The Elliott Waves

 tags:Wave extensions,basic Elliott Wave pattern,Basics of Wave Analysis,Impulse Wave Variations,complete market cycle,Elliott Waves,interpretation of Elliott Waves,Bear market failure,Failures,Truncated Fifths,bearish pattern,bullish pattern,Diagonal Triangles

Basics of Wave Analysis

The Elliott waves principle is a system of empirically derived rules for interpreting action in the markets. Elliott pointed out that the market unfolds according to a basic rhythm or pattern of five waves in the direction of the trend at one larger scale and three waves against that trend. In a rising market, this five wave/three-wave pattern forms one complete bull market/bear market cycle of eight waves. The five-wave upward movement as a whole is referred to as an impulse wave, and the three-wave countertrend movement is described as a corrective wave (See Figure 6.1). Within the five-wave bull move, waves 1, 3 and 5 are themselves impulse waves, subdividing into five waves of smaller scale; while waves 2 and 4 arecorrective waves, subdividing into three smaller waves each. As shown in Figure 6.1, subwaves of impulse sequences are labeled with numbers, while subwaves of corrections are labeled with letters.

Figure 6.1. The basic Elliott Wave pattern

Following the cycle shown in the illustration, a second five-wave upside movement begins, followed by another three-wave correction, followed by one more five-wave up move. This sequence of movements constitutes a fivewave impulse pattern at one larger degree of trend, and a three-wave corrective movement at the same scale must follow. Figure 6.2 shows this larger-scale pattern in detail.

As the illustration shows, waves of any degree in any series can be subdivided and resubdivided into waves of smaller degree or expanded into waves of larger degree.

Figure 6.2. The larger pattern in detail

The following rules are applicable to the interpretation of Elliott Waves:

1. A second wave may never retrace more than 100 percent of a first wave; for example, in a bull market, the low of the second wave may not go below the beginning of the first wave.
2. The third wave is never the shortest wave in an impulse sequence; often, it is the longest.
3. A fourth wave can never enter the price range of a first wave, except in one specific type of wave pattern, the form of market movements is essentially the same, irrespective of the size or duration of the movements.

Furthermore, smaller-scale movements link up to create larger-scale movements possessing the same basic form. Conversely, large-scale movements consist of smaller-scale subdivisions with which they share a geometric similarity. Because these movements link up in increments of five waves and three waves, they generate sequences of numbers that the analyst can use (along with the rules of wave formation) to help identify the current
state of pattern development, as shown in Figure 6.3.

Figure 6.3. A complete market cycle

As the market swings of any degree tend to move more easily with the trend of one larger degree than against it, corrective waves often are difficult to interpret precisely until they are finished. Thus, the terminations of corrective waves are less predictable than those of impulse waves, and the wave analyst must exercise greater caution when the market is in a meandering, corrective mood than when prices are in a clearly impulsive trend. Moreover, while only three main types of impulse wave exist, there much more basic corrective wave patterns, and they can link up to form extended corrections of great complexity. A most important thing to remember about corrections is that only impulse waves can be “fives”. Thus, an initial five-wave movement against the larger trend is never a complete correction, but only part of it.

Impulse Wave Variations

In any given five-wave sequence, a tendency exists for one of the three impulse subwaves (i.e., wave 1, wave 3, or wave 5) to be an extension—an elongated movement, usually with internal subdivisions. At times, these subdivisions are of nearly the same amplitude and duration as the larger degree waves of the main impulse sequence, giving a total count of nine waves of similar size rather than the normal count of five for the main sequence. In a nine-wave sequence, it is sometimes difficult to identify which wave is extended. However, this is usually irrelevant, because a count of nine and a count of five have the same technical significance. Figure 6.4. shows why this is so; examples of extensions in various wave positions make it clear that the overall significance is the same in each case. Extensions can also occur within extensions. Although extended fifth waves are not uncommon, extensions of extensions occur most often within third waves, as shown in
Figure 6.5.

Figure 6.4. Wave extensions

Figure 6.4. Wave extensions

Figure 6.5. Wave extensions

Extensions can provide a useful guide to the lengths of future waves. Most impulse sequences contain extensions in only one of their three impulsive subwaves. Thus, if the first and third waves are of about the same magnitude, the fifth wave probably will be extended, especially if volume during the fifth wave is greater than during the third.

The Diagonal Triangles

There are some patterns familiar from the Technical Analysis theory, particularly two types of triangles, which should be noticed in frame of Elliotts waves consideration.

The diagonal triangle type 1 occurs only in fifth waves and in С waves, and it signals that the preceding move has, in accordance to Elliott, "gone too far, too fast." All of the patterns' sub-waves, including waves 1, 3, and 5,consist of three-wave movements, and their fourth waves often enter the price range of their first waves, as shown in Figures 6.6. and 6.7. A rising diagonal triangle type 1 is bearish, because it is usually followed by a sharp decline, at least to the level where the formation began. In contrast, a falling diagonal type 1 is bullish, because an upward thrust usually follows.

Figure 6.6. A bullish pattern

Figure 6.7. A bearish pattern

The diagonal triangle type 2 occurs even more rarely than type 1. This pattern, found in first-wave or A-wave positions in very rare cases, resembles a diagonal type 1 in that it is defined by converging trendlines and its first wave and fourth wave overlap, as shown in Figure 6.8. However, it differs significantly from type 1 in that its impulsive subwaves (waves 1, 3, and 5) are normal, five-wave impulse waves, in contrast to the three-wave subwaves of type 1. This is consistent with the message of the type 2 diagonal triangle, which signals continuation of the underlying trend, in contrast to the type 1 's message of termination of the larger trend.

Figure 6.8.

Failures (Truncated Fifths)

Elliott described as a failure an impulse pattern in which the extreme of the fifth wave fails to exceed the extreme of the third wave. Figures 6.9 and 6.10 show examples of failures in bull and bear markets. As the illustrations show, the truncated fifth wave contains the necessary impulsive (i.e., fivewave) substructure to complete the larger movement. However, its failure to surpass the previous impulse wave's extreme signals weakness in the underlying trend, and a sharp reversal usually follows.

Figure 6.9. Bull market failure

Figure 6.10. Bear market failure

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Fibonacci Analysis

 tags: Fibonacci Analysis, important role, forecasting of market,Fibonacci sequence, financial markets

Fibonacci Analysis

The Fibonacci analysis gives ratios which play important role in the forecasting of market movements. This theory is named after Leonardo Fibonacci of Pisa, an Italian mathematician of the late twelfth and early thirteenth centuries He introduced an additive numerical series - Fibonacci sequence.

The Fibonacci sequence consists of the following series of numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, (etc.), which exhibit several remarkable relationships, in particular the ratio of any term in the series to the next higher term. This ratio tends asymptotically to 0.618 (the Fibonacci ratio). In addition, the ratio of any term to the next lower term in the sequence tends asymptotically to 1.618, which is the inverse of 0.618. Similarly constant ratios exist betweennumbers two terms.

Golden spirals appear in a variety of natural objects, from seashells to hurricanes to galaxies.

The financial markets exhibit Fibonacci proportions in a number of ways, particularly it constitute a tool for calculating price targets and placing stops. For example, if a correction is expected to retrace 61.8 percent of the preceding impulse wave, an investor might place a stop slightly below that level. This will ensure that if the correction is of a larger degree of trend than expected, the investor will not be exposed to excessive losses. On the other hand, if the correction ends near the target level, this outcome will increase the probability that the investor's preferred price move interpretation is accurate.

Moving Average Convergence-Divergence (MACD)

tags: Moving Average Convergence,The Parabolic System (SAR),The Directional Movement Index (DMI),DMI,Commodity Channel Index (CCI),CCI,Bollinger Bands,Divergence (MACD),MACD,The Larry Williams %R,Momentum,Rate of Change (ROC),ROC,The Relative Strength Index (RSI),RSI

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 Moving Average Convergence-Divergence (MACD)

The moving average convergence-divergence (MACD) oscillator, developed by Gerald Appel, is built on exponentially smoothed moving aver ages. The MACD consists of two exponential moving averages that are plotted against the zero line. The zero line represents the times the values of the two moving averages are identical.

In addition to the signals generated by the averages' intersection with the zero line and by divergence, additional signals occur as the shorter average line intersects the longer average line. The buying signal is displayed by an upward crossover, and the selling signal by a downward crossover. (See Figure 5.41.)

Figure 5.41. An example of MACD

Momentum

Momentum is an oscillator designed to measure the rate of price change, not the actual price level. This oscillator consists of the net difference between the current closing price and the oldest closing price from a predetermined period.

The formula for calculating the momentum (M) is:

M=CCP-OCP, where
CCP - current closing price
OCP - old closing price for the predetermined period.

The new values thus obtained will be either positive or negative numbers, and they will be plotted around the zero line. At extreme positive values, momentum suggests an overbought condition, whereas at extreme negative values, the indication is an oversold condition. (See Figure 5.42.) The momentum is measured on an open scale around the zero line.

Figure 5.42. An example of the momentum oscillator

This may create potential problems when a trader must figure out exactly what an extreme overbought or oversold condition means. On the simplest level, the relativity of the situation may be addressed by analyzing the previous historical data and determining the approximate levels that delineate the extremes. The shorter the number of days included in the calculations, the more responsive the momentum will be to short-term fluctuations, and vice versa. The signals triggered by the crossing of the zero line remain in effect. However, they should be followed only when they are consistent with the ongoing trend.

The Relative Strength Index (RSI)

The relative strength index is a popular oscillator devised by Welles Wilder. The RSI measures the relative changes between the higher and lower closing prices. (See Figure 5.43.)

Figure 5.43. An example of the RSI oscillator

The formula for calculating the RSI is:

Л5/=100-[100/(1+RS)], where
RS - (average of X days up closes/average of X days down
closes);
X - predetermined number of days The original number of
days, as used by its author, was 14 days. Currently, a 9-day
period is more popular.

The RSI is plotted on a 0 to 100 scale. The 70 and 30 values are used as warning signals, whereas values above 85 indicate an overbought condition (selling signal) and values under 15 indicate an oversold condition (buying signal.) Wilder identified the RSI's forte as its divergence versus the underlying price.

Rate of Change (ROC)

The rate of change is another version of the momentum oscillator. The difference consists in the fact that, while the momentum's formula is based on subtracting the oldest closing price from the most recent, the ROC's formula is based on dividing the oldest closing price into the most recent one. (See Figure 5.44.)

Figure 5.44. An example of the rate of change (ROC) oscillator

ROC = (CCP/OCP) * 100, where
CCP - current closing price;
OCP = old closing price for the predetermined period Larry
Williams %R.

The Larry Williams %R

The Larry Williams %R is a version of the stochastics oscillator. It consists of the difference between the high price of a predetermined number of days and the current closing price, which difference in turn is divided by the total range. This oscillator is plotted on a reversed 0 to 100 scale. Therefore, the bullish reversal signals occur at under 80 percent, and the bearish signals appear at above 20 percent. The interpretations are similar to those discussed under stochastics. (See Figure 5.45.)

Commodity Channel Index (CCI)

The commodity channel index was developed by Donald Lambert. It consists of the difference between the mean price of the currency and the average of the mean price over a predetermined period of time (See Figure 5.46.). A buying signal is generated when the price exceeds the upper (+100) line, and a selling signal occurs when the price dips under the lower (-100) line. (See Figure 5.46.)

Figure 5.45. An example of the Larry Williams %R oscillator

Figure 5.46. An example of the commodity channel index

Bollinger Bands

The Bollinger bands combine a moving average with the instrument's volatility. The bands were designed to gauge whether prices are high or low on a relative basis via volatility. The two are plotted two standard deviations above and below a 20-day simple moving average.

The bands look a lot like an expanding and contracting envelope model. When the band contracts drastically, the signal is that volatility is low and thus likely to expand in the near future. An additional signal is a succession of two top formations, one outside the band followed by one inside. If it occurs above the band, it is a selling signal. When it occurs below the band, it is a buying signal. (See Figure 5.47.)

The Parabolic System (SAR)

The parabolic system is a stop-loss system based on price and time.The system was devised to supplement the inadvertent gaps of the other trend-following systems. The name of the system is derived from its parabolic shape, which follows the price gyrations. It is represented by a dotted line. When the parabola is placed under the price, it suggests a long position. Conversely, when placed above the price, the parabola indicates a short position. (See Figure 5.48.) The parabolic system can be used with oscillators. SAR stands for stop and reverse. The stop moves daily in the direction of the new trend. The built-in acceleration factor pushes the SAR to catch up with the currency price. If the new trend fails, the SAR signal will be generated.

The Directional Movement Index (DMI)

The directional movement index provides a signal of trend presence in the market. The line simply rates the price directional movement on a scale of0 to 100. The higher the number, the better the trend potential of a movement, and vice versa. (See Figure 5.49.) This system can be used by itself or as a filter to the SAR system.

Traders use different combinations of technical tools in their daily trading and analysis. Some of the more popular oscillators are shown in Figure 5.50.

Figure 5.47. A market example of Bollinger bands

Figure 5.48. An example of the SAR parabolic study

Figure 5.49. Example of the directional movement index (DMI)

Figure 5.50. Example of oscillator combinations used for trading

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Mathematical Trading Methods (Indicators)

tags:Mathematical Trading Methods,Indicators,Moving Averages,arithmetic,linearly weighted,Oscillators,Stochastics,stochastics ,exponentially smoothed,Trading Signals

Mathematical Trading Methods (Indicators)

The mathematical trading methods provide a more objective view of price activity. In addition, these methods tend to provide signals prior to their occurrence on the currency charts. The tools of the mathematical methods are moving averages and oscillators.

Moving Averages

A moving average is an average of a predetermined number of pricesover a number of days, divided by the number of entries. The higher the number of days in the average, the smoother the line is. A moving average makes it easier to visualize currency activity without daily statistical noise. It is a common tool in technical analysis and is used either by itself or as an oscillator.

As one can see from Figure 5.35., a moving average has a smootherline than the underlying currency. The daily closing price is commonly included in the moving averages. The average may also be based on the midrange level or on a daily average of the high, low, and closing prices.

Figure 5.35. Examples of three simple moving averages—5-day (white), 20-day (red) and 60-day
(green)

It is important to observe that the moving average is a follower rather than a leader. Its signals occur after the new movement has started, not before.

There are three types of moving averages:

1. The simple moving average or arithmetic mean.
2. The linearly weighted moving average.
3. The exponentially smoothed moving average.

As described, the simple moving average or arithmetic mean is the average of a predetermined number of prices over a number of days, divided by the number of entries.

Traders have the option of using a linearly weighted moving average (See Figure 5.36.). This type of average assigns more weight to the more recent closings. This is achieved by multiplying the last day's price by one, and each closer day by an increasing consecutive number. In our previous example, the fourth day's price is multiplied by 1, the third by 2, the second by 3, and the last one by 4; then the fourth day's price is deducted. The new sum is divided by 9, which is the sum of its multipliers.

Figure 5.36. Example of a 20-day simple moving average (red) as compared to a 20-day
weighted moving average (white)

The most sophisticated moving average available is the exponentially smoothed moving average. (See Figure 5.37.) In addition to assigning different weights to the previous prices, the exponentially smoothed moving average also takes into account the previous price information of the underlying currency.

Figure 5.37. Example of a 20-day simple moving average (red) as compared to a 20-day
exponential moving average (white)

Trading Signals of Moving Averages

Single moving averages are frequently used as price and time filters. As a price filter, a short-term moving average has to be cleared by the currency closing price, the entire daily range, or a certain percentage (chosen at the discretion of the trader).

The envelope model (See Figure 5.38.) serves as a price filter. It consists of a short-term (perhaps 5-day) closing price based moving average to which a small percentage (2 percent is suggested for foreign currencies.) are added and substracted. The two winding parallel lines above and below the moving average will create a band bordering most price fluctuations. When the upper band is penetrated, a selling signal occurs. When the lower band is penetrated, a buying signal occurs. Because the signals generated by the envelope model are very short-term and they occur many times against the ongoing direction of the market, speed of execution is paramount. The high-low band is set up the same way, except that the moving average is based on the high and low prices. As a time filter, a short number of days may be used to avoid any false signals.

Figure 5.38. An envelope model define the edges of the band. A close above the upper
band sends a buying signal and one below the lower band gives a selling signal

Usually traders choose a number of averages to use with a currency. A suggested number is three, as more signals may be available. It may be helpful to use intervals that better encompass short-term, medium-term, and long-term periods, to arrive at a more complex set of signals. Some of the more popular periods are 4, 9, and 18 days; 5, 20, and 60 days; and 7, 21, and 90 days. Unless you focus on a specific combination of moving averages (for instance, 4, 9, and 18 days), the exact number of days for each of the averages is less important, as long as they are spaced far enough apart from each other to avoid insignificant signals.

A buying signal on a two-moving average combination occurs when the shorter term of two consecutive averages intersects the longer one upward. A selling signal occurs when the reverse happens, and the longer of two consecutive averages intersects the shorter one downward. (See Figure 5.39.)

Oscillators

Oscillators are designed to provide signals regarding overbought and oversold conditions. Their signals are mostly useful at the extremes of their scales and are triggered when a divergence occurs between the price of the underlying currency and the oscillator. Crossing the zero line, when applicable, usually generates direction signals. Examples of the major types of oscillators are moving averages convergence-divergence (MACD), momentum and relative strength
index (RSI). 

Figure 5.39. Examples of a sell signal (first and third crossovers) and a buy signals (second
crossover) provided by the 5-day (red) and 20-day (white) moving averages

Stochastics

Stochastics generate trading signals before they appear in the price itself. Its concept is based on observations that, as the market gets high, the closing prices tend to approach the daily highs; whereas in a bottoming market, the closing prices tend to draw near the daily lows.

The oscillator consists of two lines called %K and %D. Visualize %K as the plotted instrument, and %D as its moving average.

The formulas for calculating the stochastics are:

%K = [(CCL -L9)I(H9 - L9)] * 100, where
CCL = current closing price
L9 - the lowest low of the past 9 days
H9 - the highest high of the past 9 days
and
%D=(H3/L3~) * 100,
where H3 = the three-day sum of (CCL - L9)
L3 = the three-day sum of (H9 - L9)

The resulting lines are plotted on a 1 to 100 scale, with overbought and oversold warning signals at 70 percent and 30 percent, respectively. The buying (bullish reversal) signals occur under 10 percent, and conversely the selling (bearish reversal) signals come into play above 90 percent after the currency turns. (See Figure 5.40.) In addition to these signals, the oscillator-currency price divergence generates significant signals.

Figure 5.40. An example of the stochastic

The intersection of the %D and %K lines generates further trading signals.
There are two types of intersections between the %D and %K lines

1. The left crossing, when the %K line crosses prior to the peak of the
%D line.
2. The right crossing, when the %K line occurs after the peak of the %D
line.

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types of gaps: common, breakaway, runaway, andexhaustion

tags:Common Gaps,Breakaway Gaps,Exhaustion Gaps,Runaway Gaps,Signals for Breakaway Gaps,Trading Signals for Runaway Gaps 

gaps

An opening outside the previous day's or other period's range generates a price gap.

Price gaps, as plotted on bar charts, are very common in the currency futures market. Although currency futures may be traded around the clock, their markets are open for only about a third of the trading day. For instance, the largest currency futures market in the world, the Chicago IMM, is open for business 7:20 am to 2:00 pm CDT. Since the cash market continues to trade around the clock, price gaps may occur between two days' price ranges in the futures market.

There are four types of gaps: common, breakaway, runaway, and exhaustion.

Common Gaps

Common gaps have the least technical significance of all the types of gaps. They do not indicate a trend start, continuation, reversal, or even a general direction of the currency other than in the very short term. Common gaps tend to occur in relatively quiet periods or in illiquid markets. When price gaps occur in illiquid markets, such as distant currency futures expirationdates, they must be completely ignored. The entries for distant expiration dates in currency futures are made only on a closing basis, and they do not reflect any trading activity. Never trade in an illiquid market because getting out of it is very difficult and expensive. When gaps occur within regular trading ranges, the word on the street has been that, "Gaps must be filled.". Common gaps are short term. When currency futures open higher than yesterday's high, they are quickly sold, targeting the level of the previous day's high.

Breakaway Gaps

Breakaway gaps occur at the beginning of a new trend, usually at the end of long consolidation periods. They may also appear after the completion of some chart formations that tend to act as short-term consolidations.Breakaway gaps signify a brisk change in trading sentiment, and they occuron increasingly heavy trading. Traders are understandably frustrated by consolidations, which are rarely profitable. Therefore, a breakout from the slow lane is embraced with optimism by the profit-hungry traders. The price takes a secondary place to participation. As always, naysayers follow the initial breakout. Sooner rather than later, the pessimists have no choice but to join the new move, thus creating more volume.

Breakaway gaps are not likely to be filled during the breakout and for the duration of the subsequent move. In time, they may be filled during a new move on the opposite side.

In Figure 5.34., the currency futures trades sideways in a 100-pip range between 0.6550 and 0.6690 for a period of time. A price gap between 0.6690 and 0.6730 signals the breakaway from the range. 

Figure 5.34. A typical breakaway gap.

Signals for Breakaway Gaps:

1. A breakaway gap provides the price direction.
2. There is no price objective.
3. Increasing demand for a currency ensures a solid move on good volume in the foreseeable future.

Runaway Gaps

From a technical point of view, runaway, or measurement, gaps are special gaps that occur within solid trends. They are known as measurement gaps because they tend to occur about midway through the life of a trend. Thus, if you measure the total range of the previous trend and extrapolate it from the measurement gap, you can identify the end of the trend and yourprice objective. Since the velocity of the move should be similar on both sides of the gap, you also have a time frame for the duration of the trend.

Trading Signals for Runaway Gaps

1. The runaway, or measurement, gap provides the direction of the market. As a continuation pattern, this type of gap confirms the health and the velocity of the trend.
2. Volume is good because traders like trends, and confirmed trends attract more optimism and capital.

3. This is the only type of gap that also provides a price objective and a time frame. These characteristics are also useful for developing hedging

Exhaustion Gaps

Exhaustion gaps may occur at the top or bottom of a formation when trends change direction in an atypically quick manner. There is no consolidation next to the broken trend line: The trend reversal is very sharp through a bullish move, looks a lot like a measurement gap. So traders buy the currency and stay long overnight on that assumption. The following day the market opens below the previous low, generating a second gap. If the second gap is filled or does not even occur, the trading signal remains the same. Traders do not have to get caught badly in this exhaustion gap. A sudden trend reversal is unlikely to occur in an information void. Some sort of identifiable event triggers the move—maybe a government fall or a massive and well-timed central bank intervention. Therefore, traders should at least be warned.

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