Spot Clearer Elliott Wave Signals

04/09/2012 12:20 pm EST

Focus: STRATEGIES

Juan Sarmiento

Independent Trader, putcallgenie.com

By replacing the Fibonacci grid with lesser-known but more effective Ichimoku clouds, Elliott Wave analysts can generate cleaner, more accurate signals about the markets and their trades, says Juan Sarmiento.

As a trader, I believe that Elliott Wave (EW) theory is the best shot we have at predicting market direction, despite the subjectivity and the common errors. It would be very easy if the markets matched the idealized impulse and correction pictures that are shown in the EW books, however, in my 17-year career as an EW trader, I have often been frustrated by the difficulty in turning the hypothetical scenarios into profits, even despite my early success in the 90s.

The corrective patterns are too numerous to memorize and are easily misread when in progress. Then, we only realize where we went wrong retrospectively.

In order to trade options using EW theory, the best approach is probably to be a contrarian and to wait for the pullbacks on completed (first) impulse waves, as they form a corrective series in advance of the third impulse wave, which is often the most powerful of the trending patterns.

Unfortunately, the pullback can be shallow or deep. In the past, I have used the Fibonacci ratios (38.2%, 50%, and 61.8%) to determine when the correction might be complete, but let’s face it, these are not precise points where the markets turn with any accuracy. They are more like potential “zones,” and some people even include other ratios (e.g. 23.6%, 78.6%, and others) as additional reversal points to consider. 

See also: Fibonacci Analysis: Master the Basics

Then there is the Fibonacci time series. Some believe that the timing of the reversal point of a correction should follow a Fibonacci ratio of the original impulse. So you can construct a grid of time and price Fibonacci lines, yet the markets are hardly ever limited to those grids. The reversal, it might seem, could occur almost anywhere.

If you are an options trader, time is of the essence, and the time of entry is as important as the price of entry. You can use an oscillator, such as Stochastics, to act on a buy signal when you are sure that the reversal is imminent, but this, too, is a guessing game.

With the improvements in technology over the last few years, real-time charts have become quite common, and retail traders have access to minute-by-minute charts in stocks, currencies, and futures. I have found that the S&P 500 and Nasdaq E-mini futures charts are particularly easy to follow, even in intraday and five-minute charts.

I presume that the liquidity in these instruments is so great that even the five-minute charts have high resolution, which is sufficiently good for accurate EW counting. You can make your analysis and then wait a couple hours to confirm that your counts were correct.

I have used this approach not only to make trades, but also to learn EW patterns more rapidly. I am able to recognize my errors, and even learn new patterns and develop my own strategy for EW analysis.

Using this approach, I have been able to determine that the Fibonacci grid can be easily substituted by the Ichimoku cloud. Instead of trying to figure out what corrective pattern might be under development and to attempt to choose among a myriad of possible corrrective patterns, the trader can instead use the Ichimoku cloud as the intersection between price and time support, rather than the questionable Fibonacci grid.

See also: Trading on Clouds: The Art of Ichimoku

NEXT: Video Explains This Method in Greater Detail

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Once a rally has been in place for a while and a correction has begun, you might be tempted to buy a long call once a Fibonacci ratio (let’s say, the 38.2%) has been tested, only to realize that the signal was weak and that the market will continue down to test the 50% or 61.8% ratios. Your long call will lose value in a hurry, and even if the market bounces back up, you’ll end up with a loss.

The Ichimoku cloud gives you an area of support at a lower price, but because the cloud has a time component to it, it is easy to determine when the correction should be over, whether it turns out to be deep and quick (e.g. zigzag) or shallow and slow (e.g. contracting triangle). The signal will be as clear as the price action bouncing out from the Ichimuku cloud.

Furthermore, if your count was wrong and there is not going to be a bounce, you can simply wait to see if the price action crosses below the Ichimoku cloud, which is a strong bear signal, thus allowing you to avoid the trade altogether. 

The markets have been overbought for quite a while as of late, but this extreme bullishness should come to an end soon. Whether we are going to enter a bear market, or simply have a deep and quick or shallow and slow correction remains to be seen, but the EW trader has an edge if he uses the Ichimoku cloud in place of the Fibonacci ratios.

For more details, watch the video below:

By Juan Sarmiento, trader and blogger, OptionsVet.com.

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