Category Archives: Trading Tips

General trading tips and techniques

Entry Timing Technique Using Bollinger Bands® and Elliott Wave Oscillator

Set up the following indicators on a 15 minute chart:

– Bollinger bands; 1 sd and 2 sd.

– Elliott wave oscillator, or MACD (to use the histogram only).

The sequence of steps is:

1. Get the expected direction from your Elliott wave count. On the hourly chart draw a channel about the most recent movement which should be nearing an end.

2. Wait for a channel breach. Depending upon risk appetite, either on the hourly chart (less risky) or the 15 minute chart (more risky).

3. Wait for price to enter the two Bollinger bands on the OPPOSITE side to the expected trend direction. If you expect price to go up wait for price to enter the lower two bands. If you expect price to go down wait for it to enter the upper two bands.

4. Finally, wait for a bar on the histogram which is smaller than the one before it.

5. Enter your trade.

6. Take profit either using a target calculated from your Elliot wave count, or after a channel breach of the new movement.

Example for an upwards trend:

upwardstrend

Example for a downwards trend:

downwardstrend

New to Elliott Wave? Read This First!

Upon first hearing about the Elliott wave principle most people have one of two reactions.

Many will disclaim the concept that it is social mood which moves the markets (it’s normal to think it’s the other way around) and they will insist that the market cannot be patterned and must be random. That’s okay. If this is how you think you’re with the majority. I must ask though, if the market is random then how do some people manage to consistently profit from trading it?

Others may think that they have found a magic bullet and can use Elliott wave to tell them where and when the market will move with enough accuracy to profit from the principle. This is problematic for a few reasons.

If you are already a trader then I would point out that you probably do not make trading decisions using only one technical analysis tool. This would be extremely unusual and mostly confined to those new to trading. Most traders know that in order to make good trading decisions a variety of tools should be used. Elliott wave is no different. It is best used as one tool amongst several when making trading decisions. If a wave count agrees with your other tools you may have increased confidence in your trading decision. If the wave count disagrees it is up to you to decide what to do based upon your risk appetite and experience.

However, Elliott wave is one of the most difficult tools to learn to apply. It takes years of daily analysis to become truly proficient and it takes hours each day to analyse a market in enough depth for the analysis to be useful to traders. This is why traders subscribe to my service.

Elliott wave is the best tool I know of for predicting price direction. It can sometimes be uncannily accurate in target calculation. Sometimes does not mean it is always accurate though, as not all waves have Fibonacci ratios between them. Elliott wave cannot always be accurately applied however because the analyst who never makes mistakes simply does not exist. No method will have 100% accuracy.

At any one point in time there may be multiple alternate Elliott wave counts possible. An expert analyst should be able to see as many alternates as possible and present them ranked in order of probability. Probability of a wave count is based upon several factors, the strongest being the likelihood of the structure unfolding. If the structure is common the wave count would have a higher probability. Rare structures must have a low probability. This means that when a rare structure unfolds (as probability says they must do sometimes) then the analyst would have advised that wave count has a low probability and would not have expected price to move in that direction. Many people fail to understand how probability works in Elliott wave and so dismiss it when they see an analyst make a wrong call when a rare structure unfolds.

Most of the time it is common structures which unfold, that’s why they’re common, and most of the time an analyst should predict the next movement correctly.

A common complaint of Elliott wave is changing targets. Again I must say that you would not expect any other technical analysis tool to predict tops and bottoms and be always right, and for a prediction once made to never change. Why should Elliott wave be any different? There are several Fibonacci ratios. No analyst is going to be able to predict which Fibonacci ratio will be the relationship which is eventually seen. All an analyst can do is to state which is the most commonly seen ratio (there’s that probability again!) and calculate targets based upon several possible ratios ranked in order of probability, or in price order.

Another common complaint of those new to Elliott wave is an analyst changing a wave count. This complaint shows a depth of misunderstanding of not just Elliott wave but markets in general. If an analyst were to never change a wave count what they must do is to pick the right wave count from the very start of a movement amongst several possibilities, and they must pick the right wave count even if it has a lower probability than others. Which is patently ridiculous.

If you can get past the initial enthusiasm and see Elliott wave for what it is, an exercise in probability, then you’re on your way to learning how to profit from it.

Members of Elliott Wave Stock Market who have stayed for years tend to be seasoned experienced traders who understand how probability works. They stay with this service because I am able to predict direction for them correctly more often than not; I’m better than a coin toss. But they understand it is not possible to be always right.

Fibonacci Ratios

There is a great deal of misinformation online about what ratios are correct Fibonacci ratios. Some charting packages have ratios that are not correctly Fibonacci ratios in their Fibonacci tool kits.

So in the interests of clarity and mathematical accuracy, this article will explain what is a Fibonacci ratio and how it is derived.

From a purely mathematical perspective the Fibonacci sequence is “seeded” by 0 and 1 and the subsequent numbers in the sequence by adding the previous two numbers

f_(n+1) = f_n + f_(n-1)

so the sequence is:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 …

When talking about Fibonacci ratios we are strictly just talking about the numbers that are *converged* on when you divide a number by its predecessor (or its predecessor’s predecessor, i.e. its predecessor two back etc). Or, conversely, we can do the reverse (which results in the inverse number) and divide by a number’s successor (or its successor two forward etc). This results in the two ratio sequences:

 

  a number divided by its
  successor predecessor
1st   0.618 1.618
2nd 0.382 2.618
3rd   0.236 4.236
4th   0.146 6.854
5th   etc etc

Mathmaticians were quite interested in the fact that the 1st ratio 0.618’s inverse was 1+0.618 (also known as the Golden Ratio or Golden Mean). This can be proved by finding the limit of the ratio f_(n+1)/f_n for the Fibonacci sequence when n tends to infinity. i.e. it is no accident, it is due to the recurrance relation f_(n+1) = f_n + f_(n-1).

The important thing to note here is that correct Fibonacci ratios are numbers that are converged upon when one divides one Fibonacci number by another.

Therefore 0.5 is not a Fibonacci ratio although it can be obtained by dividing 2 (the third number in the sequence) by 1 (it’s predecessor). This is not what the number converges upon as one moves up the Fibonacci number sequence. Once you start down this track, you could just as easily divide the third by the fourth and get 0.66666, etc.

0.786 is therefore not a Fibonacci ratio either, although many charting packages include it in their Fibonacci tools. We can obtain 0.786 from the square root of 0.618 but this is not the correct method to find a Fibonacci ratio. 0.786 cannot be obtained by dividing one Fibonacci number in the sequence by another.

3.618 is also not a Fibonacci ratio as it cannot be obtained by dividing one Fibonacci number in the sequence by another. Likewise 1.382 and 1.236 are also not Fibonacci ratios.

Fibonacci ratios cannot be derived by manipulating the above list of correct Fibonacci ratios; by squaring them, finding the square root of, multiplying one by another or otherwise manipulating Fibonacci ratios to find other ratios. Such derived ratios are not correctly Fibonacci ratios. They may still have a use and a place in technical analysis, but they cannot be referred to as Fibonacci ratios.

A big thank you to Alicia Monteith (Phd) for providing mathematical clarity for this article.

A Trading Strategy Using Elliott Wave Analysis

Elliott wave analysis is useful in providing the most likely next direction, but often traders may be unsure exactly when to enter and exit based upon analysis.

If the market is predicted to move lower then obviously you would wait for prices to stop falling before buying, or for more aggressive traders they may sell short. If your wave count expects price to move upwards then obviously you would buy. Trying to trade against the main trend is extremely risky. The wave count should tell you what the main trend is.

Invalidation points are the most obvious place to put stops, and targets are the most obvious point at which to take profit. But this does not tell you where to enter a trade or how to add to your position.

In an effort to bridge this gap I offer the following. Please feel free to add your own comments and suggestions.

Basic Elliott Wave Structure - Actionary Waves 2011

Using Elliott wave analysis we want to trade the actionary waves within the basic structure.

Actionary waves are waves which carry price in the direction of the main trend. Within an impulse (or a diagonal) actionary waves are 1, 3 and 5. Within a correction actionary waves are waves A and C.

Using a trend channel about 2 to enter 3 - Elliott Wave 2011

For each actionary wave the method is similar. Draw a trend channel around the prior reactionary wave. When the channel is breached then the next actionary wave should be underway, at that point enter a trade in the direction of the main trend. For the example above we enter a long position to trade the third wave upwards when price moves above the small orange channel containing the second wave zigzag.

When do you exit this trade?

You would calculate a target at which point you could close the trade and take profit. However, targets are not always met. If price falls short of the target how do you know when to get out?

Using a trend channel about 3 to exit - Elliott Wave 2011

Using Elliott’s technique we draw a trend channel about the impulse which here is a third wave. Draw the channel from the highs of 1 to 3, and place a copy on the low of 2. If this does not contain wave 4 then redraw the channel as follows: draw a trend line from the lows of 2 to 4 and place a copy on the high of 1. If neither of these methods work then construct a “best fit” channel which contains as most of the movement as possible.

When the channel is breached in the direction opposite to the main trend in which you are trading then you should exit the trade.

In exactly the same manner you would enter a trade for a fifth wave when you have confirmed that the fourth wave is complete:

Using a trend channel about 4 to enter 5 - Elliott Wave 2011

And you would either take profit at your calculated target if price reaches the target, or you would exit the trade when it is clear that the trend has changed.

Using a trend channel about 5 to exit - Elliott Wave 2011

What wave degree you choose to trade will depend entirely upon what style of trading suits you best. If you don’t like to hold positions overnight or over a weekend then you would trade on hourly charts at wave degrees below minor. If you like to hold trades for weeks or months and don’t like to enter and exit so often you would trade on daily charts wave degrees at minor or intermediate.

Using a trend channel about 5 to exit - Elliott Wave 2011

Using this strategy you would trade this first wave at intermediate degree which may last several weeks to a few months. If your calculated target was reached you may exit about the high. If price fell short of your calculated target you would exit the trade when the channel is breached in the direction opposite to your trade.

How would you add to a longer term position?

Corrections may be used as opportunities to join the trend.

Using a trend channel about 5 to exit - Elliott Wave 2011

In the above diagram you may add to your position in the early stage of the third wave, and again in the early stage of the fifth wave. You can take this idea and move it down one degree; you may also add to your position when each of the lower degree corrections are confirmed complete with their own channel breaches. There would then be several opportunities to add to a position.

Within stock markets the easiest wave degrees to trade would be at least minor, or intermediate. With wave degrees much below this the movements are mostly smaller and brief. However, this concept can work at all wave degrees and for all types of traders. Scalping would work on lower wave degrees, on hourly charts and down to 5 minute. Longer term trading would work best on daily charts at minor degree and intermediate degree, or even above. It depends upon your particular style and risk appetite.

In the diagrams above the structures shown are the simplest possible; impulses and zigzags. However, in reality there is a lot more variation than this, particularly for corrections. Zigzags lend themselves very well indeed to parallel channels, but flat corrections do not. Combinations and double and triple threes also do not lend themselves to trend channels at all. For these structures you draw a channel about the final C wave of the final structure and use this channel to indicate an end to the correction. Some real life examples from the S&P 500 Index are provided below.

Real life examples of third waves.

The holy grail of Elliott wave analysis for traders is a third wave. Third waves are strong and carry price in a clear direction. They’re usually the longest movement within a larger movement so offer the biggest profit opportunity. The best thing about third waves I think is their structure. They can only subdivide into a five wave impulse. This is the easiest structure to analyse and also to trade. Because there is only one structure variation is limited, and so there should be less error in analysis.

Unfortunately within the stock market the best third waves have been downwards for the last few years. At the time of writing this article we have one just ended (mid August 2011). There will be more to come.

SPX500 hourly 2011

In the example above we were looking for the end to a second wave. This second wave is a simple zigzag and so we can draw a trend channel about it. When the channel is breached we have our indication that upwards movement may be the third wave we are expecting. Once we have trend channel confirmation that a third wave is underway we may enter long.

If the wave count is correct and this is a third wave we would want to take profit at the target. In this instance there are three targets, and when price reaches each target we may use our Elliott wave analysis to see if the wave is likely to be over, or not.

SPX500 hourly 2011

In that particular instance price reached a little above the first target. We had recalculated the target, but a trend channel breach and invalidation point told us when the third wave was over two weeks later.

Sometimes the market is unclear and we have more than one wave count. When all the possibilities except one remain, when all the wave counts but one are invalidated, then we can have more confidence in our analysis.

In the following example the third wave is downwards. Up to the point where price moved below 1,258.07 we had an alternate bullish wave count. When price moved below 1,258.07 we had only one wave count and a target at 1,190.75 for the third wave to end.

SPX500 daily 2nd Aug, 2011

Once the third wave develops further we can use ratios within it to refine the target for it to end. At each point along the way there will be small bounces and for particularly aggressive traders these may be used as opportunities to join the trend, if the wave structure and technical indicators tell us that the trend is unfinished.

GBPUSD 25th Feb, hourly 2011

In this instance after markets closed for the 8th of August we had our final target calculated and expected it to be reached within the following day or two. We could also draw a trend channel, here not quite Elliott’s technique but a best fit, to tell us when the third wave was over. But in this instance we did not need the trend channel as price ended just above the lower end of our target zone, the perfect place to exit and take profit.

This method does not always work as well as the two examples above show. If the wave count is wrong then price will probably not move in the direction you expect. That is why it is essential to always use stops. If the analysis you are using is more often right than wrong then you should be able to make a profit more often than a loss.

The approach to using Elliott wave analysis to trade markets as outlined here is not by any means the only valid approach. You may find it too cautious, you may find it too risky. Every trader will have their own preferred methods.

In conclusion, the best most profitable and longest lasting traders are the ones who manage the money in their trading accounts most wisely. Even if your wave count correctly predicts direction for the next 2 weeks you can still manage to lose money, if you over leverage and let fear be your guide. Keeping leverage low will allow you to have losses and still survive.