Monthly Chart

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TQ 20/20 © 1991 CQG Inc.

Figure 7.13 Monthly Bar Chart of Soy Bean Futures-trading on the tong-term 2B. This monthly bar chart (each bar on the chart represents 1 month) of soy bean futures shows several long -term 2Bs. At point B, the 2B presents an excellent selling opportunity when prices failed through the highs established in A. Point 2 is a long-term 2B which is an excellent buying opportunity when prices break out above the tows established in t. At point 4, trading by the 2B criterion would have caused a long-term investor to be "whipped out" at feast once. But the losses taken would have been very small relative to the ensuing long-term movement which finally followed where you should have re-established your long position.

off the high previous high of 2752.10 set on September 1. All related averages were also selling off. The chances for a 213 failure were high going into October 13. The rest is history. With a little push from the news, the market plunged 191 points on panic levels of volume.

THE CAUSE OF TESTS AND THE 2B PATTERN

To identify the roots of these patterns, you must understand what happens on the floors of the exchanges. The floors of the commodities exchanges, for example, are made of locals and brokers-professionals trading on their own account, and those who execute trades for others for a commission, respectively. Many of the brokers also trade on their own account. While the brokers execute orders for their clients, the locals always attempt to follow the daily trend, to move with daily tides of price movements.

Daily Chart

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TQ 20/20 01991 CQG Inc. Figure 7.14 The Dow Industrial and Transportation Averages, showing an in tetmediate 213 on the Dow Industrials. The Transports fail to confirm, further supporting the shorting opportunity.

People who trade the commodities markets from the outside through brokers frequently use stop orders. A stop order is an order to buy or sell "at the market" (the current market price) once a stated price in that order is reached or passed through. For example, when making an S&P 500 futur es trade you might say to your broker, "Buy me five March S&P futures at 356.20 stop." If the market was trading at 356.10 and then shot up to 356.40, the floor broker holding your order would buy you five contracts at whatever the current market price was because your stop had been "hit."

Traders often use stops to limit their losses. A trader might, for example, buy five contracts at the market, and then put an order to sell five at a stop at some level where the market proves him wrong. Because locals are in "the pit" every day, the good ones develop a sense for how the world trades -in particular, where people set stops on their trades. In the absence of significant news, the only concrete points of reference for setting stops are previously set highs or lows, whether of a major or minor nature.

Aware of these stop points, the locals as well as the brokers who trade on their own account have a vested interest in driving prices slightly above or below these "resistance" or "support" points to force execution of the stop loss orders. This is called, "taking out the stops." After the stops are executed, the market will readjust. This is exactly what happens in the case of most 2Bs and is typical action

in all markets. Taking out stops is most prevalent n a short-term basis, but it also applies to the intermediate and long term. In the stock market, there is another subtlety which comes into play.

The floor of the stock exchange also has locals and brokers, but the locals are called "specialists"-men and women who specialize in trading specific stocks allocated only to them. They operate from a "book"-a list of orders to buy and sell specific quantities of stock at certain prices. It is the specialists job to "make the market," to put together buyers and sellers for the stocks) that they handle in an orderly fashion.

Often, the quantities of stock in the book are in the tens of thousands of shares, and the specialists are paid a flat fee per hundred shares traded upon execution, in effect, as a broker. It is obviously in their interest that prices move so that they can execute their larger orders, and they have the advantage of knowing ahead of time what the long and short interest of their stocks are, at least with respect to their books.

The talented traders, the big players that trade in size, know the identity of the specialists and can develop a feel for the levels at which large orders exist in their book by observing specialists behavior. If so, then they, too, have an interest in driving the price movement to the point at which the large orders exist.

For example, suppose that, in the middle of a bull market, 5000 shares of IBM are bid at llO/s, 5000 offered at 4. The specialist has buy orders for 10,000 shares at X, 20,000 shares at 1/2, and anoth er 20,000 atV

A smart trader, a big player that the pack may follow, has a feel for the specialists book and buys 5000 shares on his own account at Y8. The other traders who are aware of his activity follow suit, assuming accurately that the specialist h as buy orders to execute on the way up. A long interest is generated on the floor for IBM. Volume swells, the price ticks up, and the specialist executes his orders, makes his commissions, and also makes profits by buying and selling for himself on the way up, knowing that he has nothing to lose. All the way up, the traders are driving the move and profiting along the way. When the momentum of the move finally plays out, the price corrects back down.

There is another subtlety in the world of the specialist. When I said that he makes money buying and selling for himself in a rally, that really isnt quite accurate. What happens is this: Prudential calls the specialist and says, "Buy me 1,000,000 shares of IBM." The specialist says, "Oh youre a buyer of a million shares-what a coincidence-so am I!" This puts him at "parity" on his purchases of IBM with Prudential.

Every time he buys 10,000 shares, he gets 5000 and Prudential gets 5000. Now, long interest builds for IBM as I described above. But, unlike Prudential who buys the stock to hold, the specialist buys the stock to feed the rally; that is, he buys the stock and then sells it on the next uptick, and he does it all the way up knowing that the move will carry because it is right there in his book! It is no wonder that the specialist business is passed on from one generation to the next; it is the most risk -free way to make a lot of money that exists in the financial markets.

Obviously, specialists cant act irresponsibly. If they attempt to drive price movements with disregard to the interest of those whose orders they execute, they are likely to be censured and will surely lose their bread and butter commission business, as well as any future allocations of new stocks listed on the NYSE. The point is that the observable patterns that are detectable in chart watching have their basis in large part in the activity of professionals on the floor of the exchanges.

This whole discussion of the 2B and how it occurs presupposes market activity in the absence of major news or new developments in any particular security or market. To trade on the 2B observation alone without particularized knowledge can be very risky, especially in the commodities markets, which are so news sensitive. But when used in the widest context of knowledge available, this observation can make the speculator a lot of money.

THE ABCs OF SECONDARY CORRECTIONS

Elliot wave theory is, in my opinion, too subjective to be of general use in pro fessional speculation, but