Elliot Wave, Gann, TED Spread and ATR

Q. What is your opinion of Elliott Wave Theory and Gann Theory? Do these methods work?


A: William Gann was a stock market trader of the early 1920s. Basing his theories on very old maths and the study of numbers as well as geometry and astrology, he claimed that his market concept cycle theories originated from the Holy Bible! In practice, Gann Theory points out that certain geometric price patterns and angles have special significance that when taken into consideration can predict future price action. He believed that the 'Law of Vibration' drove financial markets; which law forecasts future market price action with a good degree of accuracy. Additionally, Gann believed that the 'Rate of Vibration' of individual securities and futures determines the up and down movements of their prices.

On the other hand Ralph Elliot (an accountant) developed his theories in the 1930s. Elliot stated that market price action tends to follow specific patterns, which technical analysts today refer to as 'Elliot waves'. In a nutshell his research concluded that the stock markets follow a pattern of five waves up and three waves down. Ralph went on to publish his views of market action in the book 'The Wave Principle' (1938), and again in a number of articles in Financial World magazine in 1939, and culminated in his final major project, Laws - The Secret of the Universe (1946). Elliot believed that people are rhythmical and their actions and decisions could be forecasted in rhythms, as well. However, opponents argue that the Elliot Wave Principle has no scientific basis and opposes the efficient market theory.

Does this suffice to answer your question? Trying to forecast the stock markets basing oneself on mathematical formulae, natural law or even people's rhythm is akin to attempting to predict individual human behavior on the same theories. My initial opinion is that traders who try to trade on those theories are no more successful than those who trade on Dow Theory or any other theory for that matter...

Q. What is the TED Spread and how can it help you make investment decisions?

A: The TED Spread represents the price difference between the three month futures contract for US Treasuries (aka T-bill) and the three month eurodollar futures contract hence the TED.

The TED Spread measures the difference between the yield on the 3-month Treasury Bill (T-bill) and the value of the euro dollar futures contract, which is based on the 3 month LIBOR rate. To calculate the TED Spread, simply subtract the yield on the 3 month T Bill from the value of eurodollar futures contract. For instance, if the value of the euro dollar contract is at 3.75% and the yield on the 3 month T Bill is at 2.25%, the TED spread is 1.50% or 150 basis points.

So what does the TED Spread tell us?

The TED Spread can be used as an indicator of credit risk. This is so because (so far at least) US T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers.

As the TED spread increases it indicates that either interbank trust is falling (banks charging each other higher interest rates because of default fears) or investors are crowding to buy T bills because they believe stock markets are faltering. It also confirms that credit markets are not functioning as smoothly as they should.

On the other hand when the TED spread is decreasing, it can signify that banks believe the other banks they are lending to have a lower risk of defaulting on the loans so they are charging a lower interest rate charge to offset this risk or that investors are selling T-bills because they believe their money will perform better in the stock market. i.e. investors have regained their appetite for risk. A decreasing TED spread can also signal potential economic expansion.

The normal range of the TED is below 0.5% and back in September/October 2008 it spiked up to about 5%. Understanding the TED Spread and its significance has to be seen as just one more tool in your trading armoury but as always must be considered in the broader context of the market.

Q. How do you measure the daily fluctuations or volatility of a share?

A: The average true range (ATR) measures the volatility of a stock i.e. the ATR is used as an indicator of a market's daily price fluctuations. Although the indicator was originally designed to measure volatility in commodities, it can also be used for stocks and indices. The ATR indicator takes account of gaps in prices unlike other measurements of historical volatility. The true range is founded on either the difference between the peak and trough of a day, the difference between the previous day's peak to the trough and the difference between the previous day's peak to the peak.

When the previous day's lowest point is greater than the day's highs - as in the case of a sharp gap down - the true range will probably be the difference between the previous day's close and the peak. Conversely, when there is a sharp gap higher, the true range will likely be the difference between the previous day's close and the low of the day.

The ATR is just the average of the 'true ranges' over a determined period of days which is usually 2 weeks. As with moving averages, as each day of new data is added, the last calculation is left out. The ATR helps to spot the historic highs and lows where volatility is concerned. A dropping range means that volatility is retreating. A historic low can signal an imminent strong move to the upside while historical highs will lead to lower volatility.

High volatility periods usually occur during sharp swings and strong moves in a stock or index while low ranges happen during periods of quiet trading. Sometimes the ATR indicator is coupled with another indicator referred to as standard deviation to help determine big moves with more accuracy (it can also help determine appropriate stop loss levels).

 ...Continues here - IG Index - Autochartist?

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