Wave, Swing, and Cycle Analysis

Wave and swing analysis is one of those nebulous terms that means different things to different people. It is often associated with swing trading, which also harbors a variety of connotations (the swing trader usually keeps a trade open longer than the typical session or day trader). I define wave, or swing analysis, as the study of the distance between local peaks and troughs in the closing prices for the purpose of identifying recurring patterns and correlations. The swing chart, like its older sibling the point and figure chart, requires the use of a massaging algorithm that filters out lateral congestion (whipsawing) during periods of low volatility.

For this purpose, a minimum box size must be selected. Within currency trading, this is almost always a single pip in the quote (second) currency of the currency pair. Also, a minimum reversal quantity must be selected. This is simply the number of pips (box sizes) required before a retracement can be drawn in the opposite direction (the continuation of an existing trend requires only one box size to plot the next point). Unlike the P&F chart, the swing chart does not necessarily distort the time element. That is, swing charts are frequently overlaid directly on top of a vertical bar chart since both use the same numerical scaling for the x- and the y-axis. See Figure below. [caption id="attachment_13119" align="aligncenter" width="550"]Zig Zag Indicators in MetaTrader 4 to Define Swings or Waves Zig Zag Indicators in MetaTrader 4 to Define Swings or Waves[/caption] In above Figure, it is clear that a swing chart is a sequence of alternating straight lines, called waves, which connect each peak with its succeeding trough, and vice versa. The swing analyst is particularly interested in retracement percentages. Market behavior is such that when a major trend does break out, there is a sequence of impulse waves in the direction of the trend with interceding retracement waves (also called corrective waves). The ratio of the corrective wave divided by the preceding impulse wave is referred to as the percentage of retracement. Famous analysts such as William D. Gann and Ralph N. Elliott have dedicated their lives to interpreting these ratios and estimating the length of the next wave in the time series. Gann believed that market waves moved in patterns based on, among other things, the Fibonacci number series, which emphasizes the use of so-called magic numbers, such as 38.2 percent, 50 percent, and 61.8 percent. Actually, there is no magic involved at all; they are simply proportions derived from the Golden Mean, or Divine Ratio. This is a complete study unto itself and has many fascinating possibilities. In his analysis of stocks in the 1920s and 1930s, Elliott was able to identify and categorize nine levels of cycles (that is, a sequence of successive waves) over the same period for a single bar chart. This entailed increasing the minimum reversal threshold in the filtering algorithm, which creates fewer but longer waves with each new iteration. He believed each major impulse wave was composed of five smaller waves, while major corrective waves were composed of only three smaller waves. I refer interested readers to the website www.elliottwave.com for more details on Elliott and his theories. The author uses Goodman Wave Theory (GWT), which he has found to be more predictive and easier to apply than Elliott Wave Theory (EWT).

Cycle Analysis

Every market is composed of traders at different levels slugging it out. Scalpers, day traders, and position traders are all attempting to profit from price changes. Each group has a different time focus or horizon. Cycle theory believes these groups behave in cyclical fashion and that some composite of their behavior would parallel the market. If that composite were identified, the cyclical parameters could be run past today's price into tomorrow's, resulting in a forecast.
By Michael Duane Archer
Michael Duane Archer has been an active futures and FOREX trader for more than 35 years. He has worked in various advisory capacities, notably as a commodity trading advisor, registered SEC investment advisor, and branch manager for Heinold of Hawaii. He currently trades FOREX and futures and is involved in several technical analysis research projects.

Copyrighted 2016. Content published with author's permission.

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