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Elliott Wave: The Best Of The Theory

By Matt Blackman with Mike Green
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For those not familiar with Elliott Wave theory its most basic tenet is that market movements are based on crowd behavior, which is seen as predictable given similar situations. Creator R.N. Elliott showed that these movements occur in a series of impulse and corrective waves. (To learn more, see Elliot Wave Theory.)

For example, a bearish impulse swing consists of three waves down and two waves up (see Figure 1). Major impulse waves down (1, 3 and 5) can be further broken down into smaller five-part impulse down waves and corrective up waves, depending on the time frame over which the waves are observed. Bullish waves move in the opposite direction.

But this is where it starts to get more complicated. These smaller waves can be further broken down into more waves, which are interrelated by Fibonacci numbers (1, 1, 2, 3, 5, 8, 13, 21, 34, etc.), and on it goes. (Read more about how these numbers are used in technical analysis in Fibonacci And The Golden Ratio.) Wave analysis runs the gamut from supercycles lasting hundreds of years to sub-minuets that may last only a few minutes on an intraday chart.

One of the hardest things about trading Elliott Wave is its degree of complexity. To make it even more challenging, there are alternates to every potential move, which basically tells the trader that if this move doesn't go up, it will go down, but he or she will know that only after the fact! The rule of alternation also means that the corrective waves 2 and 4 will alternate. If a wave 2 down is a simple wave, then wave 4 will probably be complex, but not necessarily. Then there are X waves. These are waves that connect complex corrections.

It is easy to see why many novices shy away from using Elliott Wave and why many traders who have invested thousands of hours into it (and lost dollars trying to develop working trading strategies) finally abandon it altogether.

Starting with the End in Mind
To begin with, the trader must have realistic expectations. Most new traders spend the majority of their time looking for a system that has an unrealistically high win/loss ratio. Those still seeking a system that consistently produces more than 50% winners in the long term haven't learned that surviving the market means knowing how to deal with losses. Such traders are looking for the Holy Grail, and it doesn't exist. (For more on this, read Losing To Win.)

It's worth remembering what well-known author and professional trader Perry Kaufman had to say after years of exhaustive testing of various trend-following systems, some of which were discussed in his book "Trading Systems And Methods" (1998): "You can expect six or seven out of 10 trend trades to be losses, some small some a little larger."

And yet, Kaufman says that trend-following systems are some of the best trading systems around. In other words, trend-following systems have more losers than winners, but professional traders who use them make money consistently.

Renowned technical analyst John Murphy echoes this sentiment when he states that veteran professional traders experience winning trades 40% of the time. Granted, it is possible to outperform this record over short-term periods, but expecting any system to do much better over the long haul is unrealistic.

This means that for any system to be profitable long-term, money management is key. If a trading system cannot be profitable with more losses than winners, find another system or spend more time on money management. In short, losses must be kept small and profits must be allowed to accumulate. Unfortunately, the majority of traders do just the opposite and end up going out of business.

Figure 1 – Chart of Dow Industrial Average () five-minute intraday chart showing a short-term bear Elliott five-wave impulse pattern. On a one-minute chart, a further breakdown of smaller impulse and corrective waves could be observed. The colored bands are key areas of support, which are potential areas of reversal.

Applying this idea to trading Elliott, Figure 1 shows a five-minute chart of the Dow Industrial e-mini futures with a five-part impulse wave. Colored bands show the points of support (or resistance in an uptrend) and are where the trader looks to place a trade or adjust stops on current positions.

Programming Elliott to Trade
In the 500+ page manual for MTPredictor, author and creator of the program Steve Griffiths makes an interesting observation. He says there are basically three types of people when it comes to Elliott Wave.

1) Those who are new to the principle and still completely amazed at what it promises.

2) Those who are experienced but frustrated by their lack of success/consistency.

3) Those who have completely given up (sometimes after years of trying to make it work) and are frustrated by the whole experience.

To avoid falling into the third category, the modern trader needs to ask how Elliott Wave theory can be used to make money in today's markets. Is there a way of automating the analytical process using the complete theory, or is it possible to strip it down and isolate specific aspects of the principle to pick money-making trades? Becoming an expert but finding it impossible to make money is a waste of time.

As an Elliot Wave expert and a private trader with more than 17 years of experience, Griffiths asked himself the same questions. After spending years trying to make money on a consistent basis using alternate methods, he went back to Elliott Wave basics. He started with the premise that if Elliott Wave was to work in a program, he had to find setups that limited risk to a minimum that allowed profits to run. These setups had to be specific, identifiable and consistently profitable. If overall losses are greater than profits, what good are the longer-term forecasts for which Elliott Wave analysis is famous?

According to the theory, the strongest moves in a trend, whether up or down, are the impulse waves 1, 3 and 5. Of the three impulsive waves, the largest and most profitable is generally wave 3. Therefore, the ideal place to enter a trade is at the beginning of wave 3, which is the end of a corrective wave 2. Could the program be designed to hone in on these ABC corrective patterns (see Figure 2) that normally unfold in a wave 2 and provide the trader with a high-probability point of entry? Here is what Griffiths said in an October 2004 interview to discuss how the program came into being:

"In computer testing, we found that it was possible to enter with a minimum risk after an ABC had recently unfolded and the best were those that made up wave 2. By entering long trades very near significant support levels (and short traders near significant resistance levels), losses would be kept small if the trade turned out to be a loser. Winners had the potential to be very profitable indeed when the trader caught a wave 3 but the system had to be designed in such a way that the large gains were a bonus, not essential to the profitability of the system."

Figure 2 – End-of-day chart of iShares Japan on quick breakout from an ABC corrective pattern buy signal.

This became Griffiths' goal: to design a computer program for his personal use that could search for ABC patterns that made up a wave 2 ending at or near significant support or resistance areas with a minimum risk/reward of 2:1. He could then choose only those that met specific risk/reward ratios according to his written trading plan. A more aggressive approach would be to take every trade generated by the program. A more conservative style allowed him to choose trades with a minimum risk/reward of 2.5 or 3:1.

After the first version of the program was completed four years ago, Griffiths realized that the application he had developed had commercial potential since there had to be others like him who were frustrated with the lack of success using Elliott but knew that it was based on sound technical and crowd behavior principles.

Figure 3 – An intraday trade on the Dow e-minis futures (YM) showing a very profitable trade.

Figure 3 shows the program in action. It is a chart of the five-minute Dow (YM) e-mini futures trade with the proprietary colored bands of significant support/resistance. These are generated with the use of automatic Fibonacci price clusters of varying degree and from multiple pivots that tell the trader where the highest probability of pauses and reversals should occur. As you can see, the trade was very profitable having moved well past the ‘two to three times' profit area (blue band) to end the day at a new multi-period low resulting in a profit of approximately 12 times the initial risk (ignoring slippage and commission) at the lower projected profit target. While this is not a typical trade, it demonstrates what can happen when the trader catches a strong wave-3 move.

For the sake of those unfamiliar with the program, MTPredictor includes a record of all trades the program has called (with a minimum risk/reward ratio of 2:1) since July 26, 2004. Since real money was not used and commissions and slippage not included, the trade results are hypothetical. It is not unusual to see more losses than wins, but what is important is the comparison of the number of points or dollars that were won to those that were lost. This is the acid test of whether a money management system is working.

For those who are interested, a software review of the program, "Software Review: MTPredictor Real-Time 4.0", was published in the September 2004 issue of The Technical Analyst.

The Key to Success

Here is what fund trader John McClure of Equitrend said when asked about profitability in an Oct 2004 interview:

"Profitability cannot be discussed without mentioning the other side of the equation: risk. The trap that many investors and traders fall into is to focus on the first part of the equation while not paying attention to the second. The professional money manager's goal is to improve profits by managing risk. Risk should be the most important part of the equation, not the other way around."

In other words, find a system that manages risk first and the profits will usually take care of themselves.

To borrow an old saying, there are many ways "to skin a cat" when trading. No single trading system will attract or work for everyone. This is especially true for Elliott Wave.

Finding specific parts of Elliott theory and transforming them into a workable trading system in which risk can be carefully controlled is one way to use the theory. And MTPredictor shows that you don't have to use the complete Elliott Wave theory to trade successfully. By taking small parts of the theory, using a computer and the right program, traders can now learn to trade Elliott without having to become experts in the theory itself. This is a good example of how one company has taken Elliott's brainchild and adapted it to work in the twenty-first century.
Elliott Wave: Shifting Into Trading Gear