Published with the compliments of Mr Larry Jacobs, publisher Traders World.

If you accept the standard premise that active markets tend to move in a pattern of 3 waves in the direction of the trend - ‘impulsive’ or ‘motor’ waves - with 2 waves in between correcting against the trend – ‘corrective’ waves (see the chart below) - you may be forgiven for thinking that you have cracked the secret to trading for profit. Surely, if you know a wave 5 follows a wave 4, you can know where and when the move will finish and trade perfectly every time? Well, the real world is not quite like that.

Diagram 1 Click to zoom.

As anyone who has ever tried knows, there are numerous difficulties with using the standard interpretation of Elliott wave, including simply being able to identify the waves to begin with; fitting a small pattern cozily inside a bigger (called larger-degree) pattern; breaking down a big pattern into smaller, snug patterns; connecting patterns following each other by using convenient bridges or ‘x’ waves; treating an unconventional pattern in a wave as just ‘complex’ and so on. And we have not even touched on the challenges of actually trading with Elliott wave!

So, why not use or trade Elliott wave only on those occasions when the pattern or sequence of waves is crystal-clear? When it is not – as may be the case more often than not – simply avoid making an analytical call or actually risking capital in trading. If you are strong enough to let go mentally and do this, you have broken through the barrier to be able to start using the 4 stage process employed by all good professional traders – to find a trade, to assess its risk/reward outlook, to determine how much to risk and to manage the trade. If you can’t even find a trade because you are busy forcing Elliott wave labels on everything that moves, you cannot even start the process!

So, you can achieve stage 1 and find a trade by focusing solely on identifying, for instance, a simple wave 2 or wave 4. Using the typical Fibonacci ratios (0.618x, 1.00x, 1.618x, 2.618x and so on), you can project target levels for the subsequent wave 3 or wave 5 to reach. This enables you to cover stage 2 and calculate the potential reward (the distance from the entry trigger price to the 1st target) against the definite risk of loss (the gap between the entry trigger price and your initial protective stop loss). If the resulting risk/reward ratio is better than 2:1, in conventional trading terms that is a good trade to consider. You can now move to stage 3 and work out how many shares, futures contracts, forex lots and so on to trade for a given amount of risk. If you are risking 0.5% of a US$20,000 account on each trade, you have $100 available. Divide the difference between your entry price and initial protective stop into that $400 and hey presto...your money management or Position Sizing™ is sorted. Finally, this all means you can manage the trade with discipline and control – stage 4. For example, if you are trading off daily charts, look to move your protective stop from its initial level to your break-even if price reaches 100% risk (in other words, the open risk/reward is 1:1 and you have, therefore, covered your risk)...and plan to take half your profit if the price reaches your 1st projected Elliot wave target and the remaining half profit if price moves further to reach the 2nd target. Simple!

See the chart below, on the same US stock as in the previous chart - APH, as an example of this simple process:

Diagram 2 Click to zoom.

Notice in this example how the potential correction down is a clear and simple 3 waves – usually called a zig-zag or abc correction, as labeled here. The previous uptrend is also clear. It would be difficult for a room full of Elliott experts to argue with this – though some might have a go! In doing so, however, they run the risk of over-analyzing and missing a simple trade opportunity.

Remember also that stage 3 is by far the most important stage in the flow diagram – although it has to follow the previous 2 stages in the sequence. Without consistent money management it doesn’t matter how well you pick trades, you are likely to end up losing. You will not have any way to link your profits on winning trades with your losses on losing trades. As the industry-leading trading mentor Van Tharp says “Research has proven that about 90% of the variance in performance between portfolio managers is due to money management. For the average trader, it makes the difference between losing, and winning big.”

Of course, you can use other analyses or indicators to give added weight to Elliott trade set-ups, however you must avoid at all costs a ‘paralysis of analysis’. For example, a simple 14 period RSI or Relative Strength Indicator showed a clear bullish divergence (not shown) on the wave 5 low in the first chart, suggesting the lower price was a fake move and a reversal upwards could result. Note the word ‘suggesting’, not ‘guaranteeing’! As another simple example, the weekly chart of APH was also showing a clear wave 2 low at the same time as the abc Buy set-up came in on 6 March 09 on the second APH daily bar chart above, adding weight to a long position.

We will cover this ground more thoroughly in future articles.

Tony Beckwith
MTPredictor Ltd.