3121121314181
82.5 degrees75 degrees71.25 degrees63.75 degrees45 degrees26.25 degrees18.75 degrees15 degrees7.5 degrees
This is also called a 1  1 angle (i.e., prices rise one price unit foreach time unit).Gann angles are drawn between a significant bottom and top (orvice versa) at various angles. Deemed the most important by Gann,the 11 trend line signifies a bull market if prices are above thetrend line or a bear market if below. Gann felt that a 11 trendline provides major support during an uptrend and that when thetrend line is broken, it signifies a major reversal in the trend. Gannidentified nine significant angles, with the 11 being the mostimportant (Table 11-1).Note that in order for the rise/run values (i.e., 11, 18, etc.)to match the actual angles (in degrees), the x and y axes must haveequally spaced intervals. This means that one unit on the x axis(i.e., hours, days, weeks, months, or years) must be the same distance as one unit on the y axis. The easiest way to calibrate thechart is make sure that a 11 angle produces a 45-degree angle.Gann observed that each of the angles can provide support andresistance depending on the trend. For example, during anuptrend, the 11 angle tends to provide major support. A majorreversal is signaled when prices fall below the 11 angled trendline. According to Gann, prices then should be expected to fall tothe next trend line (i.e., the 21 angle). In other words, as oneangle is penetrated, expect prices to move and consolidate at thenext angle. Gann developed several techniques for studying market action. These include Gann angles, Gann fans, Gann grids, andcardinal squares.
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Figure 11-1 S&P 500 with Gann Angles.
A Gann fan displays lines at each of the angles that Gann identified. Figure 11-1 shows a Gann fan on the Standard & Poor’s(S&P) 500 Index.Figure 11-2 shows the same S&P 500 data with a Gann grid. Thisis an 8080 grid on which each line is 11, and the lines arespaced 80 weeks apart.Gann based his market trading and forecasting methods ontime, as well as on price, and said repeatedly that time is mostimportant when it comes to analyzing and forecasting marketmovements. Gann was able to determine not only what the turning point’s price would be but also when it would occur. Being ableto forecast both time and price is the ultimate goal of technicalanalysis, and many believe that it is impossible to do; the legendof Gann, however, stands as the main opposition to this belief.Another Gann aphorism is, “When you know how to use time withprice, you know how to trade.”Whether or not Gann revealed his real techniques and whetheror not Tunnel Through the Air did contain them in concealed form,
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Figure 11-2 S&P 500 with Gann Grid.
the Gann techniques on the public record can be summarized asfollows:• Time and price are “the same.” When they “square out,” a majorchange of trend is due.Time is the most important factor. Do day/week counts of 30, 45,60, 90, and 180.• Resistance levels in both time and price are 25, 33, 50, 66, and75 percent of the previous range. They can be extended (extrapolated) to 100, 150, and 200 percent.• Trend lines work, and Gann can claim to have invented their use.Gann believed that human nature is constant and that thisshows up in repetitive price patterns that are identifiable andwhich therefore can be acted on to increase profit potential.
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CONSTRUCTING GANN ANGLESPredicting the market using Gann angles requires subjective judgment and practice. Here is the procedure:1. Determine the time units. One common way to determine a timeunit is to study the chart and look at the distances over whichprice movements occur. Then put the angles to the test and seehow accurate they are. The intermediate-term time frame (oneto three months) tends to produce the optimal number of patterns compared with short-term daily or multiyear charts.2. Determine the high or low from which to draw the Gann lines. The mostcommon way to accomplish this is to complement it with otherforms of technical analysis, that is, Fibonacci levels or pivotpoints. Gann used what he called “vibrations” or “price swings.”He determined these by analyzing charts using such theories asFibonacci numbers.3. Decide which pattern to use. The three most common patterns arethe 1  1, the 1  2, and the 2  1. These are simply variationsof the slope of the line. For example, the 1  2 is half the slopeof the 1  1. The numbers simply indicate the number of units.4. Look for patterns. The direction would be either downward andto the right from a high point or upward and to the right froma low point.5. Look for repeat patterns on the chart. The basis of this technique isthe premise that markets are cyclical.The most common use for Gann angles when predicting themarket is to indicate support and resistance levels. Many othertrading methods use support and resistance lines, so what setsGann’s method apart from the rest?Quite simply, predicting the market using Gann, angles adds anew dimension to support and resistance levels in that they canbe diagonal. The optimal balance between time and priceexists when prices move identically with time. This occurs when theGann angle is at 45 degrees. In total, there are nine different Gannangles. When one of these trend lines is broken, the followingangle will provide the next level of support or resistance.
Chapter
12
Kondratiev WaveNIKOLAI KONDRATIEVNikolai Dmitrievich Kondratiev (1892–1930) worked at theAgricultural Academy and Business Research Institute in Moscow.His research covered the major economies of the time: the UnitedStates, Great Britain, Germany, and France. He first consideredwholesale prices and then looked at interest rates, wages, andforeign trade. Finally, he analyzed data on the production andconsumption of coal, pig iron, and lead. He adjusted productionfigures to allow for population change and used a nine-yearmoving average to remove statistical noise. Kondratiev thoughtthat the presence of a long wave was probable but could not bespecific as to its cause, deeming it to be inherent in a capitalisteconomy. He postulated that it could arise because of the wearingout of capital goods, but he admitted that lack of reliable data curtailed conclusive verification. Numerous critics have attacked hismethodology.What was dangerously unacceptable to his Communist masterswas the idea that there was an inherent self-correcting mechanismperpetuating capitalism. He was banished to the Gulag, wherehe was quickly condemned to solitary confinement. He becamementally ill and died.Again, it was posthumous publication that drew attention to hiswork. His work was translated into English in 1935 (a Germantranslation had been printed outside Russia in 1926, but it did not75Copyright © 2007 by The McGraw-Hill Companies. Click here for terms of use.
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attract much attention at the time). There were two waves in wholesale prices during the nineteenth century in the United States ofabout 50 years each that conformed to Kondratiev’s waveform.Both became identified as “Kondratiev cycles,” and consequently,his work was given prominence in America.Kondratiev was exiled to Siberia by Bolshevik officials who flatlyrejected his conclusions. To the faithful, there could be only onefalling phase of the capitalist economy, followed by the socialist revolution and the dictatorship of the proletariat. And followingthat, there was to be only one rising phase, leading to eternal blissunder Communism. Kondratiev died in the Gulag in 1930 at theage of 38. His work was later updated by other economists usinghis original methodology.
ECONOMIC CYCLESA 50- to 60-year economic cycle was observed by a Dutchman, VanGelderen, in 1913, although there is no evidence of a connectionwith Kondratiev. W. H. Beveridge (1879–1963) studied wheatprices back to the 1500s and is reputed to have deduced them backto 1260. He discovered many cycles, publishing his findings in 1921and 1923 (three years earlier than Kondratiev). One of thesecycles occurred every 50 to 60 years, with an average periodicity of54 years.The long-wave rhythm, which varies from 45 to 60 years, hasattained its periodicity from averaging a wide distribution. It is widelyknown as the Kondratiev wave or, less elegantly, as the K-wave.Economists generally recognize four major cycles, or regularfluctuations, in the economy as follows:1. Kitchin’s short-wave cycle of average duration of 3 to 5 years,discovered in 19302. Juglar’s cycle of average duration of 7 to 11 years, discovered in18623. Kuznets’ medium-wave cycle of average duration of 15 to 25years, discovered in 19234. Kondratiev’s long-wave cycle of average duration of 45 to 60years, discovered in 1922.
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J. Schumpeter, who served as president of the AmericanEconomic Society in the 1950s, was an outstanding student ofeconomic cycles. He believed that the various cycles are interdependent, in contrast with the views of others such as Forrester, whobelieved that the cycles act independently of one another.Schumpeter baptized three of the four cycles by naming them aftertheir discoverers.Kondratiev identified three historic waves:1. First wave: Rising phase from 1780–1790 to 1810–1817;falling phase from 1810–1817 to 1844–18512. Second wave: Rising phase from 1844–1851 to 1870–1875; fallingphase from 1870–1875 to 1890–18963. Third wave: Rising phase from 1890–1896 to 1914–1920; fallingphase started 1914–1920After Kondratiev’s death, economists found that the fallingphase of the third wave ended in 1947–1948 and that there is afourth wave: rising phase from 1947–1948 to 1973–1980; fallingphase started 1973–1980.
CAUSESAmong economists, there is a lot of controversy as to whyKondratiev’s long-wave cycle exists. Analysis of varying periods ofeconomic prosperity, recession, depression, recovery, and improvement may provide a more understandable answer.Much of the material in this chapter borders on the theoretical,and further information can be found at http:\en\wikipedia.org.We included this material because of the possibility that reversalsin major economic cycles may have a direct or indirect influenceon short- and medium-term trading. However, it is essentiallygeneral in nature and very difficult to apply to small-cap short-termspot currency trading. Nonetheless, knowledge is power.
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Chapter
13
Elliott WaveTheoryR. N. ELLIOTTRalph Nelson Elliott (1871–1948) had a successful career as afinancial consultant to numerous railroad companies, a boomingsector when he began his professional life just before the turn ofthe twentieth century. He was considered an expert in businessplanning, and his services were in very high demand. Such was hisreputation that Elliott caught the eye of the U.S. State Department,which sent him to Nicaragua as an economic consultant, where hehelped to reorganize the country’s finances. It is said that one ofhis greatest talents in business was a shrewd eye for detail.Training his meticulous eye on decades of market charts, Elliottdiscovered a persistent and recurring pattern that operatedbetween market tops and bottoms. He theorized that these patterns, which he called waves, were a collective expression of investorsentiment, giving the market a distinct form and behavior. Througha use of measurements that he called wave counting, an analyst couldforecast market turns with a high degree of accuracy.After testing his theory over four years, Elliott organized hisresearch into an essay that he titled, “The Wave Principle.” Thisessay was published in book form on August 31, 1938, with theassistance of Charles Collins, a respected newsletter publisherwho helped popularize Elliott wave analysis in its early years.79Copyright © 2007 by The McGraw-Hill Companies. Click here for terms of use.
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By the early 1940s, Elliott had fully developed his concept thatthe ebb and flow of human emotions and activities follow a naturalprogression governed by the laws of nature. He tied the patternsof collective human behavior to Fibonacci numbers and the GoldenRatio, a mathematical phenomenon known for centuries by mathematicians, scientists, artists, architects, and philosophers as one ofnature’s ubiquitous laws of form and progress.Elliott then put together what he considered his definitive work,Nature’s Law: The Secret of the Universe. This rather grandly titledmonograph, which Elliott published at age 75, includes almostevery thought he had concerning the theory of the wave principle. The book was published June 10, 1946, and the reported 1000copies sold out quickly to various members of the New Yorkfinancial community.
WAVE PATTERNSElliott believed that one business cycle consisted of a five-wavemotive or impulse component and a three-wave correctivecomponent. A motive or impulse pattern consists of five wavesrepresenting a distinct trend in one direction (Figure 13-1).This pattern always satisfies the logical conditionWave 1 > wave 2 < wave 3 > wave 4 < wave 5
Figure 13-1 Impulse Pattern.
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Figure 13-2 Corrective Pattern.
A corrective pattern consisting of three waves represents a countertrend in the opposite direction to its preceding impulse pattern(Figure 13-2).The corrective pattern must obey the following constraint:Wave A > wave B < wave CElliott identified several other wave patterns (such as zigzags, triangles, flats, and so on), but the impulse and corrective patternsare the most important when analyzing trends.
HERD PSYCHOLOGYThe following is a short description of herd psychology duringeach wave as it pertains to stock trades:Wave 1. The stock makes its initial move upward. This is usuallycaused by a relatively small number of people that all of the sudden (for a variety of reasons real or imagined) feel that the priceof the stock is cheap, so it is a perfect time to buy. This causesthe price to rise.Wave 2. At this point, enough people who were in the originalwave consider the stock overvalued and take profits. This causesthe stock to go down. However, the stock will not make it to itsprevious lows before it is considered a bargain again.Wave 3. This is usually the longest and strongest wave. The stockhas caught the attention of the mass public. More people find
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out about the stock and want to buy it. This causes the stock’sprice to go higher and higher. This wave usually exceeds thehigh created at the end of wave 1.Wave 4. People take profits because the stock is consideredexpensive again. This wave tends to be weak because there areusually more people who are still bullish on the stock and arewaiting to buy in the valleys.Wave 5. This is the point that most people get on the stock andis most driven by hysteria. This is when the stock becomes themost overpriced. Contrarians start shorting the stock, whichstarts the ABC pattern.
TRADING TIMELINEThe motive phase contains five waves. The five waves may move upor down, that is, a bull or bear market.The first wave is generally a tentative rally with only a small percentage of the traders participating. Elliott’s rules state that wave 2must retrace wave 1 by at least 20 percent, but it generally is a deepretracement of between 30 and 80 percent. Volume and volatilitygenerally decline in wave 2 (Figure 13-3).Wave 3 begins slowly with light to average volume, and it finallypushes toward the end of the previous wave 1. Many traders haveplaced stops at this level, thinking that the move is unsustainable.If wave 3 moves past the end of wave 1, these stops will be takenout, creating a gap and an increase in volume (Figure 13-4).Traders who are skeptical of the move are adding shorts (in abull move) or going long (in a bear move). This is the fuel thatignites the wave 3 impulse (Figure 13-5).Stops placed above wave 1 are taken out, creating a gap and asurge in volume. Gaps and volume are indicative of a third wavein progress (Figure 13-6).As the third-wave move gathers momentum and exceeds the previous wave 1 top (or bottom in a bear market), the stops are takenout, and gaps generally are left open. More traders are now readyto jump in and join the trend. Wave 3 accelerates, and volumeincreases.
Elliott Wave Theory
Figure 13-3 Second-Wave Retracement.
Figure 13-4 Third-Wave Rally.
Figure 13-5 Third-Wave Shorts Stopped Out.
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Figure 13-6 Third-Wave Accelerates.
Traders who got stopped out join the trend and add positions thatfurther accelerate the third-wave impulse. The herd now hasdecided that the move is genuine and adds positions. As profit taking sets in, wave 4 begins.Wave 2 usually exhibits massive selling with a deep retracement.Elliott rules state that wave 2 cannot retrace more than 100 percent of impulse wave 1. Wave 4 exhibits an orderly profit-takingdecline. Traders who are still convinced that the trend has notchanged begin “buying the dip” to get in on the next move, andwave 5 begins (Figure 13-7).The fifth-wave rally is weaker and generally has less volume thanthe third-wave rally. New highs are made in the impulse fifth wavebut with less strength. As the buying interest fades, the motivephase ends, and the corrective phase ensues. Additional information is available at www.wavemagician.com/elliottwave.htm.
WAVES WITHIN A WAVEElliott proposed that the waves existed at many levels, meaning thatthere could be waves within waves. Figure 13-8 shows how primarywaves could be broken down into smaller waves.This figure displays four of the eight waves as their componentwaves:Wave 3 consists of a five-wave bull impulse cycle.Wave 4 consists of a three-wave corrective cycle.
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Figure 13-7 Completed Impulse Cycle.
Wave A consists of a five-wave bear impulse cycle.Wave B consists of a three-wave corrective cycle.Elliott assigned the nomenclature shown in Table 13-1 to thewaves in order of descending size.
Figure 13-8 Waves within Waves.
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Table 13-1 Cycle Names1. Grand supercycle2. Supercycle3. Cycle4. Primary5. Intermediate6. Minor7. Minute8. Minuette9. Subminuette
The concept of waves within other waves dates back to CharlesDow and probably earlier. However, Dow believed that there wereonly three levels of wave composition. The scientific name for thisphenomenon is fractal geometry.
RULES AND GUIDELINESThere are over 273 major rules and guidelines in the Elliott waveprinciple. Elliott rules must be obeyed in detail for a pattern toqualify as an Elliott wave or cycle. The guidelines do not have tobe obeyed precisely. The more guidelines obeyed by an Elliott pattern, the higher is its probability of being correct.A very brief summary of the rules governing a bull impulse cyclefollows:• No part of wave 2 can more than retrace wave 1.• Wave 2 must retrace wave 1 by a minimum of 20 percent.• The maximum time for wave 2 is nine times wave 1.• Wave 3 must be longer than wave 2 in gross distance by price.• Wave 3 and wave 1 cannot both have wave 5 failures.• Wave 3 cannot be less than one-third of wave 1 by price.• Wave 3 cannot be more than seven times wave 1 by price.• The absolute maximum time limit for wave 3 is seven times wave 1.A comprehensive list of the major rules and guidelines for theElliott wave principle can be found at www.geocities.com/
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WallStreet/Exchange/9807/Charts/SP500-Articles/EWRules.htm#imprule.
USEThere are two immediate methods for applying Elliott wave theoryto a specific time frame in a given financial market. The firstrequires identifying where the most recent price is located in thecurrent Elliott business cycle. This information allows the trader todetermine the direction and possible magnitude of the subsequentwave in that cycle. Calculating the next-higher fractal wave level (i.e.,the parent wave) offers the trader some confirmation if the parentwave indicates a move in the same direction as the child wave.The second method involves use of the Elliott wave oscillator basedon a standard moving-average convergence/divergence (MACD)crossover method. Author and trader Perry Kaufman recommendsusing a 5-period moving average for the oscillating moving-averageindex and a 35-period moving average as the basis for the movingaverage index. Plotting the residual difference between the twomoving averages will highlight five peaks (or valleys) when a valid 5-3wave pattern is in progress. This technique is described in detail atwww.investopedia.com/university/advancedwave/elliottwave3.asp.Of course, there are several other methods for interpretingElliott wave results. For the serious trader interested in Elliott waveanalysis, we recommend Elliott Wave Principle: Key to Market Behavior(New Classics Library, 1978), by Robert Prechter and A. J. Frost.
CAVEATA Google Internet search on “Elliott waves” generates over two millionmatches, thus confirming the immense popularity of the system.Elliott wave theory is an extremely complex and elegant system worthy of additional investigation. Some of the later material in this bookrelates directly or indirectly to Elliott’s principles. Nonetheless, thereis a semiserious caveat involved when deciphering the results ofElliott wave analysis: “Place 12 Elliotticians in different rooms with thesame financial bar chart and you will get 12 different interpretations.”
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Chapter
14
Gartley PatternsH. M. GARTLEYBorn in 1899, Harold McKinley Gartley grew up in Newark, NJ. Heattended New York University, where he received a bachelor’sdegree in commercial science and a master’s degree in businessadministration. He began working on Wall Street in 1922. Over theyears, he was a broker, a security analyst, and a financial advisor.In addition, he gave lecture tours and private courses on the stockmarket that were attended by many of the prominent people ofWall Street. Gartley was one of the founders and an active member of the New York Society of Security Analysts. He also foundedthe Wall Street Forum for younger analysts. From 1947 on, heworked in the field of financial and shareholder public relations.In his later years, he was chairman of his own financial public relations firm until he retired in 1969.Gartley wrote many articles on the stock market, but his best workis considered to be his book, Profits in the Stock Market, which was published in 1935 by Contemporary Traders and Analysts. Of specialinterest to many traders is his chapter entitled, “Volume of Trading.”Gartley is said to have done more work on volume than anyone else.Unfortunately, Gartley’s idea of “scientific” study was somewhatprimitive as measured against today’s standards. His approach wasmore rational intuitive than statistical.
89Copyright © 2007 by The McGraw-Hill Companies. Click here for terms of use.
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GARTLEY PATTERNThe most important four-wave price formation originally analyzedby Gartley is shown in Figure 14-1.The Gartley pattern outlined in his book did not discuss specificFibonacci retracements. These ratios were assigned later by his supporters (primarily Scott Carney and Bryce Gilmore at HarmonicTraders), who attached very specific numeric values to the heightof each of the diagonals in the Gartley pattern. The preceding pattern requires the following ratios:BC = DEBC = 0.618 ABBE = 0.786 ABIf all three of these constraints are satisfied, then the pattern isbelieved to be a valid reversal.
POTENTIAL REVERSAL ZONEThe purpose of Figure 14-1 is to determine if the most recent pricehas entered the potential reversal zone. If the ratio constraints havebeen satisfied precisely, Gartley analysts believe that a valid reversalis in progress when the zone is penetrated.
Figure 14-1 Gartley Pattern.
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BUTTERFLY PATTERNThe height ratios in the butterfly pattern shown in Figure 14-2 arecredited to Bryce Gilmore of Harmonic Traders.This pattern also can have either of two different Fibonacci ratiosfor the fourth wave:BC = 0.786 ABBC = 1.27 DEorBC = 0.786 ABBC = 1.618 DE
BAT PATTERNThe bat pattern shown in Figure 14-3 was discovered by ScottCarney at Harmonic Traders in 2001.This four-wave pattern may have either of two possible ratios forthe second wave:BC = 0.382 ABDE = 1.27BC
Figure 14-2 Butterfly Pattern.
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Figure 14-3 Bat Pattern.
orBC = .50 ABDE = 1.27BC
CRAB PATTERNThe crab pattern is another discovery of Scott Carney in 2000(Figure 14-4).
Figure 14-4 Crab Pattern.
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This pattern also has two variations for the height ratio for thesecond wave:BC = 0.618 ABCD = 1.618 ABorBC = 0.382 ABCD = 1.618 AB
OBSERVATIONSIt is quite clear that the Gartley studies have focused on a specificElliott pattern (the intersection between a five-wave motive cycleand a three-wave corrective cycle), analyzed them in extremedepth, and calculated the resulting outcomes. Traders can obtainadditional information on Gartley patterns at www.harmonictraders.com.
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Chapter
15
Goodman SwingCount SystemCHARLES B. GOODMANFor nearly three decades, Charles B. Goodman was one of Denver’smost successful futures traders. The principles of the Goodmanswing count system were set forth informally in a series of annotated commodity charts from the late 1940s to the early 1970s.These trading studies were simply titled, “My System,” and werenever published during Goodman’s life time (he died in 1984). Inthe early 2000s, Goodman’s student and protégé, Michael D.Archer, decrypted and compiled Goodman’s works into a bookentitled, Forex Charting Companion (Wiley, 2005).The Goodman swing count system (GSCS) is based on ordinalprinciples (refers to measurement without specific values) and cardinal principles (refers to measurement with specific values). Thesystem provides a fresh and penetrating insight into the examination of wave theory.
ORDINAL PRINCIPLES1.
The Measured Move
The cornerstone of the GSCS is the 50 percent retracement and measured move rule (Figure 15-1).95Copyright © 2007 by The McGraw-Hill Companies. Click here for terms of use.
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Figure 15-1 Fifty Percent Retracement and Measured Move.
The first systematic description of this rule was given in BurtonPugh’s The Great Wheat Secret (originally published in 1933). In1973, Charles L. Lindsay published Trident (Trident Publishers). Thisbook did much to quantify and describe the rule mathematically.Another important text in this field is The Trading Rule That CanMake You Rich, by Edward L. Dobson (Traders Press, 1978).
2.
Congestion Phase
In 1975, a well-known Chicago grain floor trader, Eugene Nofri,published The Congestion Phase System (Success Publishing). This smallbut power-packed volume detailed a short-term trading methodusing simple but effective congestion phases (Figure 15-2).Goodman also felt that Earl Hadady’s work on contrary opinionwas a natural “fit,” especially because the GCSC support and resistance points seldom lie where anyone else thinks they should.
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Figure 15-2 Congestion Phase.
3.
Equilibrium of Buyers and Sellers
The logic of the rule is quite simple. At a 50 percent retracement,both buyers and sellers of the previous trend (up or down) are inbalance. Half of each holds profits, and half of each holds losses(Figure 15-3).The equilibrium is a tenuous one. The distribution of buyers andsellers over the initial price trend, or swing, is obviously not perfectly even. Some buyers hold more contracts than other buyers.They also have different propensities for taking profits or losses.Nor does the equilibrium account for the buyers and sellers whohave entered the market before the initial swing or during the reaction swing. Not all the buyers and sellers from the original swingmay be in the market any longer.Remarkably, the GCSC eventually takes all of this into account,especially the buyers and sellers at other price swing levels, calledmatrices.
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Figure 15-3 Market Tug of War.
Nevertheless, the 50 percent retracement point is often a powerful and very real point of equilibrium and certainly a known anddefined hot spot of which one should be aware. Remember that boththe futures markets and the currency markets are very close to a zerosum game. It is only commissions, pips, and slippage that keep themfrom being zero-sum. At the 50 percent point, it does not take muchto shift the balance of power for that particular swing matrix.The rule also states that the final (third) swing of the move—back in the direction of the initial swing—will equal the value ofthe initial swing. The logic of this idea, called the measured move,is seen in Figure 15-4.4.
The Markets Are Recursive
As we have suggested previously, to examples