chart – can you see the signals?

You were following the 5-point trading plan and were enjoying 95% success. But when you lost, you lost 30 points. Here is how it would work out over 100 trades. 95 trades would be winners at 5 points each and that equals profits of 475 points. You would also have 5 losers at 30 points each and your net profit would be 325 points (475 less 150 = 325). At £10 per point that would be £3250 but if you were using the 5-point plan you would have doubled up on making that many points and your winnings would be far higher.

To get back to the chart can you see the signals?

The key to this is the decline I have marked 1, 2, 3, 4 and 5. Once a move has seen five waves it is complete and we are due a rally (or a decline if it had been a five-wave advance) and that is the basis of the trades done on the following days.

Now I am going to mention one very important rule I use and this is that I want to see all the waves within a “five” to be roughly similar in terms of time. As a general rule, I would expect no wave to last longer than twice any other. At the same time you must be flexible. Applying Elliott Wave Theory is an art; it is not a mechanical process. If everything else is great but wave 4 is three times wave 1 in terms of time that may be acceptable.

Let me take you through this a step at a time so you can see exactly what I do:

· First do not try and “force” a wave count on the market. Just wait and you will find they develop all on their own.

· Once you have seen a count, work out the implications. For example in the chart above, I knew to expect a rally and we saw this start from “5”

· Having seen five waves down off a new high, as in this case, the implication is that we are now in a new downtrend but this is not so relevant for shorter term trading using binary bets.

· We saw the first rally off the low (marked 5) and as a wave count always has a correction following an impulsive move I was looking for a pullback. Using Elliott I also knew that any such move would fail to make new lows – ie it would be a buying opportunity.

· We duly saw the pullback come in on 29th June (I have labeled this as a re-test) and if you look at the chart carefully you will see that the decline traced out an a-b-c form.

· This was our buy signal and Lunch Time Trader duly logged a £560 gain on this trade which only lasted a few hours. That gain was assuming betting at £10 per point.

· Trade 2 was all part of the same thing. I was on guard for the rally to itself be a correction. If we see five waves off the top it suggests a major trend change – in that aspect Elliott was wrong as we did see a very minor penetration to new highs on Friday 13th July. But even if it had been a correction the wave count argued for higher prices first.

· So when we saw that a-b-c decline, marked on the chart at “Trade 2” – we went in again looking for a rally.

· The rally did come in but we got out when the trade started to look uncertain.

· One final, but important point, Elliott is not infallible, whatever anyone says, and, however carefully you work on the waves, not all your trades will win. I have to say this to counter all the hype that surrounds Elliott.

In fact, I will mention one pundit in the US who has written books on Elliott and is convinced it is infallible – we used to exchange letters but I then committed the cardinal sin – blasphemy, I questioned whether Elliott really was infallible. For this sin I was excommunicated and no longer received his letter. Good thing really, as he pretty much completely missed the bull market from 1987 – 2000 as he was so sure Elliott was “right.” He even “proved” that it had not been a bull market at all by expressing the market in terms of the price of Gold, or some such, and inflation adjusting. On that basis it was actually a bear market – but all the bulls weren’t bothered – they had already banked their profits!

Anyway enough of the deluded. On to the next chart.

This was a particularly nice trade and again its roots lay in Elliott but there were other factors as follows:

• The set-up here came in because the Elliott pattern up to the decline labeled a-b-c had been highly negative – I was looking for a big impulsive decline.

• In the event all we got was that a-b-c – a fairly feeble corrective form. This brings us to another important point because it is when a move fails to materialize that we know to look in the other direction.

• In this case all we saw was a feeble a-b-c so we had two signals we were instead going up. One in the form of the corrective nature of the decline, it counted as an a-b-c, and the second because our previous sell signal had not produced much – what does not go down, will go up! (and vice-versa)

• On top of that we had the spike low, see chart. But this is another buy signal showing determined buying.

• Then we had the form of the subsequent rally which I have labeled as 1, 2, i, ii meaning the fast action in the form of the third waves (remember these are generally the longest and also the fastest) was still to come.

• Finally, and these were critical factors, the financial markets were in disarray because of the sub-prime mortgage crisis and the US was about to make an interest rate announcement – timed at 7:15 after FTSE closed.

• I reckoned the US was not going to upset markets and that is was an odds-on bet that the announcement would be positive.

• But using binary bets I could get much better odds than that and recommended the net “FTSE to end up >50 points” at around 30. This had odds of over 2 to 1.

• This is what I was talking about when I talked about “value” bets above. If I can get 2 to 1 on a bet that should be evens I will be betting all day!

• With all these factors going for it this bet should have been a winner - and it was! After the interest rate news came out - rates down 0.5% - the bet was priced at around 60 and it closed at 100 the next day.

• I should mention that IG quote prices 24 hours on most bets and we were able to buy this bet after 17:00 on Tuesday (after FTSE had closed for that day) but based on and expiring at Wednesday’s close. FTSE was actually up over 150 points on Wednesday.

That completes a basic introduction to Elliott Wave.

Right now your task is to start looking at charts and counting the waves – I assure you it can be a very profitable way to spend some time and it’s also fun!

Finally here are a few suggestions of how you might surf the (Elliott) waves:

• Third waves are the most dynamic and it is during a third wave that the further out bets like “FTSE to end up >150 points” might come good and these bets are generally very cheap. But don’t necessarily go so far out, also check out “FTSE to end up >50 points” and “FTSE to end up >30 points” plus the HiLo bets. Remember if you are in a “downwave” you will be looking to bet that FTSE will be down, not up.
 
• Once the fifth wave is complete, up or down, think about what sort of move we might see and bet accordingly.

• The same applies when corrections look to be over. Ferret out the bets that will win once the main trend resumes.

• Sometimes FTSE gives two clear alternatives but by using “tunnel” bets you can often make money whichever of those comes good.

Summary

In this article we have learnt:

• The basics of how I use Elliott Wave Theory
• The five-wave form
• Corrective and impulsive action
• How to interpret the waves
• How to trade (surf) the waves

John Piper author of The Way To Trade

What is a 1256 contract? The IRS defines Section 1256 contracts as any regulated futures contract, foreign currency contract or non-equity option, including debt options, commodity futures options and broad-based stock index options.

By definition, these trades are marked to market on the last business day of the year in order to calculate capital gains or losses. Whether or not you have selected mark-to-market as your accounting method does not affect the 1256 status of these trades.

Our lovable Beethoven-size tax break benefits commodities and forex traders in three ways:

1. The split: Instead of having all of your trading gains subject to the short-term capital gains tax rate of up to 35%, Section 1256 contracts allow 60% of your gain to be taxed at the lower long-term rate of 15%. This results in a combined tax rate of 23%, a 12% savings over the short-term capital gains rate.

2. The carry-back: Section 1256 losses can be carried back three years, rather than merely forward to the following year, as long as you obey the rules. For instance, you can only carry your loss back to years in which you had 1256 gains, and only 1256 gains can offset them. The loss is first carried back to the most recent qualifying year; after that, any remaining loss may be absorbed by the next two most recent years. As a result, you can amend previous years’ returns to include this year’s loss and possibly even receive a refund.

3. The tax preparation: Section 1256 affords forex futures traders a significant accounting advantage over forex currency traders, beginning with the Form 1099s you receive from your broker at year’s end (currency traders don’t get 1099s). On your 1099s, you just plug the aggregate profits or losses found on Line 9 into Part 1, Line 2 of IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) and the form does the 60/40 split for you: the 60% total to be taxed at the lower long-term rate winds up on Line 9, the 40% total to be taxed at the higher short-term rate can be found on Line 8. The two totals will eventually end up on Schedule D (Capital Gains and Losses): the 60% total on Part 2, Line 11, the 40% portion on Part 1, Line 4.

Currency Traders Can Cash In, Too

It’s little wonder that currency traders choose to opt out of their default Section 988, which taxes their gains or losses as interest income or expenses at the current tax rate of 35%. The catch is, they must opt out on a “contemporaneous basis,” meaning before making the trades, by noting their intention “internally” in their records.

Because there is no requirement to notify the IRS of your decision, some traders bend the rules and make their choice a more opportune time, such as the end of the year. However, should the IRS decide to crack down on abusers who “cherry-pick” their tax bracket, a shady track record could prove costly down the road.

Unfortunately, forex traders sometimes slip into bad tax habits. Some lump their currency activity in with their 1256 commodity trading at tax time, while others fail to opt out of their default Section 988 status and end up paying the highest tax rate on their trades. A Traders Accounting tax professional can help you set the optimum course for tax savings.

Our lovable tax break may be trader’s best friend, but in some instances it may be advantageous for currency traders to avoid the cuddly beast. As a general rule, if you have currency losses, you will typically improve your tax position by not opting out and instead remaining in Section 988. In this scenario, your ordinary losses could then be offset by any form of income rather than only Section 1256 income, and would not be subject to the $3,000 capital loss limitation and restricted to 1256 offsets.

Nothing about forex taxation is ever as simple as it may appear; each trader’s individual circumstances dictate a unique set of options to choose and courses to follow to arrive at their optimal tax position.

Traders Accounting.Com

The same is true when it comes to forex trading and the tax rules that pertain to it.

There are two types of foreign exchange trades: cash (or currency) forex trades on the unregulated interbank market, a network of government central banks, commercial and investment banks, while forex futures and options trade on regulated U.S. commodity markets and foreign exchanges.

Both types of forex, currency and futures, share the same goal: to capitalize on the natural fluctuations in foreign currency exchange rates around the world. But the Internal Revenue Service treats currency and futures trading quite differently when it comes time to split your earnings with the taxman.

Currency traders fall under the default special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions). This section was originally created to tax companies on income they receive as a result of the fluctuations of foreign currency exchange rates during the normal course of business, such as buying foreign goods.

Under Section 988, gains or losses are reported as “other income” on Line 21 of Form 1040, where they are treated as interest income or expense and taxed at the ordinary income rate, currently 35%. Trades included under the 988 rules include spot forex (trades that settle in fewer than two days), forward forex (trades settling in more than two days) and several others.

Futures and options trades, by contrast, are considered IRC Section 1256 contracts and given the same advantageous capital gains split as commodity trades: 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% taxed at the ordinary short-term capital gains rate of up to 35%. The combined rate of 23% adds up to a 12% savings over the Section 988 rules.

The Escape Clause

If you think the full-freight tax rate of Section 988 seems discriminatory and onerous to currency traders, you’ll be pleasantly surprised to find that the IRS agrees with you. The reason: currency traders consider their currency position part of their capital assets in the normal course of business. As a result, the IRS allows you to opt out of high-tax Section 988 altogether and have all your currency trades taxed at the more attractive 60/40 capital gains split enjoyed by commodity traders, regardless of settlement time.

How much can you save by opting out? If you’re married and file jointly, a currency trader with a net gain of $100,000 can save $6,000 in taxes with the more favorable 60/40 split.

There are two important caveats to consider however. First, if you elected the mark-to-market accounting method, you won’t be able to opt out of Section 988 and take the 60/40 split. That’s not always a bad thing, as we’ll see shortly. Second, you must opt out of Section 988 before making the trades. You need only do this “internally” in your books or business records, meaning you are not required to notify the IRS.

Why the internal-memo provision? The IRS doesn’t want you “cherry-picking” by opting out in years when you have gains and remaining with Section 988 in years when you want to avoid the capital loss limitation of $3,000 under Section 1256. However, the IRS has shown little interest to date in punishing currency traders who wait until year’s end to exercise their option.

Silver Lining for Loses

That’s right, currency traders who experience a losing year do have a silver lining by not opting out and remaining with Section 988 rules. Because your net loss is considered ordinary interest expense, it will offset any type of ordinary income. Under Section 1256 however, your capital loss would be subject to the $3,000 capital loss limitation and can only be carried back three years, where it can only be offset by Section 1256 gains.

When it comes to accounting, there is no question that futures traders have it far easier than currency traders. At the end of the year, futures traders receive an IRS Form 1099 from their brokerage firm with their aggregate profit or loss listed on Line 9. Since currency traders don’t receive 1099s, it is up to them to segregate their cash forex from other types of trading and report it correctly on their federal income tax return.

While it can be tempting for currency traders to simply lump their cash trades in with their Section 1256 activity, it’s not advised for several reasons: you would be disregarding the rules set forth by the Internal Revenue Service (for which you one day may have to answer), you could expose yourself to fines and penalties if you show a pattern of “cherry picking,” and in the case of losses you could be paying more tax than necessary.

Traders Accounting.Com