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The primary reason to be interested in understanding the Elliott wave is that it is the best indicator of where you are in the market's movement from down to up and back down again. Reading the market is like trying to understand how New York City functions. You could spend one day with each of the five borough presidents, to get an in-depth understanding of what is happening in each borough at that time. Another approach would be to take a helicopter and view the entire city from about the height of the World Trade Center. The Profitunity approach is comparable to in-depth interviews: we find out what is happening in the "lives" of individual commodities at the present time. The Elliott wave takes us to a higher altitude and shows, from a wider viewpoint, how the market is operating.
The Elliott wave has received considerable discussion through the years. Many derogatory comments have come from those who don't profit from using it because they don't understand what it is and how it works. The Elliott wave is an analysis of the underlying structure of the market. As we will see in Chapter 8, the Elliott wave is the underlying structure of the market, and the fractal is the underlying structure of the Elliott wave.
R. N. Elliott, for whom this approach is named, studied the markets for years, searching for some repeatable pattern that would let him pick the tops and bottoms. The Elliott wave is a top and bottom picker. Normally, this is dangerous to your financial health, as most Elliott students will document.
A. J. Frost and Robert Prechtor (1978) described the Elliott wave and the personalities of the various waves. They gave excellent documentation and description of the Elliott wave, but did not give specific directions as to how to trade the Elliott wave profitably. When their work was published, I read it at least a dozen times. At that time, I was developing the MFI and I decided to do some research on the differences between the waves as measured by the MFI.
Basic Rhythms of the Elliott Wave
The Elliott sequence consists of a basic rhythm of "fives" corrected by "threes." This sequence remains constant no matter what degree of wave is being analyzed. This wave rhythm is observable as long as there is a minimum amount of trading volume. As a rule of thumb, we use a minimum average of 20 ticks per time period, although the Elliott sequence can often be seen in a shorter period market with much less volume—for example, the one-minute chart.
Even more important than the time scale is the "form" of the patterns. Waves can be stretched or compressed (both in time and price), but the underlying form remains constant. A movement will unfold in its primary direction in a series of 5 waves, labeled 1 through 5. A 5-wave movement is normally corrected by a 3-wave movement in the opposite direction. The numbered waves (1-5) were called "cardinal waves" by Elliott. Frost and Prechtor popularized the term "impulse waves" for waves 1, 3, and 5. Corrective waves are designated with small letters (a, b, c, d, e).
As shown in Figure 7-1, the first wave is corrected by wave 2, and wave 3 is corrected by wave 4. Then the 5-wave sequence is corrected by a 3-wave sequence, labeled a-b-c.
After a 5-wave sequence is complete, it will usually become a wave of "larger degree," or a wave contributing to a larger wave. The complete movement of waves 1 through 5 will complete the next higher tier of wave sequences. Therefore, the movement from wave 1 to wave 5 completes a wave 1, a wave 3, or a wave 5, and the a-b-c sequence completes either a wave 2 or a wave 4. (See Figure 7-2.)
Figure 7-1 Diagram of waves 1-5 with an a-b-c correction.
Figure 7-2 A 5-wave sequence with a 3-wave correction can be part of another wave of larger degree.
Characteristics of the Different Waves
The basic rules of wave theory are simple enough, but the applications of these rules daunt most wave theory students. By using the Profitunity indicators explained in the previous chapter, this job becomes simple, concise, and accurate. One of the greatest pleasures in trading is to watch your wave count unfold just the way you anticipated. Many of the relationships that most Elliotticians discuss are really tendencies, and they are neither permanent nor precise. In addition, these relationships change over time. Just as you begin to count on them and place money on your interpretation, they change. We have solved this problem.
Before we explain our solution, let's examine the various waves and the relationships among those waves. Again, I must emphasize that some of the concepts that make our Elliott wave analysis much more accurate is our reliance on the Profitunity indicators that describe market participation in the present tense.
First waves are always a change-in-trend movement. The first traders who get into the new trend are always running the "Have Fun" psychological program explained in Chapter 12. The beginning of wave 1 (which is either the end of a wave 5 or the end of a wave c or e, coming from the opposite direction) will be accompanied by a divergence in our MFI oscillator. Once we have all the indicators in place, we expect a sharp move off the bottom (top). This may also be a point zero (see the Profitunity Planned Trading (PPT) technique in Level Three, Chapter 9), which allows us even more trading and profit opportunities.
The best way to anticipate and target the end of a wave 1 is to examine the internal structure and waves of a smaller
degree. Look at a smaller time frame; for example, look for the 5-wave sequence inside of the developing wave 1 (Figure 7-3). Then check out (1) the divergence, (2) the target zone, (3) the fractals, (4) the squats, and (5) a change in the momentum indicator. We call these our five magic bullets because they almost always kill the current trend.
Once the first wave has finished, we anticipate a second wave in the opposite direction. Second waves are created by new selling (buying)—as opposed to fourth waves, which are created by profit taking (long liquidation or short covering). Wave 2 targets can be generated by (1) Fibonacci relationship and (2) internal wave counts.
The most common targets for the end of wave 2 are between 38 percent and 62 percent retracement of the range of wave 1 (Figure 7-4). About three out of four wave 2s will end in this
Figure 7-4 The most common retracement of wave 2.
area; only about one in six will retrace more than 62 percent. Another tip is that if wave 2 ends with less than a 38 percent correction, wave 2 will usually be an irregular correction (see Figure 7-11, later in this chapter).
Again, wave 2 is produced by new selling in an up trend (or buying in a down trend) by traders who are not in the market and do not recognize that this up move is a wave 1 in a new direction (see the section on finding point zero, in Chapter 9). These traders believe wave 1 is simply another correction in a continuing down move, so they sell at the top of wave 1. This is why wave 2 behaves quite differently from wave 4, which is a profit-taking wave. Traders in the market with profits will take more time getting out than traders seeing new opportunities in the market. It is extremely important to target accurately the end of wave 2: the greatest profit-taking opportunities per unit of time happen in wave 3, which generally moves faster and travels a greater distance.
Robert Prechtor calls wave 3 "... a wonder to behold." Wave 3 gives us great profit opportunities. When we reach Level Five (Chapter 12), we will analyze the psychological properties that accompany wave 3.
One way to recognize a wave 3 is by its slope. It is generally steeper (going through price changes faster) than a wave 1. Wave 3s sometimes seem almost vertical (Figure 7-5), and can be mistaken for wave 5 blow-offs (sell-offs). Generally, a wave 3 has heavy volume. If a powerful, fast move is accompanied by less volume, it usually is a blow-off (sell-off). During wave 3, the economic background begins to support the move (this is not true during wave 1). Fundamental reasons begin to pile atop the technical indicators. These are the most immensely profitable times to be in the market and it is imperative to "load the wagon" on these waves.
Figure 7-5 Characteristics of wave 3.
The best initial targets for the length of wave 3 are between 1 and 1.62 times the length of wave 1. Rarely will wave 3 be shorter than wave 1, and often it will be longer than 1.62 times the length of wave 1. The best way to target the end of wave 3 is to go to a smaller time frame and use a confluence of the five magic bullets to find the end of the fifth wave of wave 3 indicators. These magic bullets are:
Divergence in our MFI oscillator;
Location inside the target zone;
Formation of a fractal on the top (bottom);
A squat in one of the three topmost (lowest) bars;
A change in direction of the momentum on the Profitu-
Once the powerful wave 3 is over, profit taking enters the picture. The most skillful traders were into the trend earliest, and therefore are sitting on ample profits. The character of wave 4 is entirely different from that of wave 2. Elliott labeled this difference as the rule of alternation: If wave 2 is simple, wave 4 will be complex, and vice versa. A simple correction is usually considered to be a zigzag. If that happens in wave 2, wave 4 should be a complex sideways correction (flat, irregular, triangle, double or triple threes).
In our research, we found that 85 percent of all whiplashes occur during wave 4. If you simply cannot come up with any idea where you are in the wave count, you most likely are in a wave 4. If you wake up and are in a wave 4, the best strategy might be to go back to bed. However, as this is being written, several commodities have been in wave 4s on the monthly charts for years. I am not willing to stay in bed that long.
Besides, if we can target the end of a wave 4, we will have great profit opportunities to trade wave 5.
The retracement percentages on wave 4 (Figure 7-6) are quite different from those on wave 2. Generally, wave 4 corrections last much longer—often, up to 70 percent as long (time- wise) as the entire 5-wave sequence you are watching. Wave 4s generally do not retrace as much, pricewise, as wave 2. Again, this is caused by profit taking rather than new entries into the market. You generally see a precipitous drop in volume, volatility, option premiums, and momentum indicators.
Only about one in six wave 4s retraces less than 38 percent of wave 3. The most likely target is between 38 percent and 50 percent. In watching wave 4 develop, remember that an "unbreakable" rule is that wave 4 never goes below the top of wave 1. In actual trading, you will see a number of instances where the rule does not hold true.
In analyzing wave 4 to get good trade location to trade wave 5, use the Fibonacci relationships and look for the five magic bullets on a smaller time frame inside wave c of wave 4. Make sure that you have between 100 and 140 bars in the c wave. You get that number by manipulating the time frame on the chart.
38% = 50% = *
Figure 7-6 Wave 4 retracements. Once more, the five magic bullets are:
Location inside the target zone;
Change in momentum on the Profitunity MACD.
Wave 5, shown in Figure 7-7, is the traders' last struggle to create new high (low) prices. It is not as enthusiastic or euphoric as wave 3. Generally, the slope of the price line is less steep than in wave 3. Professional traders are using these new price thrusts to take their profits while the nonprofessionals are still getting into the trend. The end of wave 5 is calculated by a variety of methods already mentioned. When these different
smethods form targets that are in a tight cluster, confidence goes up that we can forecast the terminal point of wave 5. The length of wave 5 is measured from the bottom of wave 4, so no final targets can be projected until wave 4 has ended. (The next section, on combining the MFI oscillator with the Elliott wave, gives the minimum requirements for wave 4.)
One of the most accurate predictors of the end of wave 5 is the target zone. I learned of this methodology from Tom Joseph of Trading Techniques, Inc. (677 W. Turkeyfoot Lake Road, Akron, Ohio 44319), and have found it to be extremely useful and profitable. Measure the difference in price between the start of wave 1 and the end of wave 3 (waves 0-3). Then add this measurement to the bottom of wave 4. Take 62 percent of the length of that difference, and add it to the bottom of wave 4 also. The vast majority of times, wave 5 will end between those two numbers. You can even improve on this accuracy by doing the same procedure inside of the fifth wave of wave 5. This will give you an even smaller target zone. Normally, the smaller zone from the five waves inside the larger wave 5 will fall inside the larger target zone from the larger degree waves. This narrows your target zone even more. Next, by adding the Profitunity indicators of the fractal and squat, plus the divergence between wave 3 and wave 5, you can get very precise profit-taking and trade-entry points.
The complete movement of waves 1 through 5 will usually complete the next higher tier of wave sequences. Therefore, the movement from wave 1 to wave 5 completes a wave 1, a wave 3, or a wave 5, and the a-b-c sequence completes either a wave 2 or a wave 4 (see Figure 7-8).
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