Profitunity Trading | Bill Williams

The following material provides the best systematic approach to taking money from the market that we have seen in over 35 years of trading.* To follow this method, you must first decide what is to be your trading horizon. What time frame is most comfortable with your style of trading? This approach works with all times frames, but it becomes a bit cumbersome with intraday trading. In general, the longer-term time frame incurs less overhead in commission and transaction costs and gathers less "static" from news items and other temporary aberrations in the market. In the final analysis, most traders are more profitable on a relatively longer time frame.

The following outline is our approach for trading through a complete sequence of the Elliott wave, consisting of a five-wave impulse move and a three-wave corrective move. Assume that the market has shown a clear five-wave pattern down, with the appropriate ratios, and has an appropriate "look or fit" to the wave formation.

The first and most vital knowledge we can have about the market is the end of a trend in our trading time frame. Let's follow the various traders' behavior at a typical end-of-trend action in the market. In Figure 9-1, we can assume from the price formation that traders who are short at point d are happy; they are in profit territory. They most likely sold the breakout at point c or

sold a pullback from around point b. Regardless of their method of entry, they are happy because they are gaining profit. At this point, probably no more than 20 percent of the traders looking at this market are in the trade. All the rest are wishing they were in and saying to themselves, "If the market gives me a pullback, I will get short."

The market does indeed give them a pullback, and more traders get short. Again, they get short on the pullback at point e or the breakout down at point f in Figure 9-2. In the total population of traders watching this market, we have a larger group of happy traders. The traders who entered at points b and c are very happy; they have lots of profit. Those who entered at points e and f are happy because they too are making profits. There is still a large group of traders who are watching but haven't yet taken action. They are giving themselves hell because they have missed four selling opportunities. They are saying to themselves, "If the market just gives me another pull- back, I'm in there, buddy!"

The market becomes very kindly and does move up from point g to point h (Figure 9-3). To this last group of traders who are still not short, this pullback from point g to point h looks like the two previous pullbacks (from a to b and from d

to e) which are producing nice profits. This last group of traders go short around point h, earning the label "weak shorts" because they are in late and have little staying power.

What the weak shorts or constant losers don't see is that 0- a is wave 1, b-d is wave 3, and e-g is wave 5. What they see as an opportune pullback is really the first initial thrust of the new trend going in the opposite direction. They generally will get stopped out when the price goes above point h.

They do not see that point 0 through point g is a five-wave Elliott sequence. To be winning traders, we need a technique to (1) give us high confidence when a trend is over and (2) present us with a "market-determined" technique for maximizing our profits in the new upcoming Elliott wave sequence. We call this end of a significant trend Point Zero. Once we are satisfied that this is Point Zero, we plan a trading campaign to maximize our profits throughout the upcoming Elliott wave.

The key to "making a killing" in the market lies in the ability to know when a trend is over and when the next trend is starting. In Chapter 7, we introduced five magic bullets and said that when they are present, the odds are heavily in favor of a trend's being over. These bullets are:

• Divergence. There must be a divergence between wave
3 and wave 5 (see Figure 9-4). If the market is going
down, the price at the end of wave 5 must be lower than
the bottom of wave 3 and the Profitunity oscillator
must be higher at the end of wave 5 than it was at the
end of wave 3.

• Price in the target zone. (The technique for projecting
this target zone is found in Chapter 7.)

• A shift in momentum from down to up (up to down, in a
bull market). (See Chapter 7.) Once these five magic bullets show up, you assume that this is a Point Zero. Your situation would be:

• The price is in the target zone. This divergence is mea
sured in a time frame in which the Elliott wave you are
counting occupies between 100 and 140 bars.

• There is a change in direction of momentum as mea
sured on the Profitunity 5/34/5 MACD.

When you see all five of these bullets, you can begin your count with confidence.

At Point Zero, we expect a sharp rally of the bottom (Figure 9-5). We move down at least one significant time frame. If the

trading time frame is a daily bar, we would examine a 60- or possibly a 30-minute bar. We are looking for a smaller degree five-wave impulse in the new direction. As this rally begins to lose steam (usually with an up fractal) and starts to pull back, we want to be ready to place our first trade in this sequence. Our assumption at this point is that a possible impulse wave up has begun. If that is not the case, we are in some sort of corrective mode and our strategy must take account of this possibility. We assume that this is the end of a wave 1 up (Figure 9-5).

As this first pullback from the up move starts, we place our first buy. If we cannot watch the market on a short-term basis, we place our order somewhere between a 50 percent and a 62 percent pullback (point "B" in Figure 9-5). If we are able to watch the market as this develops, we will go to an even shorter-term chart and look for five waves in wave c of wave 2. On the smaller-term chart, we look for exactly the same signals we were searching for to determine the end of a trend. Wave 2 represents a shorter time interval. If we are watching those five magic bullets form in wave c of wave 2, we can make an even more precise entry, taking more profit and less risk.

If we are trading multiple contracts (assume our maximum trading capacity is 10 contracts), we want to place an order to buy three contracts (or 30 percent or our maximum number of contracts available for this trading sequence). As soon as we are filled, we want to determine two things: (1) where to protect against excessive losses and (2) where to take profits. Our first obligation is to cut losses, so we will place a stop and reverse to go short just below the low at Point Zero (point "C" in Figure 9-5). We place an order to sell five contracts (half of our maximum). Our logic for this stop and reverse is that if the price goes below what we thought was Point Zero, our count is wrong and what we had assumed was an impulsive wave up is, in fact, a reaction to a continuing down trend.

Being wrong can often prove to be as profitable as being right. If we are clearly wrong in our count, we should not just get out; rather, we should reverse to the opposite direction. The only time to get out is when you don't know where you are in the market movement or you are waiting for good trade location. Here, we place an order to go short two-thirds of our long position. That means that if we are long three contracts, we must place an order to sell five to be net short two, which is two-thirds of our long position. Our experience in actual trading has been that we can almost always make enough profit on this short to overcome any loss on the long side.

If we are wrong in being on the long side, we should latch on to the breakout trade on the down side. Because this is clearly a breakout to the down side, our stop would be two fractals back in the opposite (long) direction.

Assuming that we did not get stopped out one tick below Point Zero, we believe that we are in the beginning of a wave 1, which should include a five-wave pattern visible on a smaller time frame. Let's be clear here: nobody "knows" this is a wave 1. It could be a corrective wave a. No problem; our strategy will take care of that possibility also.

As the market nears our larger-degree wave CD (and our smaller-degree wave 5, inside of wave CD; see Figure 9-5), we want to bank some of our profits. We are long three contracts, so we sell two. We do this for two reasons: (1) to take some money to the bank and (2) to leave one contract long in case our target is wrong and the market continues up (at least one contract will continue to give us profits).

By using the methods described above (the five magic bullets) and applying Fibonacci expansion ratios (discussed earlier), we can calculate that the end of this five-wave pattern will make a larger wave CD (point "A" in Figure 9-5).

We have now taken profits on two contracts, are still holding one long, and are awaiting an opportunity to add to our long position on an appropriate pullback. As this larger-degree wave (2) pulls back to between 50 percent and 62 percent, we will initiate our second trade: we will attempt to buy near the bottom of wave 2 (point "D" in Figure 9-6). We will verify the bottom of wave 2 by a down fractal and a squat bar on one of the three lowest bars in this wave. In addition, we go to a smaller time frame to count the five waves inside wave c of wave (2). At this predetermined point, we would buy five contracts, giving us a total of six contracts (counting the one we left on at the end of the smaller-degree wave 1).

Once again, it is time to protect and plan where to take profits. Our stop and reverse will remain the same, just below Point Zero (point "C" in Figure 9-6). If this point is hit, we will sell ten contracts, leaving us net short four contracts. Using the same reasoning as for the first trade, we would need only a relatively small movement to recoup our losses on the six long contracts. If this point is hit, it most likely indicates that our analysis is wrong and our anticipated bullishness should turn bearish. What we had first analyzed as the top of wave 1 is more likely the end of a larger-degree wave 2 or wave 4, which means much more on the downside. After the reverse, we are in tune with the immediate trend.

If, as expected, the market moves higher, we must plan to extract some more profits (the name of this game) from the market. The next critical point in this campaign is where the young wave (3) equals the length of wave © (point "F" in Figure 9-6). At this point, we still have our order to sell ten contracts just below our Point Zero. If the market stalls here and retraces past the top of wave 1 (point "E" in Figure 9-6), we want out altogether so we sell six contracts. We do this by canceling our standing order to sell ten contracts just below Point Zero and placing an order to sell six contracts one tick below the top of what we think is wave ©. Our logic here is that our expected count is not unfolding and we should get out just until the market has time to clear the wave-count picture.

If the prices continue upward to where the emerging wave (3) is 10 percent longer than wave CD, we are most likely in a real wave (3). We want to go "whole hog" so we buy four more contracts, giving us our maximum of ten longs. This is the point to be maximally long and most aggressive: this wave gives the most profit per unit of time and contains the least risk. We also want to place a stop for the additional four contracts where we now have the order to sell six—just below the top of wave 1. If the market comes one tick below the top of what we think is wave 1, we want to be out of the market completely.

• If it does, it destroys our current count—we don't know
where we are and therefore should be out.

As the price rallies and we get totally on board, we want to calculate the most probable completion point for wave (3) (point

"G" in Figure 9-6). We do this by again using our five magic bullets that kill most trends. When we have used the bullets and the price reaches our calculated goal, we sell seven of the ten contracts. Our reasoning is exactly the same as when we sold two contracts at the top of wave ©. We want to bank the majority of the profits and stay in a minor position, in case the current movement proves to be an extended wave. At this point, the 5/34 oscillator should be considerably higher than its peak at the top of wave (D- If that happens, we are in a good situation. We are still making profit on 30 percent of our total, and we have already taken a sizable amount of money to the bank. This is the best of all trading worlds.

Now is the time to allow wave (D to retrace. We watch this retracement very carefully for clues on when to reenter on the long side. If wave a of wave ® breaks down into five waves, we normally expect a zigzag correction and much lower prices. If wave a is only three waves, we normally expect a flat, irregular, or triangle correction. When the 5/34 oscillator goes below the zero line, the minimum requirements for wave (4) have been met. It is important to remember that going below zero does not indicate that wave © is over, only that it has met the minimum requirements. It is, however, time to start looking for a place to take advantage of the upcoming wave (5). Wave @ will also contain a minimum of two down fractals and will end in a squat bar on one or more of the three lowest bars. Another good indicator is that it usually ends in the area of the previous wave 4 of a lesser degree (the fourth wave inside of wave (3)).

The criterion for determining how many contracts to enter at this point (bottom of wave (§)) is the ratio of the length of wave (3) to wave ©. If wave (D is equal to or longer than 1.62 times wave ©, it is probably an extended wave (3), and wave (5) will be relatively shorter. In that case, we would add to our three long contracts another three, giving us a total of six contracts to hold through wave (5). We would put this buy between 38 percent and 50 percent retracement of wave (3) (point "H" in

Figure 9-7). If wave (3) is less than 1.62 times as long as wave 1, we would buy five contracts, giving us a total of eight contracts long. The reason for this decision is: usually, one of the three impulse waves in a five-wave series is an "extended" wave, and this extension most often occurs in wave (3). Sometimes, however, it does occur in wave (5), even more rarely, it may be in wave (T). If wave (3) is not an extended wave, the probability is that wave d) will extend. This justifies our putting on an additional two contracts.

Our initial stop for these six (or eight) contracts would be at the top of wave CD (point "I" in Figure 9-7). We would sell enough contracts to be out of the market

If the anticipated wave 5 continues upward, it verifies our premise and wave count. The critical point here is when the rally reaches a 62 percent retracement of the down move in wave 4 (point "J" in Figure 9-7). if the market rallies above this point, it is highly unlikely that a larger move down will occur,and we need to think about taking profits again. We project the end of a five-wave sequence that makes up the larger-degree wave 5. At this point, we sell all our remaining long contracts and go flat the market (point "L" in Figure 9-7).

We basically follow the same logic in trading the three-wave corrective pattern. We watch the first down move, which is usually dynamic, and sell on a 50 percent to 62 percent retrace- ment upward (Figure "M" in Figure 9-8), placing a stop and reverse to go net long just above the top of wave (5) (point "O" in Figure 9-8). If wave a turns into a five-wave sequence, we expect a zigzag correction and a deep move back down.

At the calculated end of wave a, we buy back two contracts and leave one short in case the market continues downward

(point "N" in Figure 9-8). We then calculate that with a 38-50 percent (point "P" in Figure 9-8) retracement back up, we could sell three more units, expecting wave c to have a wave 3 personality on the down side. We place a stop and reverse above the top of wave 5 (point "O" in Figure 9-8) for seven contracts, giving us a new long of three contracts if the market moves that high. Concluding this sequence, we calculate the projected end of wave 5 of wave c (point "Q" in Figure 9-8). At that point, we cover all shorts and wait for the next movement of the market to unfold.