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Reviewing the Charts I – Elliott Wave Theory
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
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