I have noticed a new buzz-word making the rounds: ‘evidence-based’. Usually this refers to some political idea, but I’ve noticed it creeping into trading circles. Presumably, this radical theme was not on the radar before, and all ideas were drawn out of thin air and conjecture, and not based on any evidence provided by experience.
As a (lapsed) scientist, I am amazed that anyone would take seriously a method that was not based on actual evidence. This is the basis of the experimental method that underpins all proper science. Did Newton discover his theory of gravitation while idly day-dreaming in his bath?
If we apply this to trading the financial markets, a non-evidence-based method would quickly unravel. All successful methodologies that I know can be checked against the experience provided by market action. There is really no other way to verify whether a trading system is useful or not.
If you do not use the evidence provided by market action, then you will find yourself fighting the market – and there is only one winner in that battle.
And it is past market action that determines the future path of all markets.
Forget everything you know
If you come from stock investing, you will be familiar with the fundamental research methods that underpin this world. You want to know the price/earnings (p/e), the revenue growth and projections and the future prospects of the company. There is a mountain of information out there to wade through.
In swing trading, this study of the minutiae of the fundamentals is a hindrance to the goal of making profits. And that is why spread betting is often such a difficult skill to master.
My advice: forget everything you know about stock-market research and concentrate 100% on the charts.
Reading waves gives you a big advantage
Here is a great example of how I combine my reading of the Elliott waves and Fibonacci retracements in the GBP/EUR pair:
The 1.28 high set last July was the start of a large motive sequence of five waves down as sterling was heavily sold. The first move down is wave 1, leading to a rally in wave 2. Notice that the wave 2 high does not exceed the start of the sequence.
If it did, then I could not attach these wave labels. That is one of the iron-clad rules of Elliott wave theory.
Then, the market embarked on a very sharp series of down moves to the wave 3 low, then the rally in wave 4 and finally, the new low in wave 5. Note the large positive-momentum divergence at the wave 5 low. This is a tell-tale sign that the decline had come to end and that a new rally phase was about to start.
Being able to read the waves in this manner gives you a tremendous advantage. It is as if you have a roadmap for the future path of the market. If you were confident that the market would rally from the March lows, you would have money-making information. Isn’t that the kind of information that is worth having?
And from those lows, the market has rallied in an A-B-C form. This is entirely consistent with Elliott Wave theory. It states that after a five-wave impulsive pattern, the next move is an A-B-C correction (or a variation of a basic three-wave affair). This also is valuable information.
And from long experience, we know that the most common turning point for this kind of A-B-C correction is a Fibonacci 62% retrace of the main wave down.
How to select the best pivot point
Now this brings up an important point concerning Fibonacci pivot points. When dealing with five-wave patterns like this one, I have found that instead of using the start of the pattern from the absolute high, the best pivot point can be the wave 2 high.
Here is a tip: to select the best pivot point, take a look at where the turning points are landing in between the pivot points, on the way down to the wave 5 low and also up in the relief rally phase. I need to see some accurate hits on the levels.
You can see that the market has turned at the exact Fibonacci 62% level on the way down in October (red arrow). This confirms that I have selected the best pivot point at the wave 2 high. Also, adding to this confirmation, the A wave turned at the Fibonacci 38% level (within a whisker or two).
The foundations of a great trading career
To sum up this morning, we have a ‘five down and three up’ and a C wave hit on the Fibonacci 62% level.
This is a textbook setup for a trade. And all I did was use the evidence contained in this single chart. I knew nothing about the euro or sterling and couldn’t care less!
This five down three up (or vice versa) pattern is a common sight and they give high reliability/low risk trades time after time. They also often lead to very large moves – and big profits. They are well worth hunting for.
Of course, there are no 100% guarantees of success here. The best that a good trading system can provide are high percentage setups with low risk. Find enough of these while keeping your losses small and you have the foundations of a great trading career.