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Futures Trade Desk- Charting Technical Waves

Trade Desk Client Note

Global Futures Market Review

Charting Technical Waves

Technical wave analysis makes use of market momentum and sentiment flows that can be used to clarify the direction and magnitude of price movements.  This process involves examining wave patterns on two time-frames in order to identify trend changes and potential reversals. 

Wave counting and analysis can be subjective, and is best implemented as a confirmation tool of any potential that has been highlighted by sentiment, momentum, or fundamental changes.

Reaching across all time-frames, market momentum waves tend to be most apparent and more reliable when viewed on mid and long-term charts (1H, 4H, and Daily).

Technical reviews make up a part of a balanced analysis program which should also include the impact of breaking economic headlines, participation levels, times of day, globally correlation strengths, and overall sentiment reads.

Five Wave Pattern: Dominant Trend  

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern.

Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, the most distinguishing feature of fourth waves is that they often prove very difficult to count.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high, the indicator does not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

Three Wave Pattern: Corrective Trend  

Wave A: Corrections are typically harder toidentify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.