Sunday, February 14, 2010

Points Of View


I want to discuss something today that is very relevant to the current market and that is how different analysts can look at the same chart and come up with different conclusions and how we can eliminate the confusion in how to act on those differing points of view.

Do not confuse the numbers on the chart above with elliott wave labelling. They are simply a refence to the following points:

1. Point 1 is the critical area on this chart. Most elliott wave analysts that I read are calling it a truncated 5th wave of wave a down. This is extremely important because calling it a truncated 5th wave completely changes the analysis of everything that follow it. If it is not a 5th wave, then it is a 2nd or b wave.

2. Point 2 is the decline from oil's all time high. Again if point 1 is a 5th wave, then we have 5 waves down which means that another 5 wave impulse down will follow. If it is not a 5th wave, then the decline is a 3 wave movement and another decline to new lows is not assured.

3. Point 3 is the one area where there is little dispute on the form as it is clearly a triangle. However, is it a 4th wave or an X wave?

4. One's view of point 4 is completely dependent on points 1 through 3. Either it is the end of double zigzag upward correction, wave b of B of an expanded flat correction, or it is wave 5 of A.

5. One's view of point 5 naturally follows from one's conclusions about point 4. If point 4 was the end of a double zigzag upward correction, then one should hold short as oil is about to implode. If point 4 is wave b of B down of an expanded flat correction, then one should be building a long position for wave C up which is about to take off anytime. If point 4 is wave 5 of A, then one should be out of the market waiting for wave B down to complete in anticipation of the start of wave C up.

This little exercise demonstrates why trading only off of elliott wave analysis is fraught with danger. During corrections there are often too many possible outcomes. If the number of possible outcomes is greater than two, the entire process is not helping us increase the probability of success. Of course, there are times when the probable outcome using elliott wave analysis is much greater than 50/50, and traders should use those times to their advantage. But when the probable outcome is much less than 50/50, elliott wave analysis should become secondary to other methods. It can still be very useful in that once outcomes have been eliminated due to market action, risk and targets can be re-evaluated.

So, given all of the above, how does one trade oil? Fortunately, there are any number of useful technical methods that can be used. For the daily time frame, trading crosses of a short term moving average with a medium term moving average would have been very profitable, e.g. the 6dema and the 26dema. Also, using Marketclub's 3 week/3 day trade triangles would have worked as well as the MACD. For the weekly time frame Marketclub's 3 month/3 week strategy would work as well as crosses of medium term and long term moving averages, e.g. the 20 week and 40 week. In the latter case, the method is to enter long when price rises above the lower of the 20 week and 40 week MAs when that MA itself has risen for two consecutive weeks, and exit when price falls below the lower of the two MAs and that MA has fallen for two consecutive weeks. On the weekly time frame, my analysis shows oil to be neutral using the 3 Month/3 Week approach and long using the 20 week and 40 week approach.

However, we should not forget the most basic analysis of a market and that is the definition of a trend as higher highs and higher lows, or lower lows and lower highs. At the moment, there is a clear and definite uptrend in oil with higher highs and higher lows. Until a prior low is tested and that test is violated AFTER an intervening lower high, we should assume that the trend in oil is up regardless of other analysis. The trend is weakening at the moment, clearly, but patience in waiting for an exit may be rewarded in a resurgrence of the trend.

Finally, we should use intermarket analysis and cycles, when available, to weight different points of view. The seasonal cycle in oil calls for a low in mid to late February with highs in May and September. It hardly seems prudent to jump on a bearish case until we see a failure of the February swing low that would normally come at this time. What about intermarket analysis? Tom McClellan has shown that the price of oil follows the price of gold with a time lag of 4o days +/-. Sometimes this seems to work precisely, and at other times, less so. Right now, the precision is off, but the general approach would be to wait for a breakdown in gold BEFORE we position for weakness in oil. For example, gold made a lower high in July 2008 while oil was making new highs. This was a clear divergence that warned of oil's coming decline. Recently, gold made a lower high on the daily and weekly time frames that warned of the recent selloff in oil, but on the longer term monthly time frame, we do not yet have divergence.

Finally, looking at the above chart, we see that oil is resting comfortably atop the 50 and 200 week emas. Until this support is broken, we should assume that the uptrend will continue.

Putting this all together, the weight of the evidence at the moment is toward a continuation of the uptrend in oil. Either oil will continue immediately higher from here in wave C up, or will come a little under the February low and then head up in wave C up. Only if oil forms a low in February that is then violated decisively should we conclude that January was the top of the countertrend rally that began in January of 2009. Then, we would use the wave c down interpretation to determine risk and targets for the decline.

I remain long OIL expecting a continuation of the uptrend in wave C up, but awaiting a break below the still developing February swing low to confirm a change in the trend.

In conclusion, on its own, elliott wave analysis can lead to arbitrary decisions and poor trading outcomes, but coupled with other technical analysis, the most probably outcome can generally be determined with a clear rationale for taking and exiting positions.

2 comments:

dave said...

http://articles.moneycentral.msn.com/SmartSpending/blog/page.aspx?post=1628429&_blg=1,1628429

I wish that i was the judge on these cases. I'd slap BofA and their mgmt so hard they'd be begging the plaintiffs.

R. Craig Pritchard said...

Dave,

Link didn't work, but I found the article. The banks have no respect for anyone these days, if they ever did. I only wish there was some way to transact business without them.

Craig