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6 simple rules for traders

This article appeared in the March 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

How Elliott Wave principles can boost your profits - if you follow some simple trading rules.

Photo of Nick Linton-Ffrost By Nick Linton-Ffrost, Fifth Wave Limited

This article looks at what I believe are the more important factors required to run a successful trading business, and focuses on two of our favourite trading techniques, which have been independently designed by Fifth Wave Limited and incorporated into day-to-day analysis.

The cornerstone of our trading research is based on the Elliott Wave principles, a form of technical analysis used to measure financial market cycles and forecast market trends by identifying extremes in investor psychology. The principles are the most intuitive and adaptive technical tools we have come across.

The Elliott Wave framework implies price targets, stop-loss levels (a predetermined point at which to sell) and timing considerations that enable reward-risk ratios to be calculated before the trade is placed. As the market unfolds, the Elliott Wave rules recalibrate exit levels based on both price and time, allowing for more effective trade management.

Technical studies such as moving average convergence/divergence (MACD) and the relative strength index (RSI), for example, do a good job providing trading signals, but they do not provide targets and stop levels in advance. The Elliott Wave Theory does. It is worth noting that Paul Tudor Jones II, the billionaire hedge fund manager, ranks the Elliott Wave text by Frost and Prechter as one of his top four trading books.

Six guidelines for building a trading business

1. Define your process and the trading tools you will employ. They may include technical analysis, broker research, algorithmic trading, swing trading, and news events. Trading tools can be sourced from your broker, trading texts and seminars. You will also find an amazing amount of ideas online. We suggest selecting tools that make sense to you and are easy to follow.

We recommend you only use trading tools that generate entry, exit and target prices before you place the trade. This information is required to calculate the reward-risk ratio, which must be known beforehand.

2. Capital required and risk per trade. The amount of capital required depends on expected earnings. If budgeting for an annual profit of $25,000 we recommend a capital base of $100,000 and a maximum leverage of three times. Risk no more than 1 per cent of your capital base on each trade, so in this case $1,000 per trade.

3. Stick to your plan and cut losing trades. Before placing an order, determine which technical event or set-up you are trading. Then apply the trading rules you have designed for such an event. These will generate your entry, stop loss and exit levels.

Once the position is open, make sure you adhere to your planned exit levels. Do not let factors such as news headlines or emotions (positive and negative) divert you from your trading rules. Cutting losses will determine whether you stay in business or not. If you cannot cut losses, we suggest you find another business to build.

Keep a record of all your trades and analyse each one carefully. The primary focus of the analysis should be to determine the amount of times and the reasons why you failed to follow your rules. A loss-making trade is not an error if you have followed your rules.

4. Position sizing and the reward-risk ratio. Calculate your position size using the 1 per cent bet size rule and the entry and stop-loss levels generated by your system. For example, if we buy BHP at $36.00 and the stop-loss level is $35.50; our position size is $3,600 or 100 shares.

Our suggested reward-risk ratio is greater than or equal to 2.5 times, so do not place an order unless your system is generating trades that are risking 1 per cent of your capital to make 2.5 per cent or more.

5. Success rate and return expectancy. Here we bring it all together. Let's say you invest $10,000 into your business and place 100 trades over the year. You risk $100 per trade and only place orders when your system generates trading signals with a reward-risk ratio of 2.5 times or more.

At the end of the year your records show that your system produced 60 losing trades that cost $100 each (brokerage costs are excluded from this hypothetical example) and delivered 40 winning trades that made $250 each. At times your system generated 10 losers in a row so your account experienced the occasional 10 per cent drawdown. However, after a tough year of trading you will have made $4,000. That is a 40 per cent return for the year. If your system had produced 71 losing trades and 29 winners, your earnings would be nil.

6. The most important factor in your trading business is the trader (you). Building trading systems and risk-management tools is not that hard. Learning to control your emotions and follow your trading rules is extremely difficult.

If you fail to follow your trading rules because of greed, overconfidence, panic or fear, your trading business will most likely fail. We recommend you dedicate the majority of your time and resources to this facet of your business.

Fifth Wave trading techniques

I will demonstrate two of our trading signals or set-ups. These rules have been independently designed by Fifth Wave Limited using a combination of Elliott Wave principles and pattern recognition methodologies, which we employ in day-to-day analysis.

At first, these rules may seem complicated. But after running over them a few times they should become clear and easy-to-follow tools that may fit within your trading system.

For a better understanding of how our techniques work on the top 100 ASX-listed stocks, visit Fifth Wave Limited. We only cover the top 100 Australian shares because of our system's liquidity requirements (that is, buying stocks that have high turnover).

Trading technique No. 1

Step 1 - Scan the market for wave structures like this

Fifth Wave trading technique No. 1 diagram

Source: Fifth Wave Limited

If you tick most of these boxes you are on the right track:

  • The move lower from $8.10 should have traced out five waves
  • Wave 3 should not be the shortest
  • The length of the 5th wave approximates the length of wave 1
  • The 4th wave is more than likely a triangular pattern.

Step 2 - Zoom on waves 1 and 2 and look for this

Fifth Wave trading technique No. 1, Step 2 diagram

Source: Fifth Wave Limited

If you are still ticking most of these boxes you are on the right track:

  • Wave 1 breaks down into five sub-waves (i.e. the rally from $6.40 to $7.70).
  • Wave 2 has traced out three sub-waves that approximate each other in length and time.
  • Wave 2 has retraced greater than 38 per cent of wave 1. In this case is has retraced 57 per cent.

Step 3 -  Place the buy order when all the boxes below are ticked

Fifth Wave trading technique No. 1, Step 3 diagram

Source: Fifth Wave Limited

  • Wave 1 has traded above the pivot level at 'a', which is marked in orange text at $7.05
  • Wave 2 has retraced over 38 per cent of wave 1
  • The buy trigger occurs with a break above the top of wave 1, which is $7.25
  • The target is where wave 3 approximates the length of wave 1, which is $8.20
  • Set your stop-loss below the bottom of wave 2, which is $7.00
  • Before trading, check the reward-risk ratio is greater than 2.5 times. In this example you are risking 30 cents to make 90 cents, so all is good
  • Your position size using $100 risk and system-generated entry and exit levels will be 330 shares at $7.60, which is an exposure of $2,409
  • Place a stop buy order at $7.30, which is just above the top of wave 1.

Trading technique No. 2

Step 1 - Scan the market for wave structures like this

 Fifth Wave trading technique No. 2 diagram

Source: Fifth Wave Limited

If you tick most of these boxes you are on the right track:

  • Count three waves higher up from $6.00 in this case, where the 3rd wave should be longest
  • Find a sideways or triangular structure we have marked as wave 4 (blue boundary lines)
  • The 4th wave should have broken down into at least three waves within the pattern.

Step 2 - Place the trade once all the boxes are ticked

 Fifth Wave trading technique No. 2, Step 2 diagram

Source: Fifth Wave Limited

Place the trades once all the boxes are ticked:

  • Wave 5 has traded above the pivot level at $7.80
  • Wave (i) has traded back below the same pivot level
  • Wave (ii) has bounced back to retrace more than 38 per cent of wave (i) but has not traded above the top of wave 5. In this case the retracement is 50 per cent
  • The sell trigger occurs with a break below the bottom of wave (i), which is $7.58
  • The target level is at the bottom of the triangular structure, which is $6.90
  • Set the stop-loss level above the top of wave (ii), which is $7.90
  • Before trading, check the reward-risk ratio is greater than 2.5 times. In this example you are risking 30 cents to make 90 cents, so all is good
  • Your position size using $100 risk and system-generated entry and exit levels will be 330 shares at $7.60, which is an exposure of $2,508
  • Place a stop sell order at $7.60, which is just below the bottom of wave (i).

In conclusion, trading is a lot simpler than most traders make it. The market only goes up, down or sideways. Emotions, over-complicated trading tools and market noise such as news headlines, make the process a lot harder. Keep things simple and your chances of success increase markedly.

About the author

Nick Linton-Ffrost is the founder of Fifth Wave Limited, an independent trading research firm covering the ASX 100. Its analysis is based on wave count and pattern recognition methodologies it has developed over 25 years.

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