As a trading coach for a large proprietary trading firm, I’ve worked with several hundred traders. Over the years, I’ve learned some really important lessons.
One of them is that you can find three different traders, stick them in a room together, and they might hardly understand each other.
For instance, you could have a macro trader, a quant, and a pure old-school technician. Each will approach the market differently.
The technician might not care at all about macro analysis… And the macro guy might not know the first thing about a quantitative approach to the markets.
My point is there are as many ways to trade the market as there are traders.
For today’s Money Trends, I want to show you how to use my favorite trading language. But first, some background…
First Steps: Understanding “Trade Triggers”
The first trading language I learned was old-school technical analysis.
I was looking at price bars and Japanese candlesticks and learning about all the different kinds of single- and multi-bar patterns out there.
You may have heard of some of them. They have unusual names like “piercing line” or “dark cloud cover.”
As I became more fluent in this language, I started piecing together several of these chart patterns. And I started recognizing more and more advanced ones – such as pennants, head and shoulders, and falling and rising wedges.
These chart patterns were fantastic as trade triggers.
That means if I saw a pennant forming, for example, I knew I’d soon have some sort of trade I could sink my teeth into. But what I lacked was context.
You see, these are individual chart patterns. And without any further understanding of the market, it is impossible to know where they fit in the bigger picture.
With this in mind, I became obsessed with trying to figure out if there was a better language. And sure enough, there was…
My Favorite Way to Forecast the Market
Today, my favorite way to forecast the market is Elliott Wave Theory, otherwise known as the Wave Principle.
The Wave Principle also suggests there are individual chart patterns like the ones I mentioned above… but they are part of a larger overriding pattern.
That overriding pattern is made up of five waves in the direction of the larger trend, followed by three waves that retrace or correct the prior five-wave advance.
You can see a simple example of this overriding pattern in the chart below…
Notice the waves moving in the direction of the main trend, numbered “1” through “5.” The corrective waves are lettered “A” through “C.” Each label on the chart indicates where that wave ends.
Three Rules, One Unique Advantage
I like the Wave Principle because it has a unique advantage. That is, this overriding pattern gives your trading triggers some context.
Let me give you an example.
If I see a bullish pattern in the Wave C position, I can forecast we’ll begin a new five-wave cycle to the upside. And, based on the Wave Principle, that cycle should go on to make new highs beyond the extreme of the last fifth wave.
This is incredibly powerful information. But here’s what I like most about the Wave Principle…
There are clearly defined rules and guidelines that determine how to count waves. Rules absolutely cannot be broken, while the guidelines are very strong suggestions.
The good news is there are only three rules:
Rule #1: Wave 2 cannot go beyond the end of Wave 1
Rule #2: Wave 3 cannot be the shortest wave
Rule #3: Wave 4 cannot enter into Wave 1’s territory
That’s it! Pretty simple, right?
Now, let’s take a look at some charts to see the Wave Principle in action…
The Wave Principle in Action
Our first example is from November 2018. Back then, I made the call that Alibaba Group Holdings (BABA) had completed a corrective sell-off that began in June 2018.
I was forecasting that a new bullish cycle would soon begin. This was the call I made…
On this chart I have two sets of drawings, one blue and one purple.
The blue line is simply a diagonal trend line. Once it broke, it would help propel prices higher.
The two purple triangles are known as a harmonic formation. They take Fibonacci measurements of adjacent swing points. What do I mean by that?
Without getting into the weeds, as a trader, this helps me predict turning points in the market. And this particular harmonic was forecasting a turn in the market around $135.
This is what happened next…
As we can see, $135 was very close to being the bottom. From there, prices went on to reach nearly $200. Not a bad trade at all!
Now, let’s take a look at that same stock, BABA, but with some Elliott Wave labels…
Notice how this chart follows all the rules I listed above…
Wave 2 does not go beyond the end of Wave 1. Wave 3 is not the shortest wave. And Wave 4 does not enter into the territory of Wave 1.
I could also count a maturing A-B-C corrective cycle on the chart, which I’ve labeled above. That helped me forecast a renewal of the bullish uptrend.
The Power of Elliott Wave Theory
Of course, that’s not the only time the Wave Principle worked like a charm.
Next, let’s look at a forecast I made on June 30, 2019. It was for the euro/Japanese yen (EUR/JPY) currency pair. Take a look…
Based on the price chart at the time, I was able to count a complete five waves of decline. You can see these five waves above, marked by the blue lines.
This was followed by an A-B-C corrective countertrend movement (black lines). That movement ended around the 123 yen price.
Notice once again how the chart above followed each of the three rules…
Wave 2 did not go beyond the end of Wave 1. Wave 3 was not the shortest wave. And Wave 4 did not enter into the territory of Wave 1.
Back then, I wrote that I anticipated a return to the lows around 121 yen, with the possibility of a fresh five-wave decline. And that’s exactly what happened next…
As you can see in the chart above, we got a return to 121 yen before heading much lower in a fresh five-wave decline.
So there you have it – the benefits of using Elliott Wave Theory. I’m confident you’ll quickly become proficient in this new language.
Look for our next lesson on Friday…
Editor, Money Trends